Venture Capital Trusts

Better_Call_Saul

I'm looking to diversify my portfolio at the start of next year and have recently been reading good things about VCT's. Does anybody on here have any experience of these?

Your_Hero

They are perceived as higher risk and are less liquid than traditional investments. However, they do come with great tax benefits, such as 30% income tax reducer (minimum holding period 5 years or face clawback), CGT exemption, and tax free dividends.

bowlhead99

You are making a long term commitment to invest in a portfolio of smaller companies; the companies may be listed on 'junior' market like AIM or be privately held with the VCT owning shares, warrants, loans.

I think 'perceived as higher risk' is likely an understatement because I would say they are actually higher risk. By their nature, venture capital investments are risky and typically private equity and venture capital funds have an institutional investor base with great restrictions on what they can actually market to the general public.

A VCT is a tax-privileged vehicle (though none of them are endorsed by HMRC or government as being worth investing in) which can allow wealthier or more sophisticated investors to access them through public markets with some limits on what the VCT can do to still qualify for its tax-qualifying status. I say wealthier or more sophisticated because the nature of the risks and the lock-in means most investors would fill their boots on traditional firms and other tax schemes such as ISAs and pensions first, and you only need to seek 30% tax relief if you're above the basic 20% tax bracket anyway.

Some VCTs have marketed themselves as lower risk without seeming to take great risks, just exploit the tax benefits so that if you invest £100 it costs you £70 so you are still 'up' even if the fund doesn't do anything wild and crazy to deploy your capital in a risky way. However, HMRC/government will look at the schemes from time to time and if they do not believe they continue to meet the T&Cs of being a proper VCT, may no longer endorse the status causing you to lose your benefit.

Overall they can have a place in a portfolio (much like listed private equity funds and other types of less liquid assets in the alternative asset space) but you are taking a punt when you invest in a new funding round and don't know quite what they'll be spending your money on.

Also, you have to invest in a new funding round to get all the tax relief, but any vehicle that is starting from scratch and is looking to deploy capital over a period of time as opportunities come up, will be sitting on your uninvested cash for a while, which is a performance drag which you would not have in an equivalent holding vehicle that the fund manager runs for institutional investors (he lets them pay their cash in when it's actually needed). In other words they might make a headline 20%+, 30%+ return on capital in an investment over a two year period within the VCT, but if they don't deploy the cash for the first 6 months, it's actually a 20%+ return in a two and a half year period which is a lower annualised return net to you.

Annual management fees (and performance fees) can also be high compared to normal funds that invest in big blue chip companies, but that goes with the territory as seeking out these specialist opportunities is not something that can be done on the cheap by simply following an index.

So there is a some inefficiency but the income tax relief (and gains relief) is a nice boost to encourage you to give the managers the finance to invest in fledgling firms in the UK economy.

They get mentioned every so often here, I remember answering a question on tax breaks in this thread: https://forums.moneysavingexpert.com/discussion/4847508

Better_Call_Saul

Thanks for replies, and link. Good to have a bit more info.

Reaper

I agree with most of bowlhead's post except this bit:

bowlhead99 wrote: »

you only need to seek 30% tax relief if you're above the basic 20% tax bracket anyway.

I am a basic rate tax payer (thanks to substantial pension contributions) but I still get 30% tax relief on my VCT investments. You do not have to be a higher rate tax payer to qualify. Indeed for a basic rate tax payer getting 30% tax back when I only paid 20% on it in the first place means I end up better off than a higher rate tax payer doing the same thing!

My VCTs are only a very small part of my portfolio though I am toying with the idea of getting more. You can reduce many of the risks by investing in a fund that has been going for many years and wants to expand. "Boring" sounded a good option to me so I went with Proven but there are many other similar ones and I will probably choose a different one next time. It now returns a steady 5% pa, equivalent to 7.1% considering I got the tax rebate on the initial investment and best of all the proceeds are tax free - so I would have to get about 9% in a building society account to beat that once basic rate tax is deducted.

So despite the limitations and risks I think they are worth a dabble.

planteria

Reaper wrote: »

I am a basic rate tax payer (thanks to substantial pension contributions) but I still get 30% tax relief on my VCT investments. You do not have to be a higher rate tax payer to qualify. Indeed for a basic rate tax payer getting 30% tax back when I only paid 20% on it in the first place means I end up better off than a higher rate tax payer doing the same thing!

i like this. good work:T

bowlhead99

Warning long post

Reaper wrote: »

I agree with most of bowlhead's post except this bit:

I am a basic rate tax payer (thanks to substantial pension contributions) but I still get 30% tax relief on my VCT investments. You do not have to be a higher rate tax payer to qualify. Indeed for a basic rate tax payer getting 30% tax back when I only paid 20% on it in the first place means I end up better off than a higher rate tax payer doing the same thing!

Yes that can be right in terms of the mechanics although 'better off' depends on your point of view. I guess what I was generalising at, was that the riskier profile meant they were more aimed at wealthier people who exhausted their other tax benefits and would definitely be able to use up the tax benefits of a VCT. The tax benefit is the government compensating you for taking a risk in pursuit of the nation's goals.

If you are a high roller earning £110k a year and paying £10k of pension contribs you are still easily paying enough tax to get the maximum benefit available from a £30k or £40k or £50k VCT contribution. However by contrast if you are earning a more modest £40k a year and paying £10k of pension contribs, you only have a net taxable income of £30k which is only an annual tax bill of about £4k.

If you as that modest earning £4k a year taxpayer had a big lump of cash sitting around from savings or investments or inheritances and fancied putting £20k into a couple of VCTs, the most tax you can actually save is your £4k annual tax bill. If you put £20k into VCTs, the government would be offering 30% (£6k) of tax relief which a high earner could make use of, and a low earner could not make use of. You can't relieve more tax than you actually have to pay.

So in that scenario, you'd only be taking two thirds of the money that the government were willing to give you as compensation for taking the risks. The value of the tax break is lower for you than your higher earning compatriots. Someone on £50k net taxable income can put nearly £30k a year into these funds because he is paying over £9k a year tax and could knock it down by £9k thanks to the tax break. But someone of more modest means could never use a tax break of that size. Some of the tax break on a larger investment made in that tax year would be wasted and therefore you are taking on risk without compensation.

Obviously the more modest earners could make a £5k investment and get £1.5k tax relief, no problem.

...getting 30% tax back when I only paid 20% on it in the first place means I end up better off than a higher rate tax payer doing the same thing!

It's nice to think that you have gamed the system to be better off than a higher rate taxpayer. But this isn't strictly true.

If you and I make a £5k investment in a VCT. We raid our piggy banks and put £5k in. HMRC writes us each a cheque for £1.5k. So for both of us, it costs us £3500 net which we could have instead spent on a second hand car or redecorating the lounge or a big foreign family holiday or any number of other things.

Then with a bit of luck over the next 10 years we get say 7%+ compound return via a mixture of income and capital gains, so the £5k doubles its money and turns into £10k+. So both of us have paid in a net £3.5k that we could have spent on something else, and both of us now have £10k+. We've hopefully tripled our money from that £3.5k and are both happy with those results.

But the return for me as a high rate taxpayer is just as good as yours. We both tripled our money. You're not 'better off' just because your £1.5k tax break is a bigger proportion of your annual tax bill than it is of mine. If you are making that kind of comment, you are always 'better off' than me because your annual PAYE bill you get from work is a smaller proportion of your salary than mine is of mine. But neither of those concepts are relevant for investment appraisal.

For me as a high rate taxpayer, when I get dividend income outside an ISA I have to pay more tax on it at the end of the year. With my VCT income, I don't. So that's quite valuable. For you as a basic rate payer, you would not have paid any more tax on dividend income received anyway whether it was from a VCT or just shares in a normal company. So you have gained nothing in terms of tax breaks on that.

Then also for me as a high rate taxpayer, when I make capital gains I have to pay 28% tax on them on any amounts over my annual allowance. As a higher rate taxpayer, generalising, I am more likely to exceed my annual CGT allowance at some point than a lower rate taxpayer is. So saving the 28% tax on £5k+ of gains from this investment could be pretty valuable. On £5k+ of gains at 28%, the CGT saved compared to what I would have paid on a regular unwrapped fund is £1.4k+, almost as much as those tax rebate cheques we both picked up in year one.

For a basic rate taxpayer, if their tripling of their investment money leads to a gain over their allowance, the CGT is only 18% if they were in a regular unwrapped fund. So the size of the tax benefit from using a CGT-exempted VCT, if there is any at all, is rather less of a tax saving in terms of actual pounds saved, than the high rate payer gets.

So, we can look at what the alternatives were for those two types of investors.

If a basic rate taxpayer invests £3.5k net in a VCT that doubles its money over 10 years he might walk away with £10k which is a nice result. Compared to investing unwrapped in a fund where £3.5k doubled its money into £7k and he didn't need pay any income tax or CGT, he is simply better off by £3k (£10k VCT vs £7k unwrapped).

If a higher rate taxpayer invests £3.5k net in the same VCT he also gets to walk away with £10k which again is a nice result. However, if he had invested £3.5k unwrapped and doubled his money to £7k, he would be looking at potential dividend tax at 25% or CGT at 28% on the income and gains. So, almost £1k of tax bill leaving him with only £6.1k from the £3.5k investment. Whereas through the VCT he got 10k. So his overall improvement compared to unwrapped investment choices is £10k-6.1k = 3.9k.

This is 30% higher than the £3k improvement that the basic taxpayer achieved. In fact, the £3.9k excess performance by using VCT rather than unwrapped, is a bigger number than he actually invested (the 3.5k net). So, no wonder these things appear tasty to higher rate taxpayers.

So, bottom line, the government is giving a big break to high rate taxpayers to compensate them for the risk. Of course, a low rate taxpayer can invest £3.5k net and turn it into £10k just like the high rate taxpayer can. But the money on the table, over the years, as compensation to the high rate taxpayer was £3.9k (more than he invested) while it was only worth £3k to the low rate taxpayer. It is great to exploit opportunities to save tax, if they work out. But given the fund could have failed and lost 90% of its value, you have to make sure the level of compensation for the huge risk, in terms of actual returns available compared to other products, works for you.

You sound like a smart guy Reaper and I'm sure you know what you're doing when dabbling in this stuff. But it is dangerous to think you are getting a better deal because the "30% off " is more than your marginal rate of tax. The reality is, you're getting a flat £1500 off your £5k investment, which is no more money than everyone else, and then you are getting nominal tax breaks on dividend income which as a low rate taxpayer you might not even need, and a potential CGT saving at a low rate which you might not even be able to use. It is absolutely a worse deal for a low rate taxpayer than for a high rate one.

This is not to say you can't get great returns, because of course you can, and it would be blinkered to avoid any investment class that had the potential to deliver great returns. But I advise some caution.

Reaper

bowlhead99 wrote: »

Warning long post

It certainly was, even by your standards! So I won't attempt to answer it all. However I think one of your final paragraphs sums up your post

You sound like a smart guy Reaper and I'm sure you know what you're doing when dabbling in this stuff. But it is dangerous to think you are getting a better deal because the "30% off " is more than your marginal rate of tax. The reality is, you're getting a flat £1500 off your £5k investment, which is no more money than everyone else, and then you are getting nominal tax breaks on dividend income which as a low rate taxpayer you might not even need, and a potential CGT saving at a low rate which you might not even be able to use. It is absolutely a worse deal for a low rate taxpayer than for a high rate one.

My main point was really not to automatically dismiss VCTs for basic rate tax payers, as they can still benefit from the tax relief. True, a higher rate tax payer avoids paying tax on the dividends but for me as a basic rate tax payer skirting the edge of the higher rate and trying to avoid it this is another tool I can use to avoid breaching the limit (along with ISAs of course which are already maxed out and SIPP contributions). It is true I will probably never make use of the capital gains benefits but the rest is all good.

I agree I get no more back than a higher rate tax payer but I like the idea of getting more back in tax relief than I have paid on the investment.

To use another example somebody who pays no tax at all can put £2880 in a pension and have tax relief added on top to make it up to £3600, even though they haven't paid any tax. I would call that a bargain whereas you would argue they are no better off than a basic rate tax payer. It depends on your point of view.

bowlhead99

Yes I do see your point.

The government are basically saying that someone can get £720 of free money on the way into a pension investment, even if they haven't paid £720 of tax. If they have actually paid tax they could get a lot more free pension money (depending on their personal circumstances, maybe as much as £20k this year ; or £90k if they are a huge earner with unused allowances from previous years and are willing to put £200k away...) although there may or may not be some tax to pay at the end when they take it out, depending on circumstances at the time.

So, the free pension money, and the returns on the free money, is an absolute bargain for the non tax payer, even though the net returns on their own part of the investment are no better than a basic unwrapped investment and the amount of free money is not as much as the higher taxpayers.

In a similar way, a basic rate taxpayer could get their hands on some free money up to the amount of their annual tax bill, using a VCT. Someone earning 40k after pension contributions who paid £6k of tax can get £6k of assets back from HMRC by maxing their VCT purchases to £20k.

As with the pension example, it's well below the level of free money a higher earner can get (£60k on £200k invested) but it is not to be sniffed at. However, just like the nil rate taxpayer using a pension, the ongoing benefits from the wrap vs unwrapped investments are not necessarily going to be worth anything to a basic rate taxpayer using a VCT. The benefit is that first year when you get free money.

Of course, you have to be aware you could lose all the free money and all your own money due to poor investment performance, or you could lose all the free money and some of your own money if you need to cash out in the first five years. But if you're aware of those risks and don't mind them, for the potential reward, it is a useful tool like you say.

jamesd

bowlhead99 wrote: »

you only need to seek 30% tax relief if you're above the basic 20% tax bracket anyway.

Basic rate tax payers get 30% tax relief on VCT investments as well. The relief is capped at the actual tax amount paid in the tax year of investment. Everyone paying tax also benefits from the tax free income paid by VCTs and for most of the VCTs the income is where the return should be expected, though there are some more speculative ones where it is intended to be growth.

Unlike pension tax relief you can sell the VCT after at least five years then use the money to invest in a VCT again and get another 30% tax relief, repeating as often as you have taxable income available. The capital price at sale may or may not be higher than the original purchase price, though, because a lot of the focus tends to be on paying income rather than capital growth, at the lower risk end of this area.

bowlhead99 wrote: »

you are taking a punt when you invest in a new funding round and don't know quite what they'll be spending your money on.

If you invest in a new funding round for an existing VCT you get the benefit of all of the existing investments that it holds and those are reasonably well described in the prospectuses that I've seen.

bowlhead99 wrote: »

Also, you have to invest in a new funding round to get all the tax relief, but any vehicle that is starting from scratch and is looking to deploy capital over a period of time as opportunities come up, will be sitting on your uninvested cash for a while, which is a performance drag which you would not have in an equivalent holding vehicle that the fund manager runs for institutional investors (he lets them pay their cash in when it's actually needed). In other words they might make a headline 20%+, 30%+ return on capital in an investment over a two year period within the VCT, but if they don't deploy the cash for the first 6 months, it's actually a 20%+ return in a two and a half year period which is a lower annualised return net to you.

That's one reason why it is routine to offer top-up funding rounds for existing VCTs. Using three years when the minimum holding period to lose the tax relief is five years doesn't really make much sense.

bowlhead99

Agreed with the comments above.

jamesd wrote: »

That's one reason why it is routine to offer top-up funding rounds for existing VCTs. Using three years when the minimum holding period to lose the tax relief is five years doesn't really make much sense.

The comment about 2-3 years was basically that the company may end up with a good investment that they exit in a short space of time, because the time is right to exit it or they have an offer too good to refuse. Therefore the company will be reporting an excellent exit multiple in a short space of time, or a great IRR.

However the inevitable cash drag of having idle cash at the beginning and the end before it gets deployed into something else or distributed out to investors, means the investors' IRRs are not as good as they would have been if they had been feeding the investments with cash on a just-in-time basis as would be the case in the institutional versions of these VC funds. You can do a funding round every year or few but not every week that an opportunity comes up.

So, you hear that private equity or venture capital is a market sector that gives great returns, but most of the deal statistics are from the institutional investment world and VCTs are a restricted consumer product with some inefficiencies. To someone paying tax who can get a tax break, the pros can still offset the cons, but you do have to be aware of what you're dealing with.

The VCTs that are taking positions in AIM companies rather than unlisted ones might generally be expected to be able to run more efficiently because their holdings are more liquid and arguably easier to find opportunities to make strategic investments. That is not to say that their overall net returns will be any better because a manager's performance entirely depends how good they are at selecting deals and working with portfolio companies and what the fund's objectives actually are.