This is the fourth in our series of articles on venture capital trusts.
(This article can be downloaded in pdf format in portrait or landscape version at Academia.edu.)
In this article, we shall be exploring the conditions that describe what the portfolio looks like “on the outside” – the rules governing the type of investments that can be made, the way in which the company’s income must be distributed, and how much of the portfolio must be invested in the riskier class of assets that are the basis of the Venture Capital Scheme.
These conditions relate to how the portfolio is structured. Having covered these topics, subsequent articles will take a closer look at the inside of the portfolio. In particular, we shall explore the nature of the high growth companies that a VCT typically invests in, and the conditions they must satisfy in order to raise funds from investors.
As a reminder, we are here on the roadmap:
So what are the conditions that the portfolio must satisfy?
The VCT must satisfy the following conditions throughout each accounting period1:
- Its income must be derived wholly or mainly from shares or securities (the nature of the income condition);
- The VCT cannot retain more than 15% of its income from shares and securities (the income retention condition);
- No holding in any company represents more than 15% by value of the portfolio (the 15% holding limit condition) (this excludes holdings in other VCTs);
- At least 70% by value of the VCT’s investments are in qualifying holdings (the 70% qualifying holdings condition).
The last condition goes to the heart of what a VCT is about. The portfolio is split between the special high growth companies that the Venture Capital Scheme is intended to benefit, and those companies that are “not as high growth”.
One can think of the portfolio as being a split between a high risk sector on the one hand (the qualifying holdings) and “safer” investments on the other (the non-qualifying part). However, this can give a misleading impression – just because an investment is non-qualifying, doesn’t necessarily mean that it is safe. For example:
- The VCT may have shares in a company that would have been in the “qualifying pot” but for the fact that it fails one particular condition. For example, the VCT may have bought the shares secondhand instead of subscribing for them2;
- The VCT holds shares listed on the main London Stock Exchange. While this may give some degree of security, there are different degrees of safeness. “Safe” is a relative term – a listed small cap is normally regarded as less safe as a blue chip – and even the latter can fail spectacularly.
Unicorn AIM VCT
We shall now consider each of these conditions in greater detail. To accompany us on our journey, we shall have recourse to the Annual Report of a real live VCT to see how it works in practice. The Unicorn Aim VCT (“Unicorn”) has the objective of providing its investors with:
“…an attractive return from a diversified portfolio of investments, predominantly in the shares of AIM quoted companies, by maximising the stream of dividend distributions to Shareholders from the income and capital gains generated by the portfolio.”
This is what it says on the front page of the latest Annual Report for the year ending 30 September 2013, which can be downloaded from the company’s website. It is worth noting that Unicorn is very careful how it manages its business activities to keep within the VCT rules3:
“It is also the objective that the Company should continue to qualify as a Venture Capital Trust, so that Shareholders benefit from the taxation advantages that this brings. To achieve this at least 70% of the Company’s total assets are to be invested in qualifying investments of which 30% by value must be in ordinary shares carrying no preferential rights to dividends or return of capital and no rights to redemption.”
“The past twelve months have seen an improvement in the number of successful Initial Public Offerings on AIM. Despite this increase in deal flow, the Investment Manager has maintained a highly selective approach to new investment. As in previous years, the Company has remained comfortably above the threshold required to retain VCT qualifying status and this has allowed the Investment Manager to maintain a disciplined and cautious approach to making new investments.”
Income from shares or securities
HMRC will consider the condition to be satisfied if at least 70% of the VCT’s income is derived from shares and securities4. This condition tells us that the VCT’s investments come from holdings in other companies, as opposed to land and other alternative assets.
Shares denote any type of share, not just ordinary shares5. So it is quite possible to hold preference shares, and this is recognised in Unicorn’s Annual Report6, though at the time of writing, no such investments are held. However, as we shall see in the next article, a certain level of qualifying investments must take the form of ordinary shares.
Securities include any type of loan, whether secured or unsecured, and also include loan or debenture stock7. The overriding proviso is that the investment cannot be realised within five years. In particular, the terms of the loan must not permit the VCT or anyone else to demand repayment, or repurchase or redemption of the stock within this period. The one exception is where a loan is made on normal commercial terms which require repayment in the event of a default8.
This makes sense when we recall that the Venture Capital Scheme offers tax breaks in exchange for investors taking higher risks. Just as investors who subscribe for VCT shares are locked in for a fixed period, so are VCTs that provide loan finance to the companies making up the portfolio.
The income retention condition
This is effectively a requirement to distribute most of the VCT’s income, a requirement shared by other types of fund vehicle. For example, investment trusts are also required to distribute at least 85% of their income9, while REITs must distribute at least 90%10. This reflects the fact that we are dealing with a fund, which is a conduit between investors on the one hand, and the underlying investments on the other.
Another similarity with investment trusts becomes apparent if we rephrase the condition to read that a VCT is permitted to retain up to 15% of its income. As with investment trusts, VCTs can build up reserves for a rainy day, and draw on these funds when the income from the portfolio companies falls short. This is important, especially for those VCTs with a remit to provide their shareholders with an income in addition to capital growth.
(Note that the requirement to pay out 85% of income is subject to the corporate rule that the dividend must be lawful11. There is also a certain income threshold of £10,000 below which the condition to distribute doesn’t apply12).
The 15% holding condition
The 15% holding condition applies to a holding in any company – this is not necessarily restricted to the high growth companies in the qualifying part of the portfolio. The reasoning behind this is obvious, and reflects a well known investment principle of not putting too many eggs in one basket.
It should be noted however, that the legislation requires the VCT’s assets to be valued not at current value, but at book value – the value of the shares or securities at the time they were acquired13. Provided that the 15% rule is satisfied at this point in time, any subsequent increase in value of a holding will not impact the VCT’s tax status. This is the position even where it is possible to track the daily movements of the investee company’s share price on AIM, as is the case with many of Unicorn’s investments.
The 15% rule is mentioned in Unicorn’s Investment Policy14:
“Asset allocation and risk diversification policies, including maximum exposures, are to an extent governed by prevailing VCT legislation. Specific conditions for HMRC approval of VCTs include the requirement that no single holding may represent more than 15% (by value) of the Company’s total investments and cash, at the date of investment [emphasis added].”
However, it appears that the company also applies a separate 15% rule of its own when deciding whether to sell an investment. This is what the Fund Manager says15:
“The stock specific risk that arises as a consequence of having made particularly successful investments is managed by a practice of not allowing an individual investment to account for more than 15% of total assets at any time.”
The Fund Manager then goes on to mention how the company has made a partial divestment of Abcam, one of its most successful holdings, whose value appreciated by 26% during the year. The end result is that Abcam constitutes about 12% of the fund’s total assets.
It is tempting to regard this as a direct application of the 15% holding condition. However, on closer reflection, this is not in fact the case.
The Fund Manager is not concerned about breaching a tax rule, but is concerned about an investment which has become too successful. It must have satisfied the 15% holding rule when Unicorn first bought the shares – as mentioned, any subsequent increase in value cannot affect the VCT’s tax status.
However, a subsequent appreciation in value can lead to an investment dominating the portfolio. Unicorn deals with this situation by not allowing the holding to account for more than 15% of total assets at any time. In other words, the 15% figure is applied to the current value, not book value.
So for tax purposes, the partial divestment in Abcam wasn’t actually necessary. Unicorn was applying a different 15% rule which reflects the company’s policy of being financially prudent, rather than simply maintaining VCT status.
There are however, two occasions when the VCT is required to revalue a holding16:
- If the VCT makes an additional investment in the company17 – but the adjustment is only made when the additional securities are of the same type as the original18. For example, no revaluation takes place if the VCT holds ordinary shares, and subsequently acquires loan stock;
- A payment is made in discharge of an obligation attached to the holding, and this causes the value of the holding to increase19. For example, where the VCT has subscribed for shares that are partly paid, and subsequently pays the balance owing.
The 15% rule has been the subject of controversy recently. In March 2014, two of the Oxford Technology VCTs (VCT1 and VCT3) had their approval withdrawn by HMRC when the share price of one of their holdings “rose rapidly so that the rule was inadvertently breached as a result of a small funding round”. As a result of an appeal, HMRC reversed its initial decision, subject to deciding the issue afresh, and upon hearing further representations from the companies’ tax advisers. At the time of writing, HMRC has stated that the companies can retain their status as VCTs subject to satisfying certain conditions. Eventually, the companies were permitted to retain their VCT status subject to satisfying certain conditions imposed on them by HMRC.
The 70% qualifying holdings condition
The last condition goes to the heart of what a VCT is about. Qualifying holdings are the high growth companies that are the intended beneficiaries of the Venture Capital Scheme. It is these companies that investors are effectively financing when they subscribe for their VCT shares.
The idea is that the bulk of the portfolio is concentrated on risk. But we can turn this condition around as saying that up to 30% of the portfolio can be in non-qualifying holdings. The 30% zone provides an element of (relative) protection to investors, depending on how the VCT decides to fill this part of the portfolio. The holdings can be safer and more conventional, such as money market funds, cash, gilts or even other income orientated securities to draw on especially if the remit is to provide investors with dividends.
One point to note – the VCT’s exemption on selling its investments applies to all its holdings, not just the qualifying part. This is in contrast to REITs, where the exemption applies only to the company’s rental properties20.
At the end of the financial year to September 2013, Unicorn held over 75% of its total assets in qualifying companies, so they are comfortably within the limits set out in the legislation21. This is what they say about their investment policy22:
“Where capital is available for investment while awaiting suitable VCT qualifying opportunities, or in excess of the 70% VCT qualification threshold, it may be invested in collective investment funds or in non-qualifying shares and securities in smaller listed UK companies. Cash and liquid resources are held in low risk bank accounts and money-market funds.”
The company has a list of its investments which shows how they are divided between the qualifying and non-qualifying part23. The non-qualifying holdings are of particular interest – they include money market funds and OEIC funds managed by the company’s Fund Manager Unicorn Asset Management. One stock, the Mears Group, is actually listed on the main London market.
A number of questions arise, as to how to maintain the 70% condition:
- How can this condition hold at the VCT’s start-up phase, when it is raising money from investors for the first time?
- What happens when the VCT issues further shares?
- What happens when a VCT sells an investment?
The common theme arising from each of these questions is the part that cash plays in the portfolio. Cash is regarded as an investment24, but not a qualifying investment – so a sudden influx of funds can alter the balance between the two parts of the portfolio. What is the position if the balance falls the wrong way, so that the proportion of qualifying investments dips below the 70% threshold?
Cash in the portfolio – what happens when the VCT issues shares to investors?
This isn’t actually a serious problem. When the VCT is in start-up phase and seeking HMRC approval, the company has three years in which to put together the portfolio and comply with the 70% rule25. There is a similar period of grace involved when further shares are issued – the extra cash will not begin to impact the VCT’s status until three years have passed26.
What happens when the VCT sells an investment?
If the investment is a qualifying holding that has been held for at least 6 months, the following rules apply27:
- The VCT is deemed to continue to hold the relevant shares or securities for a further 6 months;
- The value of the holding will be the value it held just before disposal. This will be the book value, unless an adjustment was required to be made under the rules previously discussed;
- There will also be an adjustment to the value of the portfolio to take into account any cash profit realised on the sale.
In other words, the portfolio is effectively “frozen in time” for a 6 month period by pretending that the investment was never sold. The adjustments are made in order to maintain the proportion of qualifying holdings at above the 70% level. This can clearly be seen in the example given in the HMRC Venture Capital Manual28.
This calculation doesn’t apply to any part of the consideration that consists of shares or securities of another qualifying holding. This makes sense, since the new holding partly fills the gap left by the old.
But what happens when a non-qualifying holding is sold? Surprisingly, there is no special adjustment here. At first glance, it would appear that no such adjustment is needed, since the sale of a non-qualifying investment can only improve the proportion held by the qualifying part. But this doesn’t take into account the valuation rules set out in the legislation, as the following example shows.
This example is an adaptation of the one found in the HMRC Manual. We assume that total assets are valued at £2m, with the qualifying part valued at £1.5m. We are therefore within the 70% limit.
Now suppose that instead of selling a qualifying investment, the VCT sells a listed security such as the Mears Group. The book cost is £200,000 and the sale price is £400,000 giving a profit of £200,000. This is what the position looks like:
Qualifying holdings now make up 68% of the portfolio. The problem arises from the fact that holdings are valued at book cost and don’t take account of any capital appreciation, until this gain is realised on sale. The extra £200,000 added to the non-qualifying part is the profit element arising on the sale of the investment. If it had been a qualifying holding, this profit element would have been ignored for the following 6 months.
We are nearing the final stages on our journey into the world of Venture Capital Trusts. In the next article we shall be taking a closer look at the individual companies that the VCT invests in.
The author holds no shares in any of the companies mentioned in this article. None of the comments in this article should be considered as a recommendation for investing in these companies.
- ITA 2007 s 274(2). Note that there is one condition listed under this section that we shall not be discussing in this article. This is the 70% eligible shares condition, which we shall look at in the next article ↩
- ITA 2007 s 286(2)(b). ↩
- Unicorn Annual Report 30 September 2013, front page and Chairman’s Statement page 2. Note that the reference to the requirement to hold 30% by value of qualifying investments in ordinary shares is incorrect. The figure used to be 30% but was upgraded to 70% – this is the 70% eligible shares requirement in ITA 2007 s 274(2). ↩
- HMRC Manual VCM54050. ↩
- Note the definitions section ITA 2007 s 332, which makes a distinction between shares and ordinary shares. ↩
- Unicorn Annual Report 30 September 2013 Note 10 “Significant Interests” on page 52. The second column refers to investments in loan stock and preference shares. ↩
- ITA 2007 s 285(2). ↩
- HMRC Manual VCM54090 and SP 8/95. ↩
- Investment Trust (Approved Company) (Tax) Regulations 2011 SI 2011/2999, reg 19(1). ↩
- CTA 2010 ss 530(1)(b), 530(4)(b). ↩
- ITA 2007 s 276(5). ↩
- ITA 2007 s 276(4). ↩
- ITA 2007 s 278(2). ↩
- Unicorn Annual Report 30 September 2013, page 10. ↩
- Unicorn Annual Report 30 September 2013, pages 11-12. ↩
- ITA 2007 ss 277(1), 278(3). ↩
- ITA 2007 s 278(3)(a). ↩
- ITA 2007 s 278(4)(a). ↩
- ITA 2007 s 278(3)(b). ↩
- TCGA 1992 s 100(1) for VCTs and CTA 2010 ss 535(1), (2), (3) for REITs. ↩
- Unicorn Annual Report 30 September 2013, page 14. ↩
- Unicorn Annual Report 30 September 2013, Investment Policy, page 10. ↩
- Unicorn Annual Report 30 September 2013, page 16. ↩
- ITA 2007 s 285(4). ↩
- ITA 2007 ss 275(2), 275(3)(b). ↩
- ITA 2007 s 280(2). ↩
- ITA 2007 s 280A. ↩
- See VCM54110. ↩
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