A guide to VCTs

Considering tax-efficient ways to grow your wealth without diving into DIY investing? Venture Capital Trusts (VCTs) can be a useful addition for the right investor. Designed to support often small and unlisted UK companies, they can offer generous tax benefits but do carry more risk. In this guide, we will break down what VCTs are, how they work, and whether they could be a part of your investment strategy.

What are Venture Capital Trusts?

VCTs, or venture capital trusts, are companies in their own right that pool money together and invest in mainly small, unlisted companies.[1] Investors can buy shares in the VCT to benefit from the growth in the underlying investments. At least 80% of these investments have to be held in qualifying companies in order for the trust to be considered a VCT. These companies are typically at an early stage of growth, and the capital provided by the VCT helps them to scale, innovate or expand.

How do VCTs work?

It’s worth remembering that when you invest in a VCT, you’re buying shares in the trust itself, not directly in the start-ups or growing businesses it backs. In return for taking on the higher risk associated with backing such companies, VCT investors can receive several tax incentives, like up to 30% tax relief on new investments (provided shares are held for at least five years).

VCTs are managed by professional fund managers who source deals, conduct due diligence, and support the portfolio companies post-investment. The trusts must comply with various rules, such as not investing more than a certain amount in any one company, to help spread risk.

Which companies can be included in a VCT?

There are a whole range of rules that a company has to meet before it can qualify for VCT investment, but they generally relate to size and maturity. As such, the companies typically have to have fewer than 250 employees, can’t have been trading for longer than seven years, have to be established in the UK and can’t be listed on the main market of the London Stock Exchange.[2] By their very nature then, they are considered high risk investments.

There are some helpful mitigators though, in that VCTs are limited in how much they can hold in a single company and the remaining 20% of the trust can be in non-qualifying assets like listed companies and cash. They should then at least provide far greater diversification than things like single company Enterprise Investment Scheme (a government initiative that offers tax relief to individuals investing directly in high growth startups [3]) investments.[4]

The different types of VCTs

Venture capital trusts aren’t a one-size-fits-all investment. There are three main types of VCTs, all with their own strengths, risks and strategy.

• Generalist VCTs: These are the most common type and invest across a wide range of industries and sectors. The goal here is diversification – aiming to spread risk by backing a wide variety of companies at different stages and in different sectors.
• AIM VCTs: These invest exclusively in the alternative investment market (AIM), a submarket of the London Stock Exchange for smaller, fast-growing businesses. As these shares are publicly traded, they can be easier to buy and sell.
• Specialist VCTs: As the name suggests, these focus on specific sectors such as technology, healthcare or energy. While this narrow focus can be riskier due to its lack of diversification, it also opens the door to potentially higher returns if the chosen sector performs strongly.

Benefits of VCTs

The UK Government wants to encourage people to invest in small companies with UK operations. As  noted earlier, the primary benefit of VCTs is that they offer a significant 30% up front income tax relief.[5] In addition to this, there is also no income tax to pay on dividends and no tax to pay on capital gains.[6] Whilst they are high risk, if they are used in the correct way, and for the right person, they can have some amazing advantages.

It’s really important to stress though that the 30% income tax-relief only remains valid if you hold the investment for at least five years. Of course, it’s also up to 30% relief available. You will have needed to have generated enough income tax in the same tax year in which you invest in the VCT to benefit from full relief. You also can’t invest more than £200,000 into a VCT each tax year so the benefit is capped.

Risks associated with VCTs

While VCTs offer many benefits, they are a complex investment vehicle with high risks associated. Therefore, working with a financial adviser is recommended to ensure they are right for you.

• Capital loss: VCTs invest in small, early-stage companies which can tend to be more risky and likely to fail compared to larger, more established firms. Like with many investments, the value of VCTs has the potential to fall sharply and investors could lose all or part of their original capital.
• Illiquidity: VCTs can be hard to sell. Although VCTs are listed on the London Stock Exchange, the market for their shares can be limited. It can take time to sell VCT shares, or they may need to be sold at a discounted rate, if capital is required fast.
• Long term commitment: If your goal is to retain tax benefits, investors must hold VCTs for at least five years. Selling earlier will mean any upfront tax relief must be repaid.
• Second hand VCT shares: These do not offer the same tax benefits so the market for them is far more limited, particularly compared to listed shares, which can make them much more challenging to sell.
• Tax rules and VCT qualifying status can change: It’s important to note that tax rules and VCT qualifying status can change over time. VCT rules have had several changes occur since their introduction in 1995, for example the income tax relief shifting from 20% to 40% in 2004 and then down to 30% in 2006. It’s important to stay informed.[7]

Who should invest in VCTs?

First of all, it’s important to say that VCTs are typically only right for the few rather than the masses. Due to their high-risk nature, they are usually only suitable for people with other significant investments. Typically, a VCT is a last planning step after someone is already making the maximum pension contributions, using their ISA allowance and using up their annual capital gains tax allowance.[8] You’d also expect the remainder of their investments to be well diversified across a range of asset classes and managed by professionals who are focusing on both risk and return.

VCTs tend to be more beneficial for high earners who are earning more than £360,000 and are subject to full tapering on their annual pension contributions right down to £10,000.[9] A VCT can provide a great alternative to the income tax relief this person would have otherwise received in a pension, if they weren’t subject to such heavy tapering, and reduce their short term tax bill.

VCTs can also be a feasible option for someone already using their tax-free allowances and who has other taxable assets that may be producing significant capital gains. VCTs can act as a helpful diversifier if investors want to broaden their investments further without worsening their capital gains tax position.