Share buybacks are an attractive way in which VCT investors can realise their investment. However, HMRC is concerned that this technique is also being used to access another round of tax relief, without necessarily supplying new cash to the businesses for which the scheme was intended to benefit.
So what is the problem, and what is the Government proposing to do about it?
A recap on VCTs – what are they?
A VCT 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.
Because of the risky nature of the underlying investments, investors are rewarded with tax breaks. The specific tax break that is the focus of HMRC’s concern is that relating to upfront relief.
Upfront relief is available to those investors who acquire their shares by way of a share subscription. Provided they are within the annual limit, for every £100 invested, they get back £30 – not only does this reduce their tax bill, but it also reduces the cost of the investment, thereby boosting the overall rate of return.
Why are share buybacks so useful?
One of the conditions for being a VCT is that it must be listed on a regulated market, which includes the London Stock Exchange1. At first glance, this would appear to be a significant advantage, especially in comparison to the other venture capital schemes requiring direct investments in unquoted companies. Because VCT shares are listed, there is a ready market for investors looking to sell.
In practice however, VCT shares tend to be illiquid, with quite significant spreads between bid and offer prices. Just because there is a market, doesn’t mean that buyers will be virtually guaranteed for the price quoted – it depends on the stock. VCTs don’t fall into the same class as the Glaxos and Vodafones of this world, whose shares change hands a zillion times a day.
Share buybacks offer an attractive alternative for achieving an exit. Instead of going to the market and taking the price on offer there, the VCT itself steps in and offers to buy back the shares at a more acceptable price. This has a number of advantages:
- Firstly the investor gets the price he wants, or better than he might have achieved elsewhere;
- If the VCT has cash reserves, but there are no further investment opportunities on offer, returning funds to shareholders makes more sense than leaving the money idle;
- The remaining investors are benefited as it boosts overall net asset value per share.
So what’s so wrong with share buybacks?
This is explained in the Consultation Paper that was published in July and which you can download here.
The Consultation Paper specifically states that there is nothing wrong in principle, in buying back an investor’s shares, where the object is to enable an exit which would otherwise be difficult to achieve2. What HMRC finds objectionable is the practice of investors using the money to subscribe for further VCT shares, in order to obtain a second round of tax relief.
Consider the following scenario.
An investor has subscribed for VCT shares and has remained invested for at least five years. This means that the upfront relief cannot be clawed back if he chooses to sell his stake. The VCT uses its cash reserves to buy back the shares, and the investor uses the sale proceeds to subscribe for further shares, in a new round of fundraising. This can either be from the same VCT or another VCT run by the same fund management group.
There are two objections from HMRC’s point of view:
- The investor has effectively obtained double tax relief on what is really a single investment;
- The money has simply been recycled – no new money is finding its way into the high growth companies that the VCT scheme was intended to benefit.
This is compounded in cascade arrangements, where the same amount of VCT cash is used in a continuous stream of buybacks3. So:
- Cash reserves are used to buy back shares from a small group of investors, called the A group;
- These investors subscribe for further shares to obtain a further round of tax relief – so the money goes back into the VCT pot;
- The VCT now uses the same money to buy back shares from a second group of investors, called the B group;
- The B group subscribes for further shares, obtaining tax relief, so the money goes back to the VCT;
- The VCT uses this money to buy back from a third group, the C group…and so on.
Continuing in this way, it is possible for all of the investors to take part in the buyback process, all getting a second round of tax relief, and yet the funds employed in this process are disproportionately smaller than the total amount needed to buy everyone off. In the meantime, none of this money is actually being invested into the business cycle.
So what are the proposals?
There are two options available:
- The preferred option is to set limits on the investor;
- Alternatively, one can set the relevant constraints on the VCT itself.
The first option is preferred because it is simpler. There are already myriad rules governing the VCT’s behaviour – adding even more rules means adding even more complications4.
What are the proposals for investors?
There are two new rules that are being proposed5:
- A rule restricting tax relief when subscribing for shares within (for example) a 6 month period of exiting an investment through a share buyback. This would apply on reinvesting the sale proceeds in the same VCT or in another VCT run by the same fund management group;
- In addition, tax relief may be restricted when the share buyback is subject to an understanding that the funds will be reinvested in the same VCT or another VCT in the same fund management group. In other words, this would apply when the reinvestment takes place outside the relevant period mentioned in the first condition.
Note that it is a restriction rather than a disqualification. For example, if the sale proceeds are £10,000 and this is reinvested within the proscribed period, no further relief is obtained. However, if £12,000 is reinvested, then relief for the £2,000 excess is permitted, as this is new money.
Furthermore, the restriction applies when reinvesting in either the same VCT or another VCT from the same fund management group. There is nothing to stop an investor from using the sale proceeds to fund an investment into a different VCT provided by another venture capital outfit.
What are the proposals for the VCT?
There are two options6:
- A rule requiring at least 70% of all funds raised to be invested in qualifying holdings. This would be additional to the current rule that at least 70% of investments must be in qualifying holdings7. The idea is that this requirement limits the funds available for a share buyback, especially where cascade arrangements are involved;
- Alternatively a rule to prevent VCTs from buying back shares with funds raised from any share issue that took place within the previous three years. This rule assumes that the money has come from more recent share issues rather than from older ones.
However, as stated above, HMRC doesn’t favour adding to the already complex rules governing how VCTs operate. It is simpler to impose restrictions on the investor.
While one can understand the mischief in buying back shares and recycling the funds within the same VCT, it is not necessarily the case that mischief is afoot when the funds are reinvested in another VCT from the same fund management group.
In the first place, while two VCTs may be run by the same fund management group, they are not actually within the same economic family as is the case with a corporate group. It is tempting to regard them as related, especially if they have been branded with the name of the fund managers. For example, fund managers Acorn will label their VCTs as Acorn General VCT 1, Acorn General VCT2, and so on.
However, they are distinct economic units, and this is especially apparent if the VCT Board decides to change fund manager if investment performance is unsatisfactory. In these circumstances the VCT will be rebranded with the name of the new fund management team.
Secondly, there may be good reasons for buying back the shares and recycling into another VCT. Suppose we have a VCT with cash reserves that it cannot find a suitable home for. For example:
- The size of the fund may be such that it is harder to find further investments that will add value to the portfolio;
- Alternatively, there may be a number of suitable investments, but they all lie outside the VCT’s mandate. For example, Acorn Wind Farms VCT cannot invest in a company providing testing equipment for the oil and gas industry – but Acorn Generalist VCT, or Acorn Oil and Gas Ventures can.
In these circumstances, using the proceeds of a buyback to reinvest in another VCT makes sense. The fact that the second VCT is run by the same fund management group should not make a difference.
The consultation process ends on 26 September, and the aim is to have new legislation in place by April 2014. But this shouldn’t be taken as a signal for a glut of buybacks before the new rules kick in, as the Government has stated that they may backdate the legislation8.
Anyone who wishes to participate can send their comments in writing to: Nalini Arora, firstname.lastname@example.org, or by post to: Venture Capital Trusts Share Buy-backs Consultation, c/o Nalini Arora, 3/63, 100 Parliament Street, London SW1A 2BQ.
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