A valuable addition to the tax-efficient toolkit

This article is part of
Investment Trusts - June 2015

Building a portfolio that generates a sustainable and attractive yield has become the holy grail for income-starved investors.

This has led to renewed enthusiasm for Venture Capital Trusts (VCTs) from those attracted by their income generation and tax efficiency. The popularity of VCTs is reflected in figures from the Association of Investment Companies (AIC), which show that new investment into VCTs reached £429m in the 2014/15 tax year – the highest level of annual funds raised since 2006.

Introduced 20 years ago, VCTs are fully listed investment companies investing equity capital in smaller UK companies and start-ups. Qualifying companies have a maximum value of £15m and a maximum number of employees of 250. Investing in small businesses is risky, therefore the government provides investors with generous tax breaks. Tax reliefs available for investments in new VCT shares include income tax relief of 30 per cent, tax-free dividends and tax-free capital gains.

A UK taxpayer who subscribes £10,000 to a VCT at £1 per share would have a net cost after 30 per cent income tax relief of £7,000. If the VCT pays a 4p annual dividend per share, this would, in combination with the reduced cost of the shares, be equivalent to receiving a tax-free yield of 5.7 per cent a year. Of course, tax reliefs will depend on personal circumstances and the dividends are not guaranteed.

VCTs fall into several categories: generalist, limited life, specialist and Aim.

Generalist VCTs are broad-based, usually focusing on unquoted companies at various stages of development across a range of sectors; limited life VCTs are designed to sell their investments after the minimum holding period of five years, then wind up and distribute the proceeds to shareholders in the sixth year, although this is not guaranteed; specialist VCTs predominantly invest in one sector, such as pubs or healthcare; and Aim VCTs primarily invest in companies quoted on Aim, the London Stock Exchange’s junior market. Some managers follow a hybrid approach that combines different features of these four strategies.

In addition to providing capital, VCT managers provide their investee companies with expertise and support to help these businesses grow. Investors should focus on established providers and experienced managers who have track records that prove they have delivered on their targets.

VCTs are not suitable for all investors – unquoted and Aim-listed companies are illiquid, so they are riskier than more conventional investment strategies. Fees also tend to be higher, with initial charges generally around 2-3 per cent and annual management fees of 2 per cent and above. However, returns are potentially appealing.

Levels of risk vary between VCTs and depend on the investment policy adopted by the manager. In general, VCTs are most likely to appeal to experienced investors who are subject to higher rates of income tax and have built up a balanced investment portfolio, where VCT investments only represent a very small percentage of their overall holdings. They must also have a long-term investment horizon (at least five years) and be comfortable with the level of risk.