Venture capital trusts (VCTs) still have a ring of the bold and new about them, but they have actually been around for decades.
They were established 20 years ago by the UK government to encourage investment in smaller UK businesses. Their tax incentives compensate for the increased risk associated with investing in smaller, unquoted companies – and their existence boosts the shortfall in available funding for small and medium enterprises (SMEs).
In the past two decades, VCTs have raised more than £5.4bn for investments in UK SMEs.
VCTs are structured broadly similarly to investment trusts – investors subscribe for shares in a VCT, which is listed on the London Stock Exchange. However, it should be noted that the secondary market for VCTs tends to be less liquid than for investment trusts.
Unlike investment trusts, VCTs offer generous tax incentives, including upfront income-tax relief of 30 per cent of the sum invested, tax-free dividends and no capital gains tax (CGT) on realised gains. But certain criteria need to be met for investors to qualify, including a minimum five-year holding period and a ceiling on investments of £200,000 per investor per tax year.
In many ways VCTs do the same job as investment trusts but with the added benefit of tax-free income and no CGT liability on disposal.
But there are important restrictions that investors need to consider. For example, VCTs invest in companies that must meet certain qualifying criteria, such as employee numbers.
VCT rules also dictate that at least 70 per cent of the trust’s assets must be invested in qualifying companies. The remainder – up to 30 per cent of the portfolio – can be invested in assets such as mutual funds or investment trusts. Therefore, because of this VCT 70/30 rule and the fact dividends are tax-free, the majority of VCTs target both capital growth and regular income.
There are four main types of VCTs: generalist, Aim, specialist and limited life.
• Generalist VCTs invest in a general portfolio of companies across the smaller and private equity universe without any sector or asset focus.
• Specialist VCTs focus on companies in a specific sector, such as renewable energy, leisure, media or technology, where the manager believes they have an edge.
• Aim VCTs focus on companies listed on the Alternative Investment Market. These are the only listed companies that qualify under the VCT rules. Aim, which has roughly 1,100 companies, has been around since 1995 and is now a mature exchange.
• Limited life or planned exit VCTs are similar to generalist VCTs, but tend to focus on lower-risk, lower-return companies. The main objectives of this product are capital preservation and its ability to provide liquidity as soon as possible after the five-year qualifying date, hence the name ‘limited life’.
VCTs are playing an increasingly important role in individuals’ longer-term tax planning and they have the potential to deliver both attractive tax-free income and capital growth, but investors should satisfy themselves that dividend returns are sustainable. If you’re investing for the longer term and seeking tax-efficient total returns, a VCT could be the right vehicle.