Venture capital trusts: all change

Income tax relief at 30 per cent is available on the purchase of qualifying VCT shares (this normally means a new issue) providing the investor is aged over 18 and the investment isheld for 5 years (other than on death). The annual investment limit will be £200,000 in 2015/16 providing the potential for £60,000 income tax relief. However this is limited to the amount of income tax the individual pays.

Table 1 shows the total relief claimed in the UK and how this figure increased from 2010 to 2013.

It should be noted that tax relief on the initial investment is not available in respect of the purchase of second-hand shares. The income tax relief reduces the tax liability for the tax year in which the investment is made and there is no ability to carry to a previous tax year.

Further, VCTs are income-producing assets and investor returns are distributed via dividends after underlying investments are realised. Dividends from VCTs are tax-free, and not treated as taxable income. Until its withdrawal in April 2016, there is no reclaim of the 10 per cent tax credit.

Dividends are also tax-free for second-hand VCT shares, although no tax relief is available on the initial investment. Second-hand VCTs trading at a discount to net asset value provide investors with the ability to enhance their dividend yield.

There is also no capital gains tax on the disposal of VCT shares. However, losses cannot be used to offset against other capital gains.

And VCTs have no inheritance tax relief other than in the exceptional circumstance where the investor has owned a controlling shareholding for two years.

Finally, a VCT is a company listed on the stock exchange and which has been approved by HMRC. Generally closed-ended, they are pooled managed investment vehicles which invest largely in other companies. There is no corporation tax payable within the VCT following disposal by the VCT of an investment.

Table 2 shows the top performing VCTs ranked over three years.

VCT share purchases

There are various ways to purchase VCT shares including top-ups to existing trusts, second-hand, and new offers. So-called early bird enhancements are often available.

During the Budget in March this year it was announced that some further amendments would be introduced to the VCT legislation, most of which were specifically aimed at enabling the scheme to gain continued approval under the European Commission’s new State Aid guidelines.

The post-general election summer Budget, which took place in July 2015 then introduced additional new rules as well as amending some of the rules announced in March (this is because the March 2015 rules failed to gain State Aid approval from the European Commission).

The main aim of the revised regulations is to ensure all VCT investments are made with the intention to “grow and develop” a business. They are expected to come into force once State Aid Approval has been received from the EC and once the Finance Bill 2015 receives Royal Assent. There are a number of important implications for investors and VCT managers.

Following the amendments there will be greater restrictions on how capital raised by VCTs can be deployed to help small businesses. The main amendments can be summarised as follows:

The seven-year rule

Companies will only be eligible for VCT funding if they have made their first commercial sale within the past seven years (this is extended to 10 years for companies deemed ‘knowledge intensive’) – presently there is no limit on company age.

This will lead to a reduced investment universe (and a funding gap created); managers will likely be forced to back earlier-stage (and riskier) companies; ultimately, this will be a complex, costly and time-consuming rule to enforce

Prohibition of replacement capital deals

As well as providing new capital, VCT deals often involve an element of replacement capital (to buy out an employee shareholder, external shareholder, or allow management to realise some capital) – this will no longer be permitted

The implications of this are that, if VCTs can no longer provide replacement capital, they will be seen as a less attractive source of funding.

The rule means management buy-out (MBO) transactions will no longer be possible – these are the bread and butter of many generalist VCT managers, chiefly because of their simplicity and lower-risk profile. The investment universe will be reduced and a funding gap will be created.

Limitations on investee companies making acquisitions

VCT funds will not be able to be used to acquire other businesses, whether it is through share purchase or asset purchase. This means it will not always be easy to determine exactly what cash on a company’s balance sheet will be deemed by HMRC to have been raised from VCT funds.

This rule will be complex, costly and time-consuming to enforce, while also restricting the investment universe and creating a funding gap.

Money raised pre-2012 no longer ring-fenced

Any VCT money raised prior to 2012 was previously ‘ring-fenced’ and could be invested under the old VCT rules. Importantly, pre-2012 money retained its ‘ring-fenced’ status even after it had been through an investment cycle. This no longer applies. The risk/return profile of many VCTs could change significantly as a result because, as investments are realised, capital will be redeployed into higher risk investments under the new VCT rules.

VCT suitability

Although the various tax reliefs may effectively diminish the overall risk from ‘very high’ to around ‘medium high’, VCTs should only be offered to more sophisticated clients, happy to accept the additional liquidity risks. The client’s relative exposure to a specialist investment portfolio such as VCTs should rarely exceed 10 per cent of investable assets.

Danny Cox is a certified financial planner and a chartered financial planner at Hargreaves Lansdown