Of these, pensions and Isas are the most widely understood and used. From this April, the former will become even more flexible, with withdrawal of pension pots as cash becoming possible, although the potential tax payable may discourage this. As for Isas, they offer tax-free capital gains and income on both cash and other investment savings.
What are less well-known despite their very preferential tax treatment are venture capital trusts (VCTs) and enterprise investment schemes (EISs).
Introduced in 1994 as the successor to the business expansion scheme, EISs were designed to encourage investments into small unquoted companies trading in the UK. VCTs celebrate their 20th birthday this year, their longevity largely due to the attractiveness of their tax treatment and the support they provide to smaller companies. Such companies form the entrepreneurial element of our economy, and governments are therefore keen to incentivise funding for them.
VCTs are investment companies listed on the London Stock Exchange, thus their shares can usually be sold at any time. They are normally managed by specialist investment managers under the governance of an independent board of directors. An EIS invests in the ordinary equity of an individual company and hence can only be sold when the company is sold.
Both VCTs and EISs benefit from an income tax rebate equal to 30 per cent of the initial investment. VCTs pay attractive tax-free dividends which do not have to be included in a tax return. EISs can usually provide capital gains tax deferral and business property relief, and also benefit from loss relief.
Some VCTs offer dividend reinvestment schemes, enabling investors to compound their income further. The scheme allows investors to automatically reinvest dividends into new shares, allowing them to benefit from a further 30 per cent tax relief on the value of the dividend received and, with regular investment, the potential to compound capital growth. This is particularly useful for those who have yet to reach retirement and may not need tax-free income. Then as soon as they retire, or need extra income, they can re-elect to receive cash instead.
There are several types of VCTs. Generalist VCTs tend to be the most diverse and broadly spread. Aim VCTs invest specifically in companies that are quoted or about to be listed on the alternative investment market. Specialist VCTs focus on specific industry sectors such as renewable energy or technology. Increasingly less common are limited life VCTs which wind up after five years, selling all their investments to return cash to investors.
One of the main attractions of generalist VCTs is that they do not have fixed terms, paying out dividends on an ongoing basis and forming a fundamental and long-term part of a savings portfolio. Because of this they can also take a long-term view of the companies they invest in, which is conducive to better returns.
The first thing to consider before investing in VCTs or EISs is that they are restricted to investing in the earlier stages of potentially higher-risk small companies. As such, investors should first consider making full use of their pension and ISA entitlements before considering VCTs or EISs. However, if an adviser thinks a VCT is suitable for a client, then the first step to selecting a VCT is to assess the manager.
VCT managers are courted by hundreds of companies that seek funding every year, and must be skilled at picking future winners. They must also be good at providing strategic advice, since they play an advisory role to the investee companies, sitting on their boards and helping to increase a company’s value by means of an ultimate exit after a number of years.
Another consideration for advisers is whether their clients are looking for capital growth or income. The income tax exemption on dividends means that VCTs are an excellent method of establishing a long-term tax-free revenue stream. EISs are usually focused on short-term capital growth, making them less suited to long-term savings. The long-term nature of VCTs can make them a highly complementary component in a retirement portfolio. For example, someone in his 50s supplementing his pension provision might wish to allocate a part of their savings to a VCT. The income from a pension pot is taxable, but dividends from a VCT are usually exempt.
VCTs and EISs are not suitable for everybody. Many cautious investors will prefer to avoid backing smaller, often privately owned and inherently riskier companies. However, they can be suitable for high net-worth investors due to their tax efficiency and, in the case of VCTs, their proven ability to deliver regular income. VCTs are particularly attractive to three types of investor:
• Young high-flyers, who are likely to have high salaries and pension contributions and be heavily taxed. Time is on their side, so the long-term nature of investing in VCTs can be appropriate for them, and the opportunity to benefit from the initial 30 per cent income tax relief is especially attractive.
• Senior managers who are ready to retire with substantial pension pots close to the lifetime allowance. Investing part of their tax-free lump sum into a VCT could provide a good tax-free supplement to their pension pot as it falls outside the lifetime limit. The reduction of the annual pension contribution limit to £40,000 is also likely to be a consideration.
• The comfortably retired, who are financially savvy and seeking income in a low interest rate environment. The high tax-free income available from generalist VCTs is highly attractive to them as part of a broader savings strategy.
Being higher-risk investments, VCTs and EISs should only be considered suitable for those investors wealthy enough to make them part of a wider investment portfolio, and comfortable with investing for a minimum three years for EIS and five years for VCTs. While at the riskier end of the investment spectrum, the VCT sector is entering its third decade and has very much come of age. Generalist VCT managers have become much more experienced at controlling risks through picking high-quality investee companies and helping them succeed. Investors are rewarded not just financially, but also with the gratification of knowing they are backing small British companies, which play a key role in reinventing and growing the UK economy.
Will Fraser Allen is deputy managing partner at Albion Ventures
Key Points
VCTs and EISs are not as well-known as they probably should be, given their very preferential tax treatment.
Both VCTs and EISs benefit from an income tax rebate equal to 30 per cent of the initial investment.
Being higher-risk investments, VCTs and EISs should only be considered suitable as part of a wider investment portfolio.
