This article first appeared in FT Adviser.
The latest VCT investment review from the Association of Investment Companies (AIC) makes interesting reading. Some of the statistics should make the investment industry proud of the contribution made by VCTs since their introduction in 1995. The market for VCTs is now mature and the type of investment opportunities available today are vastly different to when these schemes were first introduced.
As the AIC reports, the impact of VCTs on UK smaller companies has been significant. For example, VCT funding has enabled UK businesses to more than double their turnover – according to the report, for every £1 million invested, turnover has increased £2.2 million. The economic contribution of VCTs shouldn’t be underestimated either. VCT investment has helped to create 27,000 new jobs.
The AIC’s review shows that 54% of all current VCT investee businesses have been held by those VCTs for longer than five years, while 20% of all businesses have been held for more than a decade. VCTs are by their nature designed to invest for the long term, and follow-on finance has played a significant part in the survival and growth of these early stage companies. The AIC’s review found that 60% of companies received more than one investment, while almost half (44%) received more than two investments. Many firms highlighted that being able to rely on continued financial support was crucial to ensuring they could move to the next stage of commercial development.
The investment case
From an investor perspective, the case for VCTs looks increasingly compelling, too. As well as offering access the growth potential of smaller companies that might otherwise fall below their radar, investors can claim a number of valuable tax incentives.
Arguably the most valuable of these is income tax relief. Investors can claim up to 30% upfront income tax relief on the amount invested, provided they are willing to keep holding their VCT shares for at least five years. Investors are also eligible to receive tax-free dividends from VCT shares, although dividend payments are not guaranteed. Finally, should the investor sell their VCT shares and make a profit, the proceeds of the sale won’t be liable for capital gains tax.
Of course, it’s always worth remembering that these tax benefits are there, in part, to offset the higher risk associated with investing in a VCT. And as with any investment, investors may not get back the full amount they invest. The tax treatment of VCTs is also something for investors and advisers to be acutely aware of. An investor’s tax treatment will depend on their individual circumstances and tax legislation is always subject to change. The available tax reliefs also depend on the VCT maintaining its qualifying status.
Another record breaking year for VCTs
According to the AIC, VCTs raised a staggering £542 million in the last tax year. This was the second-highest fundraising year on record, and an increase of 18% from the previous year. There is now a total of £3.9 billion invested in the VCT market. So what’s been driving inflows? Both pensions and property have come under increased scrutiny from a tax perspective in recent years, with property investing in the form of buy-to-let coming under particular pressure. It’s not hard to see that clients who have found themselves with a potential increased tax burden have started looking at complementary tax-efficient investments, particular those that can assist with retirement planning.
Buy-to-let cooling down
Many people have opted to invest in bricks and mortar as a way to complement or even replace pension planning. However, a series of measures designed to alleviate housing market concerns − including a 3% stamp duty surcharge on the purchase of buy-to-let properties and second homes and, more recently, the phased reduction in tax relief on mortgage interest – has made this less tax-efficient.
Previously, landlords could deduct 100% of their mortgage interest and other finance-related costs from rental income, thereby reducing their overall tax liability. To replace mortgage interest relief, landlords will be granted a 20% basic rate tax relief which can be used to offset income tax. Unfortunately, this is likely to push many property owners who were paying income tax at the basic rate into the higher rate tax bracket, despite their income from the property staying the same. It’s no surprise, therefore that increasing numbers of investors may be looking for ways to reduce their tax burden.
Pension limits are restricting investors
Another reason why VCTs are increasing in popularity is that many high earners, particularly those getting closer to retirement age, have begun to feel far more constricted as to how much they can put into their pension. Changes to the lifetime allowance have helped a large number of investors to start looking at VCTs in a new light, as a means of complementing existing retirement planning strategies.
Back in 2010, a client could withdraw £1.8 million from a pension scheme without triggering additional tax charges. Today the tax-free maximum is just £1 million. This may still seem like a large amount, but when you factor in decades of annual compound growth on the pension, people of all ages who have already started to fund their retirement – even those who invest fairly small annual amounts – risk exceeding the lifetime allowance well before reaching their actual retirement date.
In a similar vein, the annual allowance – how much an individual can contribute to a defined contribution pension scheme while still receiving tax relief – stood at £255,000 in 2010, but has been reduced to just £40,000. It’s therefore no surprise that advisers have been tell us that a growing number of clients are interested in exploring how a VCT can complement their existing pension arrangements. More generally, the pension freedoms that were announced in April 2015 – which scrapped the requirement for retirees to buy an annuity – has the potential to boost demand for products such as VCTs that aim to generate a steady stream of tax-free dividends for investors, although dividends are not guaranteed. Of course, a VCT that invests in high-risk companies shouldn’t be considered as a replacement for pension investments, which will typically be invested in lower risk asset classes.
The patient capital review
Over the years, the rules relating to VCTs have been adjusted several times. What has remained constant has been that they provide critical funding, help to generate thousands of jobs and make a significant contribution to the UK economy. This autumn, HM Treasury’s consultation paper on patient capital will be focused on how the UK investment community can offer better support to growing innovative firms over the longer term.
Back in November 2015, rule changes were introduced to ensure VCTs focused on younger companies. These changes did not materially affect the way in which VCTs work – indeed they will only help to ensure that high-growth and innovative businesses can continue to benefit from investment. They were aimed at ensuring investment continues to be targeted at those sectors and companies needing it most. We believe there will continue to be a good pipeline of potential investment opportunities, and we recently launched new share offers for two of our VCTs. But while the range of companies that now qualify for tax reliefs might be slightly smaller, there’s still a thriving and fertile market full of the type of fast-growing smaller companies, many of whom are desperate to access funding, that VCT managers look out for.
What else should advisers look out for?
When it comes to recommending VCTs to clients, there are several factors worth considering to help narrow your search. For example, how long has the VCT been in existence? How experienced is the VCT manager? A well-established VCT should be able to demonstrate a performance track record, whereas newer VCTs can take longer to reach the size and scale required to start delivering meaningful returns for investors. It therefore may be worth looking at more mature VCTs featuring diverse portfolios of companies that are already hitting their stride.
VCT shares tend to have a very limited secondary market, as second-hand shares no longer qualify for income tax relief. Therefore it’s important that investors are able to find buyers for their shares when it comes time to sell them. Most VCTs will offer a share buyback facility, where the VCT itself offers to buy the shares back from the investor at a discount to net asset value (NAV). However, it’s well worth determining the size of the discount as these do vary by manager.
It’s also worth noting that investors can now buy VCTs shares for the first time through their ISA. This should give even more people access to the planning benefits of a VCT, the growth potential of smaller companies and valuable tax benefits, all within the UK’s most popular tax wrapper.
This autumn promises to be an important time for the VCT industry. As we approach the second half of the tax year, more advisers will be looking to help their clients maximise the potential of their portfolios. With both pensions and property looking conspicuously less attractive, it’s no wonder that more people are re-evaluating their existing financial arrangements. VCTs are gaining in popularity by offering an alternative worth contemplating. If you have clients willing to put their money to work in a more tax-efficient manner and they are comfortable with the additional risks, and starting to think more holistically about their retirement planning options, then there are many reasons to give VCTs serious consideration.
 Source: AIC Transforming small business: VCT investment review, August 2017.
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. Past performance is not a reliable indicator of future results. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. 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: October 2017