More than just a tax shelter

David Prosser considers the merits of VCTs as a long-term investment, rather than as a tax break.

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Are you thinking about putting money into a venture capital trust (VCT)? If so, you are not alone – VCTs have already raised £128m since the beginning of the tax year in April according to figures from the Wealth Club investment platform. That is five times the amount they had raised at this stage of the tax year 12 months ago.

Soaring demand for VCTs reflects growing anxiety about higher taxes. These funds invest in small privately-owned companies at an early stage. Such companies come with the potential for high returns, if they grow quickly, but also carry more risk than larger, more established businesses. So, investors in VCTs get access to a bunch of attractive tax benefits to provide some compensation for that additional risk.

Tax relief upfront and ongoing

The tax breaks are really very generous. First, investors in new VCT shares – as opposed to those trading on the stock market already – get upfront income tax relief at a rate of 30%. In addition, all capital gains on VCT shares are tax-free. So too is the dividend income that the funds pay – and while the companies in VCT portfolios are generally too young to generate significant dividends, managers structure their funds in a way that enables them to offer an income stream to investors.

The dividend tax break looks particularly attractive in light of the increase in tax on dividends announced by the Chancellor last month to pay for NHS and social care costs. Outside of shelters such as VCTs, once investors have exhausted their annual £2,000 dividend allowance, they will, from next April, pay tax on such income at 8.75%, 33.75% or 39.35%, depending on whether they are basic-rate, higher-rate or additional-rate taxpayers.

However, don’t overlook the value of the other tax incentives that VCTs offer. In particular, the upfront income tax offers a real cushion if the fund struggles with some of its investments. To keep the relief, you must hold on to your VCT shares for five years, but the perk effectively means that your investment can decline in value by up to 30% without you being in the red.

Invest for the long term

Inevitably, the tax treatment of VCTs prompts people to think about the funds in those terms. But it is crucial that you consider the merits of VCTs as a long-term investment, rather than as a tax break. You are putting money into high-risk companies that may take some time to deliver – if they ever do. And while investing through a fund with a portfolio of such companies means you are spreading risk, the risk is still significant.

For this reason, financial advisers typically suggest that investors consider other tax-advantageous investment arrangements before they move on to VCTs. In particular, you can invest £20,000 inside an individual savings account (ISA) each year, with no tax to pay on dividends or capital gains on such investments. Since a far broader range of assets qualify for ISA inclusion – including many low-risk investments – it is a good idea to start here. Pension plans, too, offer generous tax incentives on a range of investments, so using your allowances here can also be sensible.

Still, a growing number of savers and investors are looking for tax-efficient options over and above these more universal schemes – particularly since pension allowances have become more restrictive in recent years. If you’re one of them, VCTs could be a good option to consider.

Move quickly

Traditionally, most fund-raising in the VCT industry has taken place over the final few months of the tax year, as investors have become more focused on using their annual investment allowances (in the case of VCTs, you can invest up to £200,000 each tax year, far more than in Isas and pensions). However, this year may be a little different, as Wealth Club’s data suggests.

Investors may even find that the most popular VCTs sell out. Importantly, VCT managers are quite strict about how much they raise, because they want to be sure they can find good homes for people’s money. This means you may miss out on the fund you want if you leave it until the last minute.

Don’t be rushed into making an investment – and don’t invest simply to get a tax break. VCTs are a sophisticated financial planning tool, and it makes sense to get some independent advice before taking the plunge. Still, if this kind of fund could work for you, take some time to study the market sooner rather than later.