Venture Capital Trusts - FAQs
What is a VCT?
What are the key tax benefits of an investment in a VCT?
What are the different types of fund?
Top-up or "C" share?
What are the 'qualifying holdings' referred to above?
What are the charges?
What are the conversion options?
What are the risks?
What are the rules for a VCT to qualify?
What can a VCT do with shareholder funds initially while building the 'qualifying portfolio' and then with the remaining 30% or the 'non-qualifying' part of the fund?
What happens when I sell my VCT shares after five years?
What other principal rules must a VCT follow?
What should I know about the secondary market in VCT shares?
When should I invest?
Who can invest in a VCT?
Venture Capital Trusts (VCTs) are fully listed companies and their shares are traded on the Main Market of the London Stock Exchange. Nevertheless it is often difficult to re-sell VCT shares because, whilst they are listed, the market in them is illiquid because there tend to be few buyers. They are similar in structure to investment trusts. Primarily, they invest in small unquoted companies, or those listed on AIM, the market for growth companies operated by the London Stock Exchange, that engage in qualifying trades in the UK. The qualifying rules exclude a number of trades including property, financial services and commodities.
What are the key tax benefits of an investment in a VCT?
On the first £200,000 of investment each tax year in new ordinary VCT shares, individuals are entitled to:
- Offset 30% of their investment against their income tax liability for the year in which their shares are allotted (hence the application forms usually allow investors to elect in which tax year their shares will be allotted) provided shares are held for the minimum qualifying period of five years;
- Receive all dividends tax-free; and
- Receive tax-free the profits on any growth in the value of the VCT shares on disposal after at least five years.
(For further information on tax and VCTs please refer to the section entitled Tax Benefits of VCTs)
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What are the different types of fund?
AIM
AIM was launched in 1995 as a streamlined alternative for firms considering a listing on the Main Market of the London Stock Exchange (LSE). A simplified rulebook, easier entry requirements and responsibility for interpretation of the rules delegated to Nominated advisers epitomised AIM's new approach. Although initially thought of simply as a stepping stone to the Main Market, the success of AIM now means that it is seen as an alternative in its own right. AIM VCTs make the majority of their investments into new shares in AIM listed companies, either when an existing AIM company issues new shares, or at an Initial Public Offer when a company first joins the market. Not all AIM issues will qualify for VCT investment due to the qualifying rules that apply to VCT investments. There is usually good quality public information about AIM companies and therefore more transparency for investors about an AIM VCT's underlying holdings. It should also be easier for a VCT to sell an AIM holding and this is the usual exit route that managers will seek. It can be an illiquid market, particularly if a VCT holds a significant stake in a company, which would make a significant disposal of shares almost impossible. AIM-traded companies tend to be smaller than Main Market-listed companies and investment in an AIM stock is usually riskier than an investment in a fully listed company.
Generalist
Generalist VCTs mainly invest in small, unquoted, entrepreneurial firms that require either seed capital, development capital or capital to support a management buy-out. They also can and do invest a small proportion of their assets in AIM stocks. This kind of private equity investment can be very 'hands-on', and members of the VCT management teams may take seats on the boards of the investee firms, change management structures and personnel and advise on all aspects of business strategy. The overall aim is to create a successful business and then for the VCT's holding to be sold, either to the business owners, through a trade sale or through the market following a flotation. Until any of these exit routes can be secured, these unquoted investments will be very illiquid and it is difficult for investors to assess their value.
Specialist
Specialist VCTs have a specific investment mandate, which usually makes them more risky than more diversified Generalist or AIM VCTs. Historically, Specialist VCTs have concentrated on a specific sector, such as technology or healthcare. However, some more recent Specialist VCT offers have been used to shoe-horn, through clever structuring, a company's area of expertise into the VCT qualifying rules. Because of their diversity and potentially complex structures, Specialist VCTs require close scrutiny so that they are fully understood before an investment is made.
Limited Life
Limited Life VCTs are focused on capital preservation and are structured to wind up and provide an immediate return to investors following the minimum holding period. They tend to invest in businesses with strong asset-backing - often in the form of loan stock, with a senior charge over assets. Limited Life VCTs were initially very popular, but became less popular following revisions in the 2006 budget which increased the minimum holding period for VCTs from three to five years. They are likely to be more sought after in periods of downturn as they tend to cater to a lower risk appetite, but still offer the same tax benefits as other VCTs. It should be noted that whilst Limited Life VCTs are structured to limit risk, any income or capital uplift is likely to be limited as well.
Most VCT offers are for new shares in a new VCT, which may be managed by a new entrant to the market or an established management group. However, there are two other ways that VCT managers can raise funds.
A top-up is where an existing VCT creates new shares to increase its available cash in order to fund further investments and to increase its size so that its running costs and Total Expense Ratio (TER) are reduced. New investors get immediate access to the existing underlying investments of the VCT, which dilutes the holdings of existing shareholders but can be very attractive for new investors as the existing investments are likely to be more mature and nearer to exit, which could trigger tax-free dividends for VCT investors. The new shares are issued at a premium to existing shares.
A 'C' share issue is typically used when an existing VCT is fully invested and needs to raise additional cash but does not want to dilute the value held by existing shareholders. A new class of 'C' shares is created for this purpose and these are allocated to new investors. There may be a promise to convert the new shares into ordinary shares at a given date in the future and in a specified manner, and therefore to merge the VCT's two co-existing portfolios. This method of fundraising protects existing shareholders and, once the two share classes are merged, overall costs are reduced and a more diversified portfolio is created with companies at various stages of development.
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What are the 'qualifying holdings' referred to above?
Qualifying holdings refers to 'newly issued shares' or securities in companies which meet the conditions of the scheme. Qualifying companies must not be listed on the Official List of the UK Listing Authority London (i.e. they must be on AIM, PLUS Markets or truly unquoted). They must exist for the purpose of carrying on a qualifying trade. The qualifying trade must be carried on wholly or mainly in the UK. Most trades qualify, provided they are conducted on a commercial basis with a view to making profits. A trade will not qualify, however, if one or more excluded activities together amount to a substantial part of it ('substantial part' is usually taken to mean more than 20%). The main excluded activities are:
- dealing in land or shares
- financial activities
- receiving royalties (other than in certain cases)
- legal or accountancy services
- property development
- farming or market gardening
- holding or managing woodlands or other forestry activities
- owning or operating hotels or guesthouses
- owning, operating or managing nursing homes, shipbuilding, coal production and steel production
The charges applied to VCTs can be a bone of contention for investors, particularly when investment performance is poor. VCT charges are higher than most collective investment schemes because of their complex structure and the high fixed cost of the professional fees associated with running them and ensuring that they continue to comply with the qualifying rules (directors' fees, legal fees, audit and accountancy fees, etc). Furthermore, many VCTs, especially in the Generalist and Specialist sectors, have large management teams to source and run their investments. All in all, a Total Expense Ratio (TER) of 3.0 - 3.5% per annum is about average. This compares to an average TER of under 1.39% for all conventional investment trusts (AITC 30/11/08).
It is therefore not surprising that some VCT managers seek to differentiate their offers by creating charging structures that are more cost effective than the norm. Some VCTs may also charge performance fees. The specific charges of any VCT offer should be scrutinised prior to investment.
What are the conversion options?
Occasionally, VCT managers will incorporate an option within their offer that allows for the investment vehicle, or an individual shareholder's stake in it, to be converted to a different type of investment in the future.
In the last two years, a number of managers marketed Inheritance Tax (IHT) offers, which sought to link the attractions of the upfront VCT income tax relief (subject to the then minimum holding period of 3 years) with the fact that most underlying VCT holdings, if held directly by clients, would qualify for Business Property Relief and therefore be exempt from IHT (if held for a further 2 years). Thus, by holding the assets in the VCT for 3 years and then directly for a further 2 years, we have a 5 year investment that is attractive from both an income tax and IHT perspective.
However, the minimum holding period for VCTs has now been increased to 5 years and the conversion option also reduces the value of a VCT's very attractive ability to pay out significant tax-free dividends from capital realisations, which are unlikely to come in the early years.
VCT investee companies, by their very nature, should be considered as high risk investments. Whilst it should be recognised that a higher-risk profile has potential for high rewards, investors should also note that they could lose their money. Investors should carefully consult the relevant prospectus for a full list of the specific risks associated with investing in VCTs and all the relevant charges, both initial and ongoing.
Tax reliefs will not be attracted unless shares in the VCT are held for at least five years and will be lost if the VCT manager fails to manage the fund in accordance with the 'qualifying holdings' rules mentioned below and the other rules applicable to VCTs. In either such case investors may be required to retrospectively repay the income tax relief obtained and any future dividends and disposal of shares will become subject to tax.
VCT investments may be difficult to sell so that it may be impossible to realise an investment in such shares. Investments in VCTs should be regarded as long term.
What are the rules for a VCT to qualify?
In order that a VCT will continue to qualify, at least 70% of its investments (by value) must be in 'qualifying holdings' within 3 years. Tax relief will be lost if the VCT's manager subsequently fails to maintain this ratio for the remainder of the VCT's life.
What can a VCT do with shareholder funds initially while building the 'qualifying portfolio' and then with the remaining 30% or the 'non-qualifying' part of the fund?
There are no material restrictions and investors should carefully check the prospectus to ascertain the manager's intentions. Usually it buys investments in index linked investments or lower risk fixed interest investments. This is an important area when considering a VCT's risk profile.
What happens when I sell my VCT shares after five years?
Any profit you make on selling your VCT shares is tax-free, so long as you have held them for the minimum period of five years and provided the managers have ensured that the VCT complied with the rules. The market in VCT shares may be illiquid, in which case it may be difficult to re-sell shares.
What other principal rules must a VCT follow?
- A VCT cannot invest more than £1m in any one tax year in a company.
- An investee company must have gross assets which do not exceed £7m before funding and £8m after, and can only receive a total of £2 million of VCT funding in any 12 month period.
- An investee company must have no more than 50 employees at the date on which the shares are issued.
- No one holding can represent more than 15% of a VCT's investments.
- A VCT must distribute the majority of its income and must not retain more than 15% of the income derived from an investment.
What should I know about the secondary market in VCT shares?
This is an important area which is often overlooked. Investment in 'second hand' VCT shares (i.e. not a new issue but bought through the markets), does not qualify for the 'up-front' income tax relief. Investment will, however, qualify for the tax-free dividends for the lifetime of the VCT and tax free profits on disposal, unless the VCT loses its qualifying status within that period.
On this basis there are not many buyers of the second hand shares because each year there are new VCTs offering the Income Tax relief on their new shares, which can bring an investor's net cost down to as little as 70p for a £1 share. Accordingly, while the shares of a VCT are required to be quoted on the Main Market of the London Stock Exchange, it should be noted that the shares are likely to be illiquid and have a wide share price spread. Indeed, many VCT share prices are currently at a discount to the Net Asset Value of the underlying assets of the VCT.
It is for this reason that many VCT investors opt to hold onto the shares for the long term, with a view to enjoying the tax-free income they may provide, (although this income is likely to be 'lumpy' as disposals are gradually made within the VCT's portfolio and distributed as tax free dividends).
Steps were taken in the 2002 Budget to increase liquidity in the aftermarket by allowing VCTs to merge without loss of tax relief for investors. VCTs also sometimes offer a buyback policy - an area worth investigating before investment.
Income tax relief can only be offset against taxable income in the same financial year as the allotment of shares in a VCT. VCTs are closed ended investment vehicles, each offer has a prescribed maximum size at outset, which is typically £20m - £30m, but can be more or less. As such, there are a finite number of shares available in any VCT and an offer will close once all of the available shares have been allocated to investors. This creates a timing issue, as investors naturally want to keep their monies in cash and earning interest for them for as long as possible, but this runs the risk of having a VCT application returned because the offer is fully subscribed. By and large the most attractive VCT offers will be taken up first and so investors late in the tax year are likely to have less quality to choose from.
Some VCT managers have tried to address this issue by offering enhanced terms for early investment, typically an uplift of 1% provided by way of a reduced initial charge. However, the best advice must be to invest as soon as possible to ensure that a subscription is accepted.
UK taxpayers who are resident in the UK and aged over 18.
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