The vogue for VCTs

Advisers are increasingly recognising their attractions.

red carpet

Will 2021-22 prove to be a bumper year for venture capital trust fund raising? If so, VCT managers will have the Prime Minister and his Chancellor to thank; their announcement of a tax hike on dividend payments to help pay for the NHS and for social care makes VCTs look more attractive than ever.

The Government’s plan is to increase dividend tax rates by 1.25 percentage points from the beginning of the 2022-23 tax year. For higher-rate taxpayers with equity portfolios generating more than £2,000 of dividends, the tax on the excess will therefore rise from 32.5% to 33.75%. And while there will still be no tax to pay on dividends from shares held within an individual savings account (ISA), the £20,000 annual allowance limits investors’ options. Many will be looking for other strategies to manage their tax exposures.

Enter VCTs. Investors can put up to £200,000 into these specialist investment companies each year – ten times’ the ISA limit. Where they buy newly-issued VCT shares, they get upfront income tax relief of 30% on their investment. Future capital gains are then tax free and – here’s the clincher given the tax rises – so too are all dividends.

VCTs may not be the most obvious vehicle for advisers and investors looking to generate income. The special tax status of these funds reflects the fact that they invest in small, early-stage businesses, rather than the large and mature businesses that produce a constant flow off dividends.

In practice, however, most VCT managers tend to structure their investment portfolios with income generation in mind. For example, one common tactic is to invest in companies by providing loan capital as well as equity funding. The repayment of the debt provides a stream of income for the VCT to pass on to investors (as well as reducing risk, since debt holders get paid before equity investors in the event of a company failure).

Using such techniques, many VCT managers have proved able to generate yields of 5% or so a year, which looks pretty handsome compared to what is available from listed equities, never mind bonds or cash. And remember, VCT dividend income is tax-free, so for a higher-rate taxpayer it is effectively worth 7% a year or more.

This is not to suggest VCTs are a free lunch. Investors get tax breaks in return for putting money into these funds because it is widely accepted that small, early-stage companies carry more risk than other types of investment. There is no guarantee any VCT manager will deliver positive returns.

Nevertheless, small changes to the tax system can drive significant demand for VCTs. Reductions in investment allowances for savers with private pensions has prompted many to look to VCTs as an alternative in recent years. This latest tax hike on dividends is likely to have a similar effect.

In the last tax year, VCTs raised £685m from investors, 11% up on the previous 12 months, even at a time when the Covid-19 pandemic was causing so much uncertainty. The all-time high for VCTs came in 2005-06, when £779m flowed into the sector, albeit at a time when the tax incentives on offer were even more generous.

It is too early to say whether 2021-22 might see that record come under pressure. But after a bumper VCT season on 2020-21, there is every reason to expect further growth this year – advisers increasingly recognise the attractions of these funds, including their valuable tax status.