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Venture Capital Trusts (VCTs) Tax Guide

Enjoy some excellent tax breaks with VCTs

VENTURE capital trusts (VCTs) offer some mouth-watering tax breaks:

For the latest information on this subject, see our guide Salary versus Dividends

What makes VCTs more attractive than other tax shelters, including ISAs and pensions, is the double tax relief: when you put your money in AND when you take it out.

Pensions provide tax relief when you put your money in but your withdrawals are taxed. You can withdraw 25% of your fund as a tax-free lump sum when you retire but you have to pay income tax on everything else, including the accumulated income and capital gains within the fund and your original contributions.

ISAs, by contrast, allow you to make tax-free withdrawals of income and capital gains but do not provide any up front tax relief for your initial contributions.

So venture capital trusts offer the best of both worlds and are arguably the most generous tax shelters available.

Even if you only receive back your original money after five years, with no capital gains or dividends, you will still have enjoyed a return of 7% per year, thanks to the initial tax relief.

Some high income earners are starting to think of VCTs as alternative retirement plans, following the Government’s decision to severely limit the tax relief on pension contributions made by those earning over £150,000.

So What’s the Catch?
The first catch with VCTs is you have to invest for a minimum period of five years. Depending on your age, pensions can be even more restrictive: you cannot touch your money until you reach age 55. ISAs, on the other hand, allow you to withdraw your money tax free at any time.

An ISA is therefore the only tax shelter that comes with no strings attached and is the best investment for those who want easy access to their money.

The second, and most important, catch with VCTs is that they have to invest your money in the smallest and arguably most risky companies. This, after all, is why the Government created such a generous tax shelter in the first place: it wants to encourage investment in small, expanding companies.

With pensions and ISAs, on the other hand, you can invest in the biggest blue chip companies, as well as small companies, corporate bonds, property unit trusts and cash.

Venture capital trusts have to put at least 70% of their money in ‘qualifying’ companies. These are companies that comply with the following rules:

The remaining 30% of a VCT’s money can be invested in anything – it can even be parked in the bank.

The £7 million ceiling and ban on quoted companies means that most of the money you invest in a VCT will probably end up in small, privately owned firms.

Many readers may feel that they already have ample exposure to this type of investment, namely their own businesses!

Illiquid Investments
A major drawback of VCTs is their lack of liquidity. The trusts themselves are quoted on the London Stock Exchange but you will probably struggle to sell your shares when the five-year period is up.

Why? Because the 30% income tax relief – the only reason most people invest in venture capital trusts – is only available on new VCT shares.

Investors who buy ‘second-hand’ VCT shares are entitled to tax-free dividends and capital gains but the all-important 30% tax refund is denied. For this reason, there are very few people willing to buy VCT shares from exiting investors.

Some VCT managers like Downing Corporate Finance have solved this problem by launching “Planned Exit” VCTs – the funds are wound up after five years and all the money is distributed to investors.

Recent Changes Mean Even More Risk
As mentioned above, 70% of a VCT’s money must be invested in small companies. However, only 30% of this amount has to be invested in ordinary company shares. The rest can take the form of less risky loans.

That’s the rule for the current tax year which ends on April 5th 2010. Thanks to proposals in the Pre-Budget Report, however, VCTs raising money after this date may have to invest 70% of their ‘qualifying’ company investments in ordinary shares, with only 30% allowed as loans.

This change will make investing in VCTs after April 5th more risky because loans are generally better than shares when companies go insolvent.

If a VCT lends money to a company that goes bust, it’s possible that at least some of the money will be recovered when the company’s assets are sold off. However, it’s rare for ordinary shareholders to receive anything in these circumstances.

The new rule may also create problems for the planned exit VCTs. These funds generally prefer to lend to companies, rather than buy shares, because it is much easier to wind up a loan after five years than sell a stake in a private company.

So investors who want to take advantage of planned exit VCTs should consider doing so before the end of the current tax year on April 5th. 

How Have VCTs Performed?
In recent years venture capital trusts have delivered shockingly bad investment returns. The average VCT has lost 22% of investors’ money over the last three years. Even over 10 years, enough time for any half-decent money manager to get all his ducks in a row, the average return has been negative 19%.

The worst of the bunch have lost over 80% of investors’ money.

Of course, it’s not just VCT managers who have lost bucket loads of money over the last few years and there are some notable exceptions.

For example, the Downing Planned Exit VCT 2 has delivered an 86% return over the last three years. The Northern Venture Trust has delivered steady returns of 31%, 39% and 78% over the most recent three, five and ten year periods respectively.

Limiting Risk
The one and only reason the vast majority of people invest in VCTs is to save tax. That the underlying companies are small and risky is not seen as a positive factor but a necessary evil.

Promoters of venture capital trusts realise this and offer VCTs that only invest in lower-risk “asset-backed” businesses (essentially businesses that own property). The VCT usually insists on having first claim over the property if the business goes into administration.

Examples of asset-backed businesses include children’s nurseries, health clubs, pubs and conference centres. Even ten-pin bowling halls show up in some portfolios.

The 30% of the fund that does not have to be put into small companies (the so-called non-qualifying holding) is usually invested in low-risk fixed-income securities, including Government bonds.

VCTs – Key Facts