A venture capital trust is similar to an investment trust. They provide investors with generous tax incentives to encourage investment in a variety of small, unlisted companies.
Please note that the author performed research to ensure that the content of this article was accurate at the date of initial publication (2012) however tax laws are subject to change, and VCTs have very complicated tax rules.
Venture Capital Trusts are only appropriate for sophisticated investors due to the complexity of these tax rules and the high risk of loss from investing in small businesses.
What is a Venture Capital Trust (VCT)?
Run by fund managers, who manage the funds assets, VCTs predominantly hold the shares of unlisted companies.
Venture capital trusts are similar to investment trusts in that they are listed on the stock exchange. Investors can subscribe for new shares during a funding round, or buy shares from existing investors in the fund.
VCTs allow investors to diversify their money across a range of small businesses. Investors love small businesses despite their high risk because a successful private equity investment can deliver returns in excess of 1000%.
Such investors therefore expect that several investments made by the VCT will not succeed, but hope that there are enough successes to still deliver an attractive return overall to compensate them for the risks taken.
VCT Tax Relief
The generous tax relief offered by the UK government helps to shift this risk and return balance in favour of investors, by ultimately shrinking the cost of entering a VCT investment.
VCTs offer multiple ways in which investors can legally avoid tax in the UK. The following rules apply to investors subscribing for new shares in a VCT:
Up-front income tax relief @ 30%
Income tax relief of 30% on the first £200,000 of investments made into a VCT each year. This gives a maximum £60,000 discount on your UK tax liabilities. This relief can be offset against UK income tax in the year of investment or offset against tax paid for the year prior.
Relief will be withdrawn if the VCT shares are disposed of within 5 years.
Use it or lose it. If you have insufficient UK income tax liabilities to fully utilise the relief in the current or prior year, you cannot carry it forward to reduce future tax liabilities.
This highlights the degree to which your own personal financial circumstances will impact how valuable these incentives are to you.
Tax relief cannot be claimed if you’ve already claimed under the Social Investment Tax Relief scheme, which shares some similarities.
Up to £200,000 of dividends received each year from VCTs will be exempt from personal income tax.
Corporation tax exemptions within the VCT
The VCT itself is exempt from corporation tax on the gains from disposing of holdings.
Capital Gains Tax (CGT) exemption
When you sell shares in a VCT, any gains made are exempt from capital gains tax (CGT).
What funds qualify to be a Venture Capital Trust?
All schemes promoted as VCTs should meet these requirements, but for completeness, here are the rules that a VCT must meet to enable their investors to benefit from the tax relief.
- VCTs must be formally approved by HMRC in advance of shares being issued
- VCTs must be listed on a recognised stock exchange, e.g. London Stock Exchange
- Its income must be mainly generated from shares or other securities
- VCTs must distribute 85% of income / retain less than 15% of income
- At least 70% of its holdings must be in qualifying holdings
These are newly issued shares in qualifying unlisted trading companies. The definition of unlisted in this case, actually includes companies traded on AIM.
- Diversification: No more than 15% of the VCT holdings should be in a single company
- At least 70% of the shares held must be in ordinary shares
- Companies invested in must have fewer than 50 employees and have raised no more than £2m in the two years leading up to receiving investment from the VCT.
- Other conditions apply
It is the VCT’s responsibility to ensure they are compliant with the VCT definition, but you will ultimately bear the financial consequences of losing access to the tax relief if the VCT fails to qualify or has its status revoked.
For peace of mind, I recommend asking to see the advance assurance letter which the VCT may have applied for from HMRC. This should provide some upfront clarity that the scheme appears to meet the criteria.
Even if a VCT qualifies as such, you will not benefit from tax relief if you or a relative is personally connected to the company. The schemes are designed to encourage inward investment from outside investors.
The risks of investing in Venture Capital Trusts
As the income tax relief is only offered on the sale of new shares in a VCT, meaning that shares offered for sale by existing investors will look unattractive in contrast.
Therefore despite Venture Capital Trust shares being listed, shareholders may find it difficult to find a buyer at a fair price as the tax relief distorts prices.
Shareholders must hold the shares for 5 years to continue to qualify for the 30% income tax relief. However this doesn’t restrict sales – investors may still attempt to sell their shares if they are prepared to lose the relief.
VCTs are more diversified than investing individually in EIS companies, however the underlying nature of the holdings will be very similar, and therefore this still represents a high risk investment.
Multiple businesses held by the VCT could fail, which would result in an immediate reduction in the value of the VCT shares.
Tax rules may change. The headline income tax relief is claimed within a year of subscribing to the new shares, however, the longer-term reliefs such as CGT deferral or CGT exemption are subject to change due to new legislation.
It is for this and other reasons that you should never use tax relief/efficiency as the primary decision making factor when making an investment.