Over £3bn has been poured into venture capital trusts since they were introduced in 1995. They remain high risk but investors are warming to their tax-free dividend potential.
In order to get us to invest, the government provides many different tax incentives. Many of these, such as ISAs and pensions, are aimed at the mass market. However there are also a number of more specialist ideas aimed at “sophisticated” investors.
I’ve always been a bit curious about the moniker of sophisticated investors. Perhaps an ordinary investor is someone who has lost lots of money but a sophisticated one also understands why they’ve lost it. Anyway, enough of the frivolous definitions.
Among the specialist tax breaks on offer to investors are Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCTs). The former allows you to invest directly in one unquoted company while the latter is an investment fund that invests in many different companies, either unquoted or listed on junior stock markets like AIM and Plus.
VCTs and money invested
It’s VCTs that I’m going to focus on here. They were introduced in 1995 and the main incentives they offer are income tax relief on money invested in new VCTs, tax-free dividends and no capital gains when any shares are sold.
You can see how much money we’ve invested in them from the table below.
Tax year | Funds raised £m |
|---|
1995/96 | 160 |
1996/97 | 170 |
1997/98 | 190 |
1998/99 | 165 |
1999/00 | 270 |
2000/01 | 433 |
2001/02 | 125 |
2002/03 | 65 |
2003/04 | 50 |
2004/05 | 505 |
2005/06 | 779 |
2006/07 | 237 |
2007/08 | 219 |
Total | 3,398 |
There has been quite a lot of variation in the money invested from year to year. That’s because our last Chancellor loved to tinker with the rules for VCTs (this guide from the AIC has full details regarding the current set-up – link to pdf file – and this Fool discussion board is also a handy resource).
The income tax relief was originally set at 20% on up to £100,000 invested. In April 2004, this was boosted to 40% and up to £200,000, hence the large amounts invested in 2004/05 and 2005/06.
In April 2006 the tax relief was reduced to 30% and the minimum holding period required to get this relief was increased from 3 to 5 years. This saw the amount of money into VCTs drop substantially in 2006/07 and 2007/08. Additionally, the maximum size company that a VCT could invest in was more than halved from £15m to £7m. This makes them considerably more risky as an investment proposition.
Hopefully our current and future Chancellors will resist the urge to tinker quite so much, as chopping and changes the rules quite understandably puts off many investors and creates a lot of uncertainty for VCT managers.
The risks of VCTs
It’s easy to get tempted by the tax reliefs on offer from VCTs. However, tax incentives are the ruin of many investment decisions. Indeed the FSA was concerned back when the tax relief was 40% that the risks of these funds weren’t being properly explained to some investors.
One problem is that management charges are very high for VCTs as the companies tend to very small – the average assets held by the 130 or so VCTs in existence is less than £20m. Total expense ratios are typically 4% pa versus 1.5% for a standard fund and 0.5% for an index tracker.
Overall VCT performance, excluding the tax incentive, can best be described as mixed. Trustnet shows around 60 VCTs with a five-year track record but only just over half have returned a profit over this period.
Perhaps the biggest problem with VCTs though is that they are very hard to sell. Few people want to buy VCT shares on the open market as you don’t get the income tax relief as a second-hand investors (you do receive tax-free dividends though). For this reason, many companies offer share buyback schemes to sweep up any VCT shares investors do want to sell, however these are often priced at large discounts to their net asset value.
There are some signs of improvement here as reported in the FT last weekend. That’s just as well because by April 2009 the large amounts invested in 2004/05 and 2005/06 will all have become free from any tax relief restrictions. This means many more investors could be looking for an exit although the vast majority keep their VCTs for far longer than the minimum time period needed to retain the tax relief.
It’s hoped that investors will increasingly become attracted by the high tax-free dividends that many mature VCTs offer and create more of a second-hand market. In order to tap into this Octopus, a well-known VCT outfit, recently launched a portfolio service for such investors which will invest in numerous older VCT funds where there is a track record that can be examined and you can see what companies have been invested in.
I have to confess I’m a VCT investor, putting some money into a Baronsmead fund in 2004 and topping it up a in a secondary offer last year. Even though it’s one of the largest funds out there, with over £50m in assets, only 5 trades at a combined value of £25,000 have been recorded in the last two weeks. It’s not exactly what you’d call the most liquid of investments!
After tax relief, I reckon I’m sitting on a capital gain of 25% although I can’t sell last year’s top-up until 2012 without losing the tax relief. Last year’s dividends of 8p represent a yield of 15% on my original investment. So far so good, I reckon. The company has a stated target of paying at least 5.5p in dividends each year although it may not achieve this of course. For a second-hand investor the 5.5p payout would represent a tax-free income of 7.5%. Other VCTs offer the prospect of similar payout levels.
Will we ever see a big demand for second-hand VCTs? Probably not in my opinion although we will continue to see a gradual improvement. It’s an issue that’s often gets discussed in the industry but even 13 years after the first VCT was launched not a lot seems to have changed.
> If you'd rather follow a lower-risk approach to investment, take a look at index trackers which offer a cheap and simple way to invest in the stock market.
