From tiny acorns

Venture Capital Trusts or VCTs are becoming increasingly popular, with demand boosted by valuable incentives for investors in these tax shelters and tighter restrictions elsewhere. However, smaller companies and start-ups held within this type of investment company are potentially higher risk and so the pros and cons of VCTs must be considered with care.

You should never invest primarily for tax breaks, although these can be an important consideration, particularly for high earners and experienced investors. VCT shareholders can qualify for upfront 30% income tax relief, regardless of the individual investor’s earnings; provided the tax paid is sufficient to cover the relief obtained.

For example, initial tax relief can reduce the net cost of £10,000 nominal stock in a VCT to £7,000, even for basic rate taxpayers. Any dividends paid by these funds and any capital gains are tax-free, provided the shares are held for five years.

As I know from personal experience, having invested in Northern 2 VCT and Northern 3 VCT nearly five years ago, this combination of initial tax relief and tax-free dividends can produce double-digit yields. But it is important to remember that dividends are not guaranteed and may be cut or cancelled without notice.

Another important consideration is that VCT shares tend to be priced substantially below their net asset value and many trade at a double-digit discount to NAV.  Even after the minimum five-year holding period has elapsed, small companies’ shares may prove illiquid or difficult to sell.

Not every acorn turns into an oak and start-ups or small companies are less likely than large or long-established firms to have big reserves or diversified businesses to help them cope with economic adversity or other setbacks. So it is important to remember that share prices may fall without warning and you might get back less than you invest.

Despite those caveats, £439m has flowed into VCTs during the 2017-2018 tax year, compared to £542m in the whole of the previous fiscal year, and several experts forecast a new annual high will be hit before the current tax year ends at midnight on April 5. One reason is tougher taxation of investors elsewhere.

For example, with effect from April 6, 2018, the dividend allowance – or the maximum equity income investors can receive without having to pay tax – will be cut by 60% from £5,000 per annum to £2,000 per annum. That means many income-seeking investors who have not made use of government-approved tax shelters, such as individual savings accounts or VCTs, will pay more tax after April.

Retirement funds are the most valuable way for long-term investors to place assets beyond the grasp of HM Revenue & Customs but pension tax reliefs have already been sharply curtailed. The maximum investment allowed in retirement schemes has been reduced both in terms of annual contributions and the lifetime allowance.

At first glance, the current maximum pension contributions of between £10,000 and £40,000, depending on the individual’s income, and a lifetime cap of £1m look sufficient for most people. But rising numbers of serious savers in their forties or fifties - and others looking to catch up with retirement planning using bonuses, redundancy lump sums or the sale of businesses - are hitting their heads on these limits and looking for alternative or supplementary tax-efficient stores of value. The maximum anyone is allowed to invest in a VCT is £200,000 this year.

However, it is important to beware the government changed the rules about which underlying businesses qualify for VCT tax breaks a couple of years ago. For example, management buy-outs are no longer eligible for new VCTs. This means VCTs might have to take higher risks than they used to in order to earn the tax breaks their investors enjoy.

More positively, rising numbers of VCT managers now have substantial track records which you can find and compare on the Association of Investment Companies’ website. They are divided into different groups, depending on the businesses of their underlying holdings. For example, these include VCT Generalists, VCT Alternative Investment Market (AIM) and specialist sub-sectors such as Healthcare & Biotechnology; Media Leisure & Events and Technology.

In most cases, the closed-end structure of investment companies – as opposed to open-ended funds, such as unit trusts – may prove valuable to shareholders and managers investing in illiquid assets, because they will never be forced to dispose of underlying holdings to raise cash to meet redemptions.

This makes VCTs a valuable source of patient capital to fund the expansion or scaling up of smaller companies and start-up businesses that are an increasingly important part of the British economy. For example, according to research by the AIC last year, VCTs enabled companies in which they invested to more than double their turnover – with an increase of £2.2m of revenue for every £1m invested by VCTs – and to create a total of 27,000 new jobs.

So, while it is vital to remember the risks as well as the rewards, VCTs can enable investors to do well by doing good – and trim tax bills while doing so.

Ian Cowie is a columnist at The Sunday Times