With just two months left of the tax year, David Prosser explains the ins and outs of venture capital trusts.
With just two months left of the 2019-20 tax year, have you used up the tax perks on offer when investing through individual savings accounts (Isas) and private pensions? Savings and investments you make inside Isas and pensions grow free from tax, but there are strict limits on how much you can contribute to these plans each tax year: £20,000 via an Isa and, for most people, £40,000 or their annual income (whichever is lower) in a pension.
Increasing numbers of people are struggling with these limits, particularly when it comes to pensions, were special rules applying to high earners mean some people are restricted to saving as little as £10,000 each year. The private pension system also caps the total amount of savings you can build up without tax penalties at a little over £1m.
In which case, venture capital trusts (VCTs) might be worth considering. These investment funds were introduced 25 years ago by the then Chancellor Kenneth Clark. They provide a range of tax incentives to encourage investors to put money into smaller, less mature businesses that might otherwise struggle to secure funding.
What VCTs offer
The VCT rules are generous. You can invest up to £200,000 a year in one or more funds, with 30% upfront income tax relief on your money, so a £10,000 investment, say, costs only £7,000. VCT managers must invest 70% of the fund in qualifying companies within three years; these businesses must be privately-owned (though some Alternative Investment Market-listed companies qualify) and below a certain size and age. Returns on the fund are then tax-free – there is no income tax to pay on dividends or capital gains tax due on profits.
Importantly, only newly-issued VCT shares qualify for the 30% income tax relief. It is possible to buy VCT shares on the stock market, but these won’t get you the upfront tax incentive. For this reason, the VCT industry operates by launching new funds each year, or new share issues on existing funds. Most launches are concentrated around this time of year, as the end-of-tax year deadline begins to press.
Should I invest?
VCTs aren’t suitable for everyone. Their generous tax breaks are there for a reason – the companies held by the funds are riskier bets than larger stock market-listed businesses. VCTs have invested in many small companies that have gone on to become household names - GO Outdoors Everyman Cinemas, Five Guys and Zoopla are good examples – but there have also been failures. You certainly need to be prepared to hold on to your shares for the long term and accept the risk of the fund falling as well as rising (indeed, if you sell your shares after less than five years, you’ll have to repay the income tax relief).
That said, the fund structure provides some protection from risk. VCT managers seek to build diversified portfolios of companies, insulating investors from the impact of individual failures. VCTs are run by specialist managers with a long track record of investing in smaller, less mature businesses. And the returns posted by many existing funds have been very impressive.
Certainly, VCTs are increasingly popular. In the 2018-19 tax year, investors put £731m into these funds, a record year for the sector in its current form (some of the tax incentives were changed in 2005).
In part, that reflects growing awareness of what the funds have to offer. But it’s also a result of the increasing frustration some savers have with Isa and especially pension savings allowances. If you’ve exhausted these, VCTs could be your next port of call.