The Enduring Popularity Of VCTs

It's that time of year when Venture Capital Trusts (VCTs) typically kick off their annual fundraising campaigns. If you're thinking about entering the world of VCTs, this season could present both opportunities and challenges that you should be well aware of.

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VCTs remain a popular investment vehicle, offering attractive tax benefits for investors.

According to HMRC’s latest set of VCT statistics, VCTs issued shares to the value of £1,122 million in 2021/22, which is 68% higher in comparison to the 2020/21 figure of £668 million and I expect that figure to increase again when the last tax year figures are announced.

But what exactly are VCTs, and are they the right choice for your investment portfolio?

This article provides a comprehensive look into venture capital trusts - their history, tax incentives, associated risks, and how they can play a role in retirement planning.

What are Venture Capital Trusts?

Venture capital trusts are investment companies that are listed on the London Stock Exchange and approved by HMRC. They invest in small, early-stage unquoted companies that often struggle to access traditional funding sources.

VCTs were introduced by the government in 1995 to encourage investment into UK based entrepreneurial ventures. The idea was to mirror the success of venture capital investment in the US and act as an alternative source of finance for start-ups and SMEs.

When you invest in a VCT, you are pooling your money with other investors, similar to most collective investments. This is then invested into a diverse portfolio of growth companies by professional VCT fund managers.

The Tax Benefits of VCTs

The key incentive for investing in VCTs lies in their generous tax reliefs:

• Income tax relief - You can claim 30% income tax relief on investments of up to £200,000 per tax year. For example, invest £10,000 into VCTs and reduce your tax bill by £3,000.

• Tax-free dividends - Any dividends paid out by VCTs are exempt from income tax.

• Capital gains tax exemption - Profits from selling VCT shares are tax-free, provided the shares are held for at least 5 years.

These tax breaks make VCTs useful for retirement planning and generating tax-efficient income in later life.

VCTs for Retirement Planning

Pension contribution restrictions for higher earners necessitate alternative investment strategies to adequately prepare for retirement. VCTs can be an effective solution in this scenario as we have seen they come with a 30% income tax relief, with is similar to pension relief.

This tax relief can be reinvested, for instance, into an Individual Savings Account (ISA) for further financial growth.

Using a very simple example; if we assume an investment of £50,000 per annum into VCTs over a 7 year period with the tax reliefs and the dividends are reinvested into ISAs each year.

Assuming zero growth on the VCTs and 5% on the ISAs, at the end of 10 years there could be a £350,000 VCT portfolio generating tax free returns of 5% per annum and an ISA portfolio of £250,000+.

VCTs are also a useful retirement planning tool for buy to let investors as rental income does not count as earned income for pension tax relief purposes, while VCT tax relief can be offset against all income tax.

Using VCTs to Maintain Income in Retirement

For high rate taxpaying retirees, maintaining a sufficient income level while minimising taxes can be challenging. This is where strategically using VCT investments could help.

Again looking at a simple scenario of a retiree who has a £50,000 investment portfolio generating £2,500 in annual dividends. As a higher-rate taxpayer, the retiree has to pay £843 in dividend taxes on this income.

Now, let's say this retiree shifts this £50,000 into VCTs*. This move will offer an immediate 30% income tax relief, reducing the retiree's tax bill for the year by £15,000.

Assuming the VCT investments yield a 5% dividend—just like the original portfolio—that's the same £2,500 in income but without any tax liability.

If the retiree also invests the £15,000 tax relief back into their standard investment portfolio, it could generate an additional £750 in dividends, which would incur a tax of £253.

By employing this strategy, the retiree ends up with a total income of £3,250 for the year, and pays only £253 in taxes, resulting in a net income of £2,997. In contrast, the original setup would have provided a net income of £1,657 after tax—an 80% increase in net income.

Over time, the tax savings would compound as more tax-free VCT income comes through.

It's worth noting that dividends and capital gains from VCTs don't have to be declared on your tax return either. Just the initial income tax relief claimed.

* Selling a portfolio to reinvest in a different asset may result in capital gains tax. However, if your current investments have decreased in value, selling them could actually offer a tax benefit. These 'underwater' losses can be carried forward to offset future capital gains.

Risks and Considerations

Higher interest rates and inflation are affecting the financial markets and impacting the value of both listed and unlisted companies, including those in Venture Capital Trust (VCT) portfolios.

Valuations of these private companies can be volatile, influenced by public market trends and limited exit opportunities.

Despite this, VCTs offer a unique investment opportunity, especially when held for the long term.

Investors need to keep their VCT shares for a minimum of five years to benefit from a 30% income tax relief, allowing them a longer time frame to navigate through market ups and downs.

While VCTs offer tempting tax incentives, they also come with risks that must be evaluated:

• Illiquidity - VCT shares aren't readily tradable. They aren't listed on the main stock market, so selling them can be difficult.

• Loss of capital - Investing in start-ups and early stage companies is inherently high risk. Many fail, meaning complete loss of investment.

• Long term commitments - VCT investments should be held for at least 5 years. You cannot access your capital during this time and in reality the hold time is much longer.

• Legislative risk - Tax reliefs could change in future, reducing incentives. However, existing investors are typically protected.

In Summary

VCTs offer generous tax breaks that can enhance retirement savings and income for suitable investors. However, the risks mean that thorough research and expert advice is essential before committing money.

Look at the VCT provider's track record, experience of the fund managers, and the underlying companies invested in. Spreading money across multiple VCTs can also mitigate risk through diversification.

It's also advisable to only invest a fraction of your portfolio into VCTs – I’d suggest no more than 5-10%.

VCTs should be viewed as a higher risk, longer term component within an overall balanced portfolio.