The increasing demand for VCTs

Pensions reform, in the end, proved to be the dog that didn’t bark. But while fevered speculation that the Chancellor would launch an attack on pensions tax relief in last month’s budget eventually proved wide of the mark, that doesn’t mean financial advisers shouldn’t be looking more closely at other tax-efficient long-term savings vehicles – and particularly venture capital trusts (VCTs).

For one thing, the reprieve may be temporary. Also, pension contribution allowances are already coming down, courtesy of changes announced by the Treasury last year. Even more importantly, the case for VCTs stacks up for many investors even leaving aside the pressure to think about new ways to save for retirement.

It’s clear that many advisers and investors have already got the picture. Despite some predictions that VCT fundraising would fall back last year, following changes to the rules on what the funds may invest in, the sector picked up £458m over the course of the 12 months to 5 April 2016. That was £29m more than during the previous tax year, itself an impressive year, and the third highest total on record.

This increasing demand for VCTs reflects the broad appeal of the funds, despite their mandate to invest in small and less mature companies, with which you would normally associate higher levels of risk. Certainly, the 30 per cent income tax relief that is available on purchases of new shares (though these must be retained for at least five years) is very important to many investors, even if it doesn’t deliver quite the level of relief available to higher-rate and additional-rate taxpayers on private pension contributions. But there are other important tax advantages too.

The tax-free status of VCT dividends – whether investors buy new shares or on the secondary market – is especially significant. The sort of small companies in which VCTs invest don’t normally pay dividends to shareholders, but the maturing portfolios of many funds in the sector, including long-term holdings in companies now in a position to make income distributions, has seen yields rise steadily. So much so that the average yield across the VCT sector as a whole is close to 9 per cent – more than twice what is available from the FTSE 100 Index, for example.

The combination of upfront tax relief and tax-free dividends can be very powerful. On a fund targeting a yield of 6 per cent, say, investors are effectively getting 8.5 per cent when you take into account the 30 per cent relief. To a higher-rate taxpayer paying no tax on their dividends, that’s the equivalent of a yield worth more than 14 per cent from a conventional fund where income tax would be payable. Even those buying in the secondary market and therefore missing out on upfront relief are getting a substantial uplift.

Investors must, of course, be happy to accept the risk profile of VCT investments. And last year’s changes, which saw VCTs limited to investments in smaller and younger companies, will amplify the risks over time. Nevertheless, for advisers seeking income or long-term capital growth (also free of tax under the VCT rules), the sector provides some compelling opportunities, even without the wider context of changing pension rules.

Moreover, if you are concerned about pension changes, it’s worth noting that the annual contribution limit for VCTs stands at £200,000, five times’ higher than the cap on pension contributions that now applies to most investors. Plus there’s no need to worry about a lifetime limit, as with pensions – under the current rules, VCT investments will remain tax-free however large they grow over the months and years ahead.