This is the second in a series of articles on venture capital trusts. In Part One we looked at the tax breaks on offer for those brave enough to risk their capital. In this article we shall take a closer look at the investors – who they are, how they can invest, and what are the strings attached to the investment.
(This article can be downloaded in pdf format in portrait or landscape version at Academia.edu.)
We are here on the roadmap:
We have already covered these in Part One, but a short recap will do no harm. There are three types of relief:
- “Upfront relief”1 – an income tax relief of 30% of the amount invested, up to an annual limit of £200,000. Investors must subscribe for the shares and hold on to them for at least 5 years;
- Dividend relief2 – no tax is payable on VCT dividends. The shares can be bought secondhand, and there is no minimum holding period, though there is an annual limit of £200,000 on the value of the shares that can be acquired;
- CGT relief3 – no CGT is payable when selling the shares. Like dividend relief, the shares can be bought second hand, there is no minimum holding period, and the same £200,000 limit applies.
All reliefs are lost if the tax status of the VCT is withdrawn.
Before we go on… a reminder and a summary
The key to understanding the conditions is to remember that these investments carry a high degree of risk. The bargain between investors on the one hand and HMRC on the other, is that the tax breaks are awarded in exchange for taking on this risk. This bargain would be broken if it were possible to structure an investment in such a way that reduces the chances of investors losing their money.
The following are the main conditions as they apply to investors:
- Investors must be at least 18 years old;
- There must be no tax avoidance motive attached to the investment4;
- The investment must take the form of equity – either eligible or ordinary shares;
Three conditions relate specifically to upfront relief:
- The purpose of the investment is to raise money for the VCT5 Recall that for upfront relief to apply, investors must subscribe for the shares. In this way, “new money” is made available to the growth companies that the VCT scheme is intended to benefit;
- Investors may borrow to fund their share subscription, but certain types of loan – “linked loans” – are not permitted;
- The rules on “linked sales” prevent VCTs from using share buybacks to enable investors to claim multiple amounts of upfront relief with the same funds.
We shall now look at the some of these conditions in more detail.
Investors – who are they?
Investors must be at least 18 years old in order to access the tax reliefs6. However, this condition is phrased in different ways, depending on which tax relief we are looking at. For example:
- For upfront relief the investor must be at least 18 years old when the shares are issued. Shares are issued when the shareholder’s name is registered in the company’s books7;
- For dividend relief, the investor must be 18 years old at the time that he is beneficially entitled to it8. Note that dividends are tax free anyway for a basic rate taxpayer;
- For CGT relief, the investor must be at least 18 years old at the time the shares are disposed of. So there is no bar to acquiring the shares before one’s 18th birthday and selling them afterwards.
What form can the investment take? Eligible shares and ordinary shares
Note that relief is only available on equity, rather than debt. In particular, the shares must be ordinary, as opposed to preference shares9 This is the riskiest class of security – while the prospect of rewards is great, ordinary shareholders rank last in the line of creditors if the company goes bust.
There are in fact, two types of ordinary shares that are relevant:
- For the dividend and CGT reliefs, “normal” ordinary shares as defined in the tax legislation will suffice;
- However, for upfront relief, the investor must subscribe for eligible shares10 – this is a special type of ordinary share, which carries greater risk than the usual ordinary share, as we shall see.
So what is the difference?
For tax purposes, ordinary shares are any type of share except for fixed rate preference shares11. As the name suggests, the latter carry a right to a fixed rate dividend, but no other rights to the company’s (income) profits.
It makes sense to exclude fixed rate preference shares, as this type of security has more features in common with a debt instrument, and is therefore a “safer” form of investment. However, for tax purposes, ordinary shares can still be preferential in nature, without losing their “ordinariness”.
For example, we can structure a particular class of shares so that:
- The shareholders are entitled to dividends in the usual way – that is, the entitlement depends on whether the profits and reserves are sufficient and a dividend declaration has been made. However;
- The shares also carry preferential rights to assets on a winding up; and/or
- The shareholders may have the right to early redemption.
The class of investors holding these shares are clearly better off than the others who have to “wait in the queue”. But in spite of the preferential nature of their holdings, they are still ordinary shareholders by virtue of the definition.
However, for the purpose of upfront relief, this type of ordinary share is not permitted. Shareholders who have a preferential right to assets and/or can redeem early, have clearly mitigated some of the risk that attaches to a VCT investment. Accordingly, particular restrictions are placed on the ordinary shares when they are issued.
In order to qualify for upfront relief, the shares must be “eligible shares”. These are ordinary shares satisfying the following conditions12:
- They carry no present or future rights to dividends;
- No present or future rights to the VCT’s assets on a winding up; and
- No present or future rights of redemption.
These restrictions last for 5 years starting from the day that the shares are issued. Note that this coincides with the holding period applicable to upfront relief.
The difference between eligible and ordinary shares can be summarised in the following diagram.
Linked loans – can an investor borrow to fund his investment?
There is no outright restriction on borrowing, but certain types of loan – linked loans – are not permitted13. These loans are made on terms where the lender has been influenced by the fact that the borrower is proposing to use the money to fund his investment. In the absence of this factor, the loan would either have been made on different terms, or it wouldn’t have been made at all14.
For example, consider the case where the loan is secured on the shares themselves, or any rights attaching to the shares, or the VCT’s assets. This type of loan is clearly linked to the investment – it couldn’t have been made otherwise.
On the other hand, an unsecured loan, or one secured on other assets is not automatically disqualified, even if the investor was intending to apply the money to subscribe for the VCT shares. The link to the investment is not so clear in this case – it passes the test if the lender would have made a similar loan to a borrower who required the funds for another purpose.
Further points on linked loans:
- The restriction covers loans given not only to the investor, but to his associates15;
- A loan includes the provision of credit, as well as assigning to the borrower or associate any debts owed by them (effectively releasing funds by cancelling the debt)16;
- The restriction covers loans made during the period that includes the 5 year lock-in period for upfront relief extending back a further two years, or to the date of the VCT’s incorporation whichever is the later17;
- The prohibition on linked loans only applies to disqualify the investor from upfront relief – the other reliefs are unaffected.
Linked sales – restrictions on upfront relief
These are rules designed to prevent the situation when an investor sells his shares back to the VCT and uses the proceeds to subscribe for another shareholding. In this way, one can have a series of share subscriptions, each one giving rise to tax relief, but with no fresh money actually going into the system and finding its way towards the high growth companies that the VCT scheme is intended to benefit.
The rules operate when an investor sells his VCT shares, and the sale is linked to another share subscription. In these circumstances, upfront relief will be denied to the extent that the proceeds from the share sale are used to fund the new subscription18.
The restriction will apply where the sale proceeds are reinvested in the same VCT19 – it is clear that the money is simply going round in a circle, and isn’t going to add anything to the underlying investment portfolio.
The rules will also cover the case where there has been a restructuring or merger of a VCT, and the sale and reinvestment involves both the merged VCT and the original20. This will apply in two ways:
- Either the old shares are sold to the original VCT and the proceeds reinvested in the new VCT into which the original subsequently merges or restructures; or
- An investor can subscribe for shares in the original and the money is subsequently returned by selling the shares that he holds in the new VCT.
This is the first scenario:
and this is the second:
Although they are distinct, there is still some measure of identity between the two funds, and so it is arguable that the sale proceeds aren’t really adding anything new to the underlying investment portfolio.
But these restrictions will not affect the case where the new VCT is in fact totally distinct from the old one. In particular, the two VCTs can even be from the same fund management stable, provided that one does not subsequently merge into the other21.
So when is a share sale linked to a share subscription? There are two cases22:
- Where the two events are interdependent – so either:
– The purchase of the shares that the investor is selling is conditional on the latter subscribing for a new share issue; or
– The subscription for new shares is conditional on the sale of the investor’s existing shares (which will release the necessary funds for the share subscription).
- When the two events are within 6 months of each other, they are automatically linked – there is no need for any interdependence between them.
The restrictions will not apply where the subscription for the new shares has been funded from VCT dividends. This is usually the case where there is a dividend reinvestment plan, or DRIP in place. In these circumstances, the upfront tax relief won’t be clawed back if there is a subsequent share sale23.
This completes Part Two of our series on VCTs. In the next part, we shall take a closer look at the VCT itself, and in particular, how the fund vehicle is structured.
- 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). ↩
- ITA 2007 s 261(3)(a); ITTOIA 2005 s 709(6); TCGA 1992 s 151A(2)(c). ↩
- ITA 2007 s 261(1)(b). ↩
- ITA 2007 s 261(3)(b); ITTOIA 2005 s 709(3)(a); TCGA 1992 s 151A(2)(a). ↩
- National Westminster Bank plc v IRC (1994) STC 580 HL. ↩
- ITTOIA 2005 s 709(3)(b). ↩
- ITA 2007 ss 261(1)(a), 273(1); ITTOIA 2005 s 709(2); TCGA 1992 s 151A(1). ↩
- ITA 2007 s 261(1)(a). ↩
- ITTOIA 2005 s 709(8), TCGA 1992 s 151A(7), ITA 2007 s 989. ↩
- ITA 2007 s 273(1). ↩
- ITA 2007 s 264. ↩
- ITA 2007 s 264(3). HMRC’s primary concern will be with the reason why the lender made the loan rather than why the borrower applied for it. See SP 6/98 for guidance, reproduced at VCM11030. ↩
- ITA 2007 ss 264(1) – associates are relatives such as spouse, civil partner as well as trustees and partners in a partnership – see ITA 2007 ss 253, 332. ↩
- ITA 2007 s 264(2). ↩
- ITA 2007 s 264(3). ↩
- ITA 2007 ss 264A(2), (3) applying to share issues on or after 6 April 2014 – FA 2014 Schedule 10, paragraph 2(2). ↩
- ITA 2007 s 264A(5)(a). ↩
- ITA 2007 ss 264A(5)(b), (7). ↩
- In the original Consultation Paper, HMRC was proposing to include VCTs within the same fund management group. This proposition has been dropped – see the Government Response to the Consultation Paper at paragraph 2.16. ↩
- ITA 2007 ss 264A(4), (6). ↩
- ITA 2007 s 264A(8). ↩
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