Tax rises are increasing the attractiveness of VCT tax breaks.
2010 is being touted as one of the best ever periods for investing in Venture Capital Trusts (VCTs) -- although admittedly it's mainly fund managers doing the touting.
When VCT managers talk of a great year, they mean that a great amount of money will be raised to put into their trusts! VCT expert Martin Churchill of Tax Efficient Review expects £250 million to be raised by new VCT issues this tax year. That would be a 70% rise on last year, which should keep VCT fund managers in Blackberries and braces for a while.
But why are VCT investors showing more interest?
Higher earnings on the run
Wealthy investors aren't getting excited about VCTs for the returns, that's for sure. The performance of these specialist investment vehicles has been so erratic over the years that very few funds can sell themselves on a spectacular investment record.
That said, recent history has been pretty good for the so-called 'secondhand' shares of many listed VCT funds -- even if that's mainly because they fell so far in the financial panic of late 2008 and early 2009.
When I looked at listed VCTs last summer, popular VCTs were trading on double-digit dividend yields and well below net asset value, despite the recovering markets. Some of these trusts have since bounced back very nicely -- for instance the Northern managed VCTs, as well as Albion VCT, Foresight 4, and ProVen Growth & Income are all well up.
But it's new VCT issues that Martin Churchill is talking about when he says more new money is coming in. And as ever with VCTs, the attraction here boils down to the VCT tax breaks, which look more attractive than ever to higher income earners facing higher tax rates.
From 6 April, personal tax allowances are being reduced for earnings over £100,000 a year, while the lucky few earning more than £150,000 face a new 50% tax band from the same date.
It's often said that tax concerns shouldn't drive investment decisions, but in my experience people earning £150,000 or more are very keen on money and rather less so on tax. The opportunity to use VCTs to reduce their tax bill may be irresistible.
30% off
Anyone investing in a new VCT issue gets 30% income tax relief, up to the level at which it wipes out their income tax bill entirely.
This means a high earner with £100,000 to spare could knock £30,000 off their 2009-2010 tax bill by investing in VCTs now. Do the same after 5 April, and they'd take a £30,000 lump out of next year's bill, too.
This income tax relief is a one-off, but there are ongoing tax benefits, too.
Most importantly, there's no tax to pay on dividends from VCTs. With the tax rate on normal dividends also increasing for the highest earners, that's now an extra incentive to consider a VCT portfolio for income.
Tax-free dividends from VCTs are also potentially attractive to high earners who are seeing their pension contributions curtailed. By investing in a VCT instead, you can get immediate income tax relief, as well as an ongoing tax-free yield that's likely to be at least 5% in a few years' time.
VCTs are also exempt from capital gains tax, although I wouldn't get your hopes up here. I can find only one VCT trading above NAV -- Ventus, the windfarm specialist -- and that's by just 2%.
Beyond the income tax relief
What's the investment case for VCTs, aside from the tax breaks?
Well, VCT insiders claim this is also improving. They say reduced bank lending to small companies means they may turn to VCTs instead, offering equity at attractive prices. This could mean bigger gains for VCTs in years to come.
Some also whisper that the initial income tax relief on investing in VCTs could rise to 50% in the upcoming budget, so the Government can claim to be supporting enterprise without having to pay the bill directly.
It's only a rumour, but it's not implausible. Only this week, the Association of Investment Companies promoted the merits of VCTs as a way of funding start-ups, finding:
- The average amount invested by VCTs in any single company is £2.5m
- After VCT investment, companies increase employment by 47%
- The cost of VCT tax breaks is more than made up for by taxes generated by VCT-backed companies
Personally I can't see the Government raising income tax relief to 50% -- it seems a 'fat cat' supporting own goal. But politicians do strange things, so you never know.
Wealth warning
Of course, the downsides of VCTs haven't gone away.
For a start, they're expensive. You can get a rebate on the 5% initial charge by going via a discount broker, but you can't escape the typical annual expenses of at least 3%.
VCTs are also spectacularly illiquid.
If you're buying for long-term exposure to venture capital and dividend income, it may be best only investing money you plan to leave in the VCT forever (though compared to say an annuity, at least you can sell your VCTs if you have to, albeit it at a discount).
If you're investing for the tax breaks, research the defined-life offerings that aim to return your money within six years. (Remember all VCTs must be held for at least five years to qualify for tax relief).
Finally, while the dividend streams from the better funds are attractive, few have a great record of maintaining their NAV, let alone growing it -- so don't think of VCTs as 'high risk, high capital gain reward' investments. The funds may be investing your money like that, but the losing investments offset the winners, and most of the gains are paid out as a dividend.
In short: Do a lot of research to find the better managers before you venture into VCTs, and consider taking advice even if you're an experienced investor.
More from Owain Bennallack:
