VCTs: buyer beware, the tax benefits may not be worthwhile

They say never let the tax tail wag the investment dog. But surely that’s what venture capital trusts (VCTs) are designed to do?

A 30 per cent up front return is a very powerful draw, along with other tax benefits. This makes VCTs dazzlingly attractive to high earners who face restricted pension allowances, but who also have a strong enough appetite for risk to buy shares in early-stage businesses.

So far, taking that risk has worked out well. But, according to the Association of Investment Companies, after 13 consecutive years of positive returns, the average VCT delivered a total return loss of 8.5 per cent in 2022.

Fans point out that most assets lost money last year and highlight healthy dividends paid out from the sector in recent years.

But the end of this VCT winning streak highlights the risks. And there are other reasons to be more wary.  

Anything with a wall of money flowing towards it makes me nervous. And that is happening with VCTs. In a year in which many investors shied away from risk — retail investors took £25.7bn out of UK based open-ended funds in 2022, according to data published this month by the Investment Association — a small subset of investors have piled into the riskiest type of funds of all.

The number of VCT investors who claimed income tax relief increased by 9 per cent to 19,475 in the 2020-21 tax year, the latest figures available. These investors are usually the small, but growing numbers of pension savers who are lucky enough to hit their pension lifetime allowance — £1.073mn in 2022-23, a level frozen until 2025-26.

They are also used by those who have more than their annual allowances of £40,000 to stash away in a pension and £20,000 to put into an individual savings account (Isa) this tax year. In fact, some VCT brokers won’t consider you unless you confirm you’ve already filled those allowances.

One is Bestinvest. Jason Hollands, its managing director, says: “Rising numbers of higher and additional rate taxpayers, coupled with restricted access to pension tax reliefs as a result of both the lifetime allowance and tapered annual allowance have certainly fuelled interest in VCT investment and that isn’t going to change given a reduction in the threshold for paying additional rate tax.”

The 30 per cent return comes from income tax relief on VCTs, conditional on holding them for at least five years. Any capital gains on VCTs are tax free, with profits made on successful exits (when companies in the portfolios are bought or float on the stock market) paid to investors as tax-free dividends.

[VCTs] are not a like-for-like replacement for pension investing, since early-stage businesses that qualify for VCT investment must fulfil some very narrow criteria

It’s obviously pleasing to get regular dividend cheques and not have to pay tax on them. And if you reinvest your dividends into VCTs, you can get another 30 per cent tax relief too.

But they are not a like-for-like replacement for pension investing, since early-stage businesses that qualify for VCT investment must fulfil some very narrow criteria. Those who use them do so sparingly. While they can put up to £200,000 into VCTs in each tax year, the average amount invested by an individual in 2020-21 was around £33,000.

As we embark on this year’s “VCT season”, you should perhaps tread more carefully. Ben Yearsley, director of Shore Financial Planning, says: “I’ve been a fan of VCTs for 25 years and have invested every year. But I’ve pared back my investment this year.”

The latest figures from HM Revenue & Customs show VCTs issued shares to the value of £1.122bn in the 2021-22 tax year. That’s a massive 68 per cent increase on the £668mn in the previous year and a 53 per cent increase on the previous record of £731mn invested in VCTs in the 2018-19 tax year.

And this year looks to be a similar story. Total capacity for VCTs for 2022-23 is £1.3bn, according to Wealth Club, of which £661.9mn has already been committed by investors.

All this money has to find qualifying investments and the bar for qualification is set higher. The scheme was introduced in 1995, but in 2015 the rules changed.

Hollands says: “The refocusing of the scheme on early-stage companies, that are typically proven concepts and generating revenue, but often not yet profitable at the time they are backed, has certainly increased their risk profile. There will be huge successes, but also failures, with the latter coming earlier than the winners in the life of a portfolio.”

More of the portfolio has to be invested in early-stage high growth opportunities and the government places restrictions on the type of company that a VCT can invest in — it must be no more than seven years old, have fewer than 250 full-time employees and gross assets below £15mn. So, lots of VCTs have refocused portfolios on tech and biotech, which means you need to watch out for a narrower focus.

The real crunch is that a VCT must now invest at least 80 per cent of the money it raises in companies that meet these criteria. Yearsley says: “Realistically, how many of these companies are there? If there’s too much money to invest, the entrepreneurs have the power and can command better prices.”

Meanwhile, the charges on VCTs remain stubbornly high, while the rest of the asset management industry has lowered them. You’d have thought a growing sector would have created opportunities for economies of scale to flow through to investors. But 5 per cent upfront charges remain common — alongside annual and performance fees.

Certainly, you’re fuelling a mini-industry by investing — there are lots of jobs behind the scenes, with managers citing the high cost of “very clever people” needed for the analysis of unlisted companies.

Some brokers, including Bestinvest and Wealth Club, offer discounted charges. But I’d also expect high returns for the risks you’re taking. Managers won’t be drawn on their expectations for these and some commentators doubt that valuations in unquoted companies are reflecting what is going on in the wider economy.

The seven VCTs that invest in Aim-listed companies are more transparent in terms of valuations and their share prices are a good 20 per cent down over the past year. This hasn’t been seen in the unquoted market.

At the time of writing some VCTs have already secured their funding but there are 23 VCT offers still open for investment. It’s likely the strongest will reach their fund-raising targets well ahead of the tax year end.

This week the Unicorn Aim VCT, which invests predominantly in shares of Aim-listed companies, raised all of its £15mn in just one day, becoming the fastest VCT to hit its maximum fundraising target this tax year.

If that makes you feel you need to move fast, make sure that’s not at the expense of a rational, thought-out decision. Or you might find a bite taken out of your tax advantage.

Moira O’Neill is a freelance money and investment writer. Twitter: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com