A venture capital trust (VCT) is a company listed on the Stock Exchange and which has been approved by HMRC. VCTs are closed-ended collective investments – a type of investment trust – and like many such trusts, VCTs almost always trade at a discount to net asset value.
The closed-ended structure is useful when the underlying investments are more illiquid, because it means the manager should not be forced into a fire sale by investor redemptions.
Notably, income tax relief of 30 per cent is available on the purchase of new VCT shares. Individuals aged 18 or over are entitled to income tax relief on subscription for qualifying shares. This relief takes the form of a reduction in the tax liability for the tax year in which the subscription is made.
With an annual investment limit of £200,000, the maximum amount of relief in the current tax year is therefore £60,000, or if smaller, such an amount as reduces the investor’s tax liability to nil. An example is given in Box One.
Income tax relief is not available in respect of the purchase of secondhand VCT shares. Relief may be claimed immediately by informing the local tax office, or by submission to HMRC of a tax certificate issued by the VCT company.
The VCT firm must issue a tax certificate to the investor within 30 days of a request, otherwise the tax certificate will be sent out with the share certificates.
Income tax relief is withdrawn if the investor disposes of the shares within five years of issue, with two exceptions:
l Where the disposal is between a married couple or civil partners who are living together;
l In the event of death within five years of issue.
Additionally, if HMRC removes its approval of the VCT within five years of issue then relief is withdrawn in full.
Ongoing income tax exemption
VCTs are ultimately income-producing investments. Investor returns are distributed via dividends after underlying investments are realised. VCT dividends are not treated as taxable income where shares are held by an individual.
The VCT’s tax-free dividends become more attractive for higher and additional-rate taxpayers, although it does not make the upfront tax relief any more attractive – this remains a flat 30 per cent.
VCT dividends are tax-free, whether shares were acquired on new subscriptions, purchased second hand, or received by way of gift or legacy. Secondhand VCTs normally trade at a discount to net asset value, which can provide a healthy enhancement to the dividend yield and compensate for the lack of initial income tax relief.
CGT disposal relief
There is no capital gains tax (CGT) on the disposal of VCT shares. This CGT relief only applies to holdings where the acquisition cost fell within the contribution limit for that year; that is, £200,000 for tax years 2004-05 onwards. CGT disposal relief is available whether the shares were purchased by or gifted to the investor who sells them.
If VCT shares are sold at a loss, then this will not be an allowable loss for either CGT or income tax purposes. The lack of an available loss is more relevant because it is exceptionally rare for VCTs to provide capital gains (the bulk of returns being returned to the investor through dividends).
Prior to 6 April 2004, it was also possible to defer capital gains into VCT shares issued. The deferred gain becomes chargeable at the rate applicable when ultimately brought back into charge.
For example, for disposals in the current tax year, the rate is 10 per cent and/or 20 per cent. Neither death nor inter-spousal transfer of the shares brings a deferred gain back into charge. However, withdrawal of HMRC relief, sale of the shares or the investor broadly becoming non-resident will trigger a disposal and potential charge.
Approved VCTs are listed shares and so will not qualify for business relief. The exception would be in the event that the investor has a controlling shareholding, in which case 50 per cent business would be available after two years – which would be unlikely given the £200,000 annual subscription limit to tax reliefs.
The secondhand market
One drawback to investing in VCTs for income is that the underlying returns from the dividends can take some time to get going. Individuals can avoid this delay by investing into existing VCTs.
In the investment trust world, big discounts, sizeable spreads and scarce trades can reduce prices and so widen the discount to net asset value on which a trust trades. This effect is heightened when it comes to VCTs. It is normally possible to purchase older VCTs at a large discount to net asset value, which may offer a healthy dividend yield, albeit at the expense of the upfront income tax relief.
A lack of demand in the secondary market means that over time, a VCT’s share price often slips further behind the net asset value. A number of managers will offer share buybacks to prevent the discount becoming too large. The VCT manager tends to repurchase shares at a discount, but this should still be more than the prevailing market price.
Tender offers occur where the VCT manager promises to repurchase shares at a predetermined price.
In the past, VCT managers might have offered investors a swap of their current shares for a new tranche of VCT shares, which would receive 30 per cent income tax relief. This was known as an ‘enhanced buyback’.
The option was attractive to investors who had reached their qualifying period for income tax relief – five years – on the original subscription and did not have deferred capital gains. But legislation taking effect from 6 April 2014 removed the income tax relief on the buyback.
Many high earners are finding that the annual allowance – particularly where reduced by either the taper, or as a result of having taken drawdown or annuity payments – is insufficient for their needs, and available carry forward may be a distant memory. In addition, the lifetime allowance can make pension contributions even less attractive.
For a high earner in this scenario, subscriptions to new VCTs may be the solution for both upfront income tax relief and a tax-free retirement income stream.
Victoria Harman is senior technical expert at Hargreaves Lansdown
