VCTs offer real gains to higher-rate taxpayers

This article is part of
Tax-efficient investing – March 2016

VCTs offer real gains to higher-rate taxpayers

The heyday of venture capital trust (VCT) investing was 10 years ago, when 40 per cent income tax relief was available and £779m was raised for investment in qualifying funds.

Since then they have become seen as the ugly sister to the fashionable enterprise investment scheme (EIS). This decline was partly tax driven, as VCT income tax relief reduced at the same time as EIS relief increased, but was also because many new investors in VCTs were burnt, with a number of newer trusts suffering heavy losses during the credit crunch.

By 2012-13 just £269m was raised by VCTs, though this was the final tax year for solar EIS. There can be little doubt that this final rush took investment away from VCTs.

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However, there are clear signs that the tide is turning in favour of VCTs, and there are three main reasons for this.

Firstly, there is the industry’s growing maturity. As at April 5 2015, total VCT funds under management were £3.5bn. The poor performers of the past have been almost entirely weeded out, and there is a smaller number of committed managers who really understand the market.

Secondly, advisers understand VCTs better and are coming to realise that far from being the ugly sister of EIS, they are as beautiful as each other.

Advisers who have shunned VCTs are starting to understand they are not, on the whole, as high risk as might have been assumed.

Many VCTs – and not just those designed to be limited life – are significantly lower risk than a host of traditional equity funds which, of course, do not carry any tax incentives.

The third reason is pension tax relief. Over the past five years, more and more people have found that funding for retirement via a pension has been closed off through successive reductions in the lifetime and annual allowances.

For additional-rate taxpayers, the new tiered annual allowance could mean the amount they can save in a pension with tax reliefs is less than they can invest in Isas, and it’s no secret George Osborne wants to go further.

It is worth remembering that the main current tax relief on pensions is the 25 per cent tax-free lump sum. The income tax saving in a pension contribution is tax-deferred, not relieved.

Reductions to tax relief, especially if accompanied by restrictions in the tax-free lump sum, could mean higher-rate taxpayers will pay more tax on pension income than if they had taken the income in the first place.

VCTs are becoming more attractive as an investment for higher-rate taxpayers – reductions in pensions tax relief will make these attractions even more compelling.

A 40 per cent taxpayer saving into a pension today is taking a risk on what their tax rate will be in retirement. At 40 per cent, with a 25 per cent tax-free lump sum, the effective rate of tax they pay is 30 per cent. So the income tax relief was worth 10 per cent.