This is the first in a series of articles on venture capital trusts, an investment vehicle designed for those who want to invest in growth stocks but who want the comfort of having a professional manager doing the hard work for them. (This article can also be downloaded in pdf format at Academia.edu.)
We shall start off by looking at the tax breaks on offer. But first…
What is a venture capital trust?
A venture capital trust – “VCT” for short – is a corporate vehicle designed to provide individual investors with access to a range of small, unquoted trading companies which have the potential for growth. The VCT raises funds by issuing shares to investors and the money is then allocated to those businesses that the managers judge to have the best prospects.
The VCT Scheme is one of a number of venture capital schemes that are currently on offer. VCTs can be considered to be the “fund version” of the Enterprise Investment Scheme (“EIS”) and the Seed Enterprise Investment Scheme (“SEIS”). Both of the latter schemes involve investing in a single unquoted company, with the onus on the individual to use his own judgement. VCTs provide an attractive alternative – investments are pooled to spread risk, and investors have the benefit of the fund manager’s professional experience.
Why invest in VCTs? These aren’t exactly widows and orphans type funds – given the nature of the underlying investments, VCTs carry considerable risk. However the prospects of above average returns can, together with the tax breaks on offer, be an attractive inducement. We shall now look at these tax breaks.
VCTs are tax efficient
At the corporate level, VCTs are taxed in the following way:
- Capital gains are exempt1;
- Dividends received from the companies making up the portfolio are also exempt2, but interest income on debt securities is taxable.
The exemption on capital gains is a key exemption shared with other types of investment fund such as investment trusts, unit trusts, OEICs and REITs.
The purpose of a fund is to act as a proxy for its investors, providing them with opportunities that might otherwise be unavailable to them as individuals. In these circumstances, the fund should be as tax transparent as possible. In particular, it is important that investment decisions taken at the fund level should not be distorted by tax considerations.
The exemption covers all the assets held in the portfolio, and is not restricted to the VCT’s “qualifying holdings” – these are the high growth companies that form the raison d’etre of this type of investment fund. As we shall see, these companies must make up at least 70% of the portfolio – which means the other 30% can be filled with other types of asset. In particular, the 30% part can include safer investments as ballast for the riskier part – it is useful that these too are exempt from capital gains.
What are the tax breaks for investors?
There are three tax reliefs:
- “Upfront relief”3 – an income tax relief of 30% of the amount invested, up to an annual limit of £200,000. The relief is available provided that the investor subscribes for ordinary shares, as opposed to buying them secondhand on the stock market. There is also a minimum holding period of 5 years – selling early can result in the relief being clawed back;
- Dividend relief4 – dividends on VCT shares are exempt. Unlike upfront relief, there is no minimum holding period and no requirement that the investor subscribe for the shares – they can be bought secondhand. There is however, a ceiling on the value of the shares that can be bought in any one tax year – in this case £200,000;
- CGT relief5 – no CGT is payable when selling the shares. Like dividend relief, the shares can be bought secondhand, with no minimum holding period. There is also a ceiling on the value of the shares that can be bought in any one tax year – in this case £200,000.
It must be noted that all reliefs are lost if the tax status of the VCT is withdrawn.
The attraction of upfront relief is that it effectively reduces the cost of the investment, thereby boosting overall returns. For example, shares priced at £1, have an effective cost of 70p after tax relief. The shares only need to rise by 40p and the investor has doubled his money. Furthermore, the shares need to fall by at least 30p before a loss is incurred (not counting any dividends).
The downside is that investors must subscribe for the shares and are locked in for a five year period. As noted, these restrictions don’t apply to the other reliefs.
The dividend exemption has proved very popular with higher rate taxpayers, given the various hikes in the income tax rates over the last few years. There is no need even to subscribe for the shares – they can be bought second hand on the stock market. Although upfront relief is unavailable, this factor may be sufficiently outweighed by the prospect of tax free dividends, especially in an environment where real returns on income are hard to achieve.
It is in fact possible to obtain the equivalent of upfront relief, by waiting for the price to drop after the VCT has listed. So a VCT with a subscription price of £1, but whose price drops to 70p after listing is a feasible candidate – and this has the advantage in that there is no lock in period and the “relief” can’t be clawed back. This would have been a viable strategy shortly after the credit crunch in 2008 when discounts on VCTs, private equity and property funds were as high as 40% or even higher6.
Which tax breaks are not on offer?
The following tax breaks are not on offer, although they are available for the other two venture capital schemes:
- Although the shares are exempt from capital gains, there is no tax relief for capital losses. Compare the EIS and SEIS schemes where losses can be set against other capital gains and against general income7;
- Reinvestment relief is no longer available. This is where a gain on another investment can be deferred by applying the sale proceeds to subscribe for VCT shares. This relief was abolished for share subscriptions taking place from 2004/05 onwards.
What are the conditions? Very complicated
There are reams and reams of conditions attached to VCTs. An exhaustive analysis isn’t possible in a single article, or even a series of articles. The following is an outline, of how we shall approach this, using a “top down” approach from investors at the top to the underlying companies making up the portfolio at the bottom.
So in the next articles, we shall look at the following:
- The investors – who are they, and how can they invest?
- The VCT – how is this structured?
- The investment portfolio – what does it look like as a whole?
Then we go on to look inside the investment portfolio itself, and in particular:
- Those investments making up the VCT’s qualifying holdings – what are they and what do they look like?
- The fundraising process – what are the conditions attached to obtaining finance from the VCT?
Hopefully, this “roadmap” will cover the most salient features. Although the conditions look complicated when reading the legislation – the language can be quite arcane at times – the easiest way to understand it all is to remember that:
- The tax reliefs are awarded in return for investors risking their capital; and
- The conditions are geared towards ensuring that this capital remains at risk throughout the life of the investment.
What this means is that investors can’t try and protect themselves by getting out early, or securing a guarantee for the investment – as we shall see, such attempts lead to the tax breaks being withdrawn.
So, onwards into the exciting world of VCTS…
Update 30 July 2015
It is important to note that for VCTs, the upfront income tax relief is detached from the dividend and CGT exemptions. In particular, the five year holding period only applies to upfront income tax relief – there is no need to hold the shares that long in order to benefit from the other tax breaks.
It is easy to fall into this mistake – no less a paper than The Times has made it. In last Saturday’s Money Section (Saturday 25 July 2015 at page 61), there is a piece on investing, and one section mentions the Venture Capital Schemes, saying that investors must hold on to their shares for five years to enjoy the VCT tax breaks. Of course, this is only true for one of the tax breaks, not all.
I wrote to the journalist who wrote the piece, pointing out their error, but only got an out of office autoreply saying that she was away on maternity leave and I should “Please try Anne Ashworth (email@example.com) in my absence.”
Alas no answer as yet. Well, I am only a very small cog in a very big wheel. But let’s hope that our intrepid financial journalists don’t make the same mistake again. More importantly, let’s hope no tax professional makes the same mistake either!
— Satwaki Chanda (@SatwakiChanda) July 30, 2015
- TCGA 1992 s 100. ↩
- CTA 2009 s 931A(3) – this is simply a consequence of the fact that distributions paid to companies aren’t normally taxable. ↩
- ITA 2007 ss 261, 262(3);263(2), 266. ↩
- ITTOIA 2005 ss 709(1), 709(4). ↩
- TCGA 1992 s 151A, ITTOIA 2005 s 709(4). ↩
- See the comments on the Motley Fool VCT Discussion Board. ↩
- TCGA 1992 s 151A(1) makes it explicit that capital losses are not allowable for VCTs. Contrast SEIS – TCGA 1992 s 150E(3), ITA 2007 s 131(2)(b); EIS – TCGA 1992 s 150A(2A), ITA 2007 s 131(2)(a). ↩
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