The benefits of VCTs

Venture capital trusts got something of a reprieve in the Chancellor’s autumn budget, with the generous tax reliefs they offer previously tipped for the axe. But if VCTs did indeed dodge a bullet, they’re certainly seizing the opportunity now. Octopus has just raised £120m for its Titan VCT, by some margin the largest amount ever raised by a single fund in the sector, while fundraising is proceeding at pace at a dozen other funds.

In the 2016-17 tax year, VCTs raised £542m, the second highest amount ever, but this year the industry looks set to exceed that total. It may not reach the £779m record of 2005-06, a year in which tax relief on VCT investments was doubled, but the sector is buoyant. The number of people investing in these funds, which build portfolios of small unlisted companies they hope will grow fast, continues to grow.

The particular success of Titan VCT can partly be explained by a novel structure Octopus launched last year enabling investors to access the fund using their individual savings account allowance. But more broadly, VCTs’ current popularity reflects two themes: the attractions of high-growth small companies and the growing need for smart financial planning strategies to build tax-efficient long-term savings.

The first of these ideas is VCTs’ raison d’etre. The strong performance of listed smaller company shares during 2017 is part of a long-term story of superior returns from small-cap stocks, while the idea of long-term value from high-growth businesses has been given greater profile thanks to fund managers such as Neil Woodford, who champion this style of investment. At the margins, the evolution of crowdfunding, in which investors put money directly into very small businesses via loan or equity capital, has also helped sentiment.

As for financial planning, VCTs are a hugely valuable tool, offering 30 per cent income tax relief on investments of up to £200,000 a year in new shares, tax-free dividends (the sector paid out £395m last year) that don’t even need to be declared on a tax return, and profits that are free from capital gains tax.

These tax breaks are intended to incentivise investment in growth businesses considered high risk because of their early-stage status and size, and no one should invest in VCTs without thinking carefully about the possibility of losses.

Nevertheless, the incentives look particularly attractive in the context of what has happened to private pensions in recent years. The headline annual cap on contributions to pensions now stands at £40,000 – down from £255,000 as recently as 2011 – and investors must also stay within the lifetime limit, which imposes swingeing tax charges on all pension savings above £1m. To add insult to injury, higher earners with incomes of more than £150,000 get a progressively lower annual allowance – it falls to just £10,000 for those with incomes of more than £210,000.

For anyone struggling to maximise their pension contributions in the face of these thresholds, VCTs are an attractive alternative. For many investors, they are becoming the next bucket of savings to fill each year once pension allowances have been used.

That can work well, as long as investors are conscious of the risk profile of the funds and diversify accordingly. The long-term nature of VCT investment is a good fit with retirement planning, while the tax efficiency mirrors what’s available from private pensions. Let’s just hope the Chancellor continues to resist the temptation to fiddle; small changes were made in the budget to target schemes considered not to be in the spirit of the VCT rules, but most funds are unaffected and those generous reliefs remain intact.