Venture Capital Trusts (VCTs) bounced back in 2020/21, raising 4% more cash than the previous year and almost twice as much as a decade earlier.
The current tax year is expected to see even more cash flood in, as investors shelter their money from dividend tax rises in April. But while the tax benefits are impressive, VCTs come with huge risks, so we can’t let the tax tail wag the investment dog.
Demand for VCTs waxes and wanes depending partly on rule tweaks. In 2019/20 demand fell back because the rules were tightened to restrict where VCTs could invest, which made them a riskier prospect. The change was made in 2017, but it took effect more gradually.
It’s also driven by changes in tax rules, and the 1.25 percentage point rise in dividend tax is expect to trigger a bumper year for VCTs. Demand also soars every time pension allowances get less generous, forcing those with higher incomes and large pensions to look elsewhere for tax relief. They came close to record highs between 2017 and 2019, when the pension lifetime allowance dropped from £1.25 million to £1 million.
What are Venture Capital Trusts?
Venture Capital Trusts (VCTs) are quoted private equity funds whose shares trade on the London stock market. The VCT aims to make money by investing in other companies. These are typically small companies which are looking for investment to help develop their business.
A VCT typically invests in around 20 businesses. These are chosen by the VCT manager – looking for opportunities amongst fledgling companies, and trying to negotiate attractive deals for investors. They have to be smaller and younger businesses in specific sectors in order to qualify.
There are a few common types of VCT: the generalists invest across different industries and sectors – although they’ll have a specific investment strategy to narrow down target companies; the specialists focus on specific sectors, which typically means even less diversification and higher risk; and AIM VCTs invest in new shares issued by AIM companies and tend to be easier to buy and sell. They will usually either run for the long term, or for a limited period – usually around the five year minimum allowed for VCTs – at which point they will sell out of the investments and distribute the money.
What is the appeal of Venture Capital Trusts?
Tax-efficient investment gets more difficult as your income and your pension grow. The tapering of pension allowances for higher earners, the introduction of annual allowances and the shrinking of lifetime allowances have all meant investors looking elsewhere for tax relief. ISAs are a sensible first port of call, but once the annual allowance is used, they will cast the net wider, and VCTs offer substantial tax perks.
“The right VCT investment doesn’t just offer tax breaks, it also aims to offer significant capital growth and provide a stream of higher dividends, which look particularly striking at a time of lower interest rates,” explains Sarah Coles, Senior Personal Finance Analyst at Hargreaves Lansdown. “However, these investments are much riskier than mainstream options. Some of the companies they invest in are the growth stories of the future, whereas others will fail entirely. It means VCTs are sophisticated, long-term investments only suitable as a small part of significant portfolios. Investors also have less choice than in previous years: we’ve only seen this few VCTs once before in the past decade. It means more investors chasing fewer opportunities.”
It’s also difficult to access the capital invested in the short term, Coles says, because they invest in illiquid investments, which can be difficult to sell. They also usually trade at a discount to their net asset value, because second hand VCTs don’t offer up-front tax relief, so are less attractive to investors. It means they are niche, risky, long-term investments.
VCTs have become even more risky over time too as the rules for what qualifies have become stricter, and larger more established companies have been excluded – along with those supported by subsidies.
If there’s a sensible place in your large and diverse portfolio for VCTs, they offer some impressive benefits, but if you invest purely for tax reasons, and don’t consider the risks involved carefully, you could be making an expensive mistake.
What are the tax perks of VCTs?
When you invest you get income tax relief, up to a maximum of 30% of the amount invested (capped at £200,000 per tax year). This can be offset against income tax in the year you invest. If, for example, you invest £100,000 in a VCT, you’ll be able to cut your income tax bill by up to £30,000 in that year. However, the amount you can cut it by depends on your tax bill. So if in that year you only pay £15,000 in income tax, you could only reduce your tax bill by £15,000.
Any dividends are tax-free too, and any growth isn’t subject to capital gains tax. However, the rules on VCTs have changed in the past, so your tax benefits will depend on the investments within the VCT continuing to qualify if there are rule changes in future. You also need to hold the investment for five years to get the tax benefits.