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Paul Latham

This article first appeared in GB Investments.

An incredible £728m was raised by venture capital trusts (VCT) in the 2017-18 tax year, the second-highest amount ever. Only 2005-06 has seen bigger inflows, and that was helped by higher tax reliefs of 40% and the knowledge that these would most likely be cut in the next tax year.

This year’s surge in investor demand meant several VCTs hit their fundraising capacity ahead of tax year-end. They included Octopus Titan VCT, which raised £200 million, the largest ever VCT fundraise since they were first introduced in 1995.

Why changes to pensions and buy-to-let have driven VCT demand

There have been two notable changes which have contributed to the increased demand for VCTs, and seen more advisers consider them for their clients as part of a diversified portfolio of investments.

  • Pensions changes

Restrictions on annual and lifetime pension contributions mean more people are now looking for tax-efficient ways to complement their retirement planning. As a result, more clients are turning to VCTs as one way to do this.

A client worried about exceeding their lifetime allowance, for example, could invest some money into a VCT and claim 30% of the first £200,000 they invest as income tax relief. VCTs offer this tax relief, along with tax-free dividends and capital gains, as an incentive to take on the risk of backing early stage companies, provided they are held for at least five years. That means investors need to be comfortable with the risks of investing in smaller companies, and the fact that they could get back less than they invest.

Investors can also use VCTs to take money out of their pension tax efficiently. This works by investing some of the money taken out of the pension into a VCT, and using the upfront income tax relief to offset the tax paid on the money withdrawn. Note that selling VCT shares within the five-year minimum holding period would mean paying back any income tax relief, so clients should be comfortable holding a VCT for at least five years.

  • Buy-to-let

Another area where the government has tightened restrictions in recent years is buy-to-let, for example by phasing out mortgage tax relief and raising stamp duty. The costs of being a landlord are rising. For clients who don’t yet want to sell their properties, claiming income tax relief on a VCT investment can be a way to offset these rising costs.

VCTs moving into the mainstream

Recent changes to pensions and buy-to-let have definitely helped to raise the profile of VCTs. And, it’s fair to say there is growing awareness of the benefits of VCTs and the role they play in supporting the next generation of UK business. Over the last decade, we have seen increased interest and understanding of VCTs. Whereas a typical VCT investor used to be someone working in the City investing their bonus, today we see the majority of inflows made up of investments in the £5,000 to £15,000 range. This has made VCT investment far more accessible to younger investors, who in previous generations may have considered property investing.

Concerns around legislative changes

A concern you often hear about VCTs is that legislative changes risk undermining the investment opportunity, so it’s worth reminding ourselves that successive governments have remained supportive of VCTs since they were first introduced in 1995, and this government is no different. But there are always tweaks to the VCT rules. We expect this and are used to adapting and managing these.

What’s important is that VCTs continue to do what they were set up to do – attract investment into UK smaller companies.  Most recently, the 2017 Autumn Budget saw a number of changes made to the way VCTs can invest their money. In a nutshell, the changes were focused on directing capital to the most dynamic, growth businesses where it can do the most good for the wider economy while helping investors meet their objectives.

The incentive to support and invest in these types of companies was made clear by the recent High Growth Small Business Report from Octopus. The report found that a group of 22,000 early stage companies – representing less than 1% of all the companies in the UK – create an incredible 20% of all new jobs and contribute to 22% of economic growth. These are early stage businesses that make a huge positive impact on our economy. Providing them with long term capital is precisely why VCTs exist, and the government’s Patient Capital Review underlined this in a clear demonstration of support for the sector.

Some clients may still be concerned that legislation could change again. It could, but this goes with the territory and has been part of VCT investing since they were first introduced. Nonetheless, it’s one reason why it’s a good idea to choose from one of the more established VCT providers that have experience of adapting to changes when required.

Not all VCTs are created equal

This goes without saying, but it’s important to look at a VCT’s costs, much as you would with a plain vanilla fund.

A VCT is a company in its own right, which is listed on the stock exchange. It has to produce annual report and accounts, have an independent board of directors, hold general meetings for shareholders and meet standard corporate governance requirements just like any other public company. All of which costs money. A bigger VCT can spread these fixed costs over a larger asset base, reducing their impact on each individual investor’s returns.

You should also consider how established a VCT is. A newer VCT may still be in the process of building up its holdings, which affects how much your client can know about the investment before they invest. 

Remember, a client has to hold the investment for five years to keep the upfront income tax relief. While you should expect the holdings of any VCT to change over such a period, the change is likely to be more radical for those still building up their portfolio.

Whichever VCT they choose, clients should be aware of the risks, including the fact that the value of their investment may go down as well as up and they may not get back the full amount they put in. In addition, they need to be aware that tax treatment depends on individual circumstances, and tax rules may change in the future.

Tax reliefs also depend on the VCT maintaining its VCT-qualifying status. This means sticking to the rules about the types of company VCTs can invest in. There are also rules about the maximum amount of cash they can hold as a percentage of assets, as well as how quickly VCTs must deploy newly-raised fund. It’s also worth remembering that, due to their nature, investments into smaller companies carry increased volatility and liquidity risk.

Will 2018-19 be another record year for VCTs?

It’s difficult to say whether VCT investment will reach the same level of investment this year. One of the reasons VCT investment was so high in 2017-18 is because there was a lot of fundraising capacity to satisfy demand, but there’s no guarantee that capacity will be as high next year. If it’s lower, and demand remains at current levels, it will mean VCTs fill up even faster, with the more popular ones closing first. It might seem a little hasty, but this presents an obvious reason to start the conversation about VCT planning with clients now, so they don’t miss out on the VCT of their choice. That way you also get the bonus of securing the early bird discounts on offer too.

For journalists in their professional capacity only. The value of an investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest. Tax treatment depends on individual circumstances and may change in the future. Tax reliefs depend on the VCT maintaining its VCT-qualifying status. VCT shares could fall or rise in value more than other shares listed on the main market of the London Stock Exchange. They may also be harder to sell. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. This advertisement is not a prospectus. Investors should only subscribe for shares based on information in the prospectus, which can be obtained from octopusinvestments.com. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: April 2018.