Investing in VCTs can provide great tax benefits. However, due to the nature of the investments, they are riskier than passive investing in market tracking ETFs. Therefore, we take a look at what VCTs are, what the tax benefits are, what risks they pose and some examples of historical performance.
In summary, we believe that VCTs can be a very useful investment for anyone who is paying income tax on their salary. However, these investments come with specific risks that are integral to understand.
What is a VCT?
VCT stands for Venture Capital Trust. This is a publicly listed closed-end fund which is designed to give individual investors access to venture capital investments via normal capital markets. The idea is that the VCT fund managers determine potential profitable investments in small unlisted firms in order to generate a higher than average returns for its investors. As a result, the potential risk is much higher than investing in the FTSE 100, for example. However, VCTs do have some in-built diversification as the investment is always spread over a number of different companies.
What are the tax benefits of VCTs?
There are are no capital gains or income tax due on gains made through VCTs. In this aspect, a VCT is like any other investment made in an ISA. However, where the maximum amount you can put in an ISA is currently £15,000 per year, the tax relief on VCTs is available for an investment up to £200,000 per year.
However, there is one other major tax benefit to investing in VCTs, and it is the trait that makes these investments so appealing. Separate to the tax relief on gains, an investor in a VCT is granted “income tax relief” on their income tax liability (no matter where this income arises). This income tax relief equates to the fact that you can write off any income tax liability up to 30% of the amount you invest in the VCT in that tax year.
For example, if you earn £30k a year (and contribute 4% to your pension), your income tax bill would normally be £3,760 on this salary. Therefore, if you invest £12,534 into a VCT in this year, you would be granted 30% tax relief equal to £3,760.20 (£12,533 x 30%) meaning that you will pay no tax this year. For anyone working, this can be a huge benefit and equates to earning 30% on your investment straight away!
One point to note however: you must keep the VCT for five years in order to retain the tax relief. After five years, you can usually then reinvest this money into a different (or even the same) VCT and obtain the tax relief again, without any additional initial or exit fees.
How to invest in VCTs
Investing in VCTs is fairly straight forward. Investors (or at least those wanting the tax advantages) can only buy shares in new VCTs, which can be bought through a trading platform (as you would with shares, ETFs, etc). Simply log in to your trading platform and search for the area on VCTs. Most brokers will also offer significant discounts off the initial fees for registration. Take Hargreaves Landsdown for example, who are currently offering between 1% and 5% discount on sign-ups. Note that these discounts are usually better early on, because these funds have a limited amount of investment possible and hence the discount will likely reduce as the fund moves towards capacity.
There are plenty of VCTs available. One good site for reviewing them is taxshelterreport.co.uk. There are some prospectuses of VCTs on the site including VCTs provided by Albion, Downing One, Foresight, Octopus and Unicorn. All of these would have been readily available for purchase through the capital markets.
What is the historical performance of VCTs?
To understand the long-term returns that are possible through VCTs, let’s take a look at the historical performance of some of these investments from Tax Shelter Report. All figures are in percentages.
We can see here than the average performance of these VCTs is better than the market comparatives. However, there are some important factors to consider here:
- It has been a good market for VCTs in the past 5 years. Generally, higher risk shares outperform the market when the overall market is going up and greatly under-performs the market in tougher times. Therefore, making a comparison over the past 5 years may not be the fairest comparison.
- The 10 funds selected by TaxShelterReport have probably been chosen because they have a relatively long track record and are good performing VCTs. Therefore, they may not be representative of all VCTs. To address this point, we have taken 116 VCT funds that are shown on trustnet.com. From this analysis, we can see that the long-term performance of all VCTs is lower than the 10 selected by Tax Shelter Report. However, the performance over the past 10 years is still greater than the FTSE 100 and AIM markets:
- The average VCTs shown today do not show any of the VCTs which have gone under. Therefore, there may be some -100% VCT funds which are not included in this analysis which would clearly reduce the average returns.
However, the key point here is that to make this a good investment, we need only to obtain a return on our investment of 30% lower than the market return (after adjusting for fees) over the 5 year period (until we can again obtain our 30% tax benefit). Therefore, if we were to invest in several of these VCTs with a longer track record in order to diversify our holdings, it seems likely that the additional risk will be worthwhile over the term (especially with the tax benefit included).
VCTs – an example
Let’s imagine that we are the medium income earner as a family of 2 adults and 2 children. The median gross income for this group is £44,200 per year. We are thinking about our retirement and hence we contribute 8% of our gross salary to our pension.
Annually, our £44,200 leads to an income tax liability of £6,132.80. As we are avid savers (and don’t have any consumer debt because we follow the moneystepper way!), we are able to save 50% of our gross salary (£22,100 per year).
We are considering investing in VCTs in order to wipe this income tax liability. Therefore, we invest £20,442.67 into VCTs, leading to an income tax relief of 30% x £20,442.67 = £6,132.80 which wipes out our income tax bill for the year.
We then invest this £20,442.67 across four separate VCT funds chosen at random from the list of the 36 funds with a 10 year track record, and one that went bankrupt. Using a random number generator in Excel, we have selected:
- Maven Income and Growth VCT – 165.9% gain over 5 years
- Northern 3 VCT – 120.1% gain over 5 years
- Albion VCT – 21.3% gain over 5 years
- Oxford Technology 2 VCT – (40.7)% loss over 5 years
- Gone Bust VCT – (100)% loss over 5 years
We also invest our tax savings into a FTSE 100 ETF (in order to reduce our risk on this investment a little), which returned 21.9% over the past 5 years. Our results look like this:
We can then compare this with alternative investments in either the FTSE 100, FTSE 250 or AIM:
From this, we can see that, even if we are comparing to when we invest our £15,000 limit in our ISA and get taxed on the surplus, and if we pick the best of the three possible investments, our final return is still almost £1,300 (or 3%) higher when investing in our VCT investment portfolio. Furthermore, if you had invested in the AIM without tax wrapping (as you may have already used your ISA allowance), you would be over £12000 better off with the portfolio of VCTs.
VCTs are high risk – there is no way to get around this. However, the term “high risk” should not automatically be viewed as a negative. Investing in AIM listed companies is high risk, but the additional variance also provides additional reward. This is market theory. However, this is very different to a “high-risk” scenario when the bloke down the pub asks you for £200 and he’ll give you back £300 next week!
One important thing to consider, however, is that investments in VCTs are not as liquid as ordinary shares. You may find it difficult to trade them (depending on their size and popularity) and so may end up paying a slightly higher spread if you do need to sell them in a hurry.
Some of the other risks are summarized as follows:
- Qualifying companies for VCT investment must have gross assets of under £15m before investment. These are typically “very small companies” and hence their failure rate is much higher than larger companies.
- All tax reliefs are subject to change and hence if you cannot reinvest your VCT in 5 years, you may find yourself in a position whereby you cannot reinvest your funds tax free (a situation which probably wouldn’t arise in an ISA).
- Investment strategies employed by VCT managers differ greatly. It is important to understand this before investing in a VCT.
- Some VCTs carry a minimum investment amount, which may not allow diversification across separate funds if you are investing a smaller amount than our example.
- VCTs effectively do not have a secondary market, mainly because the initial income tax relief is only available to those subscribing for newly issued shares. This compounds the problems investors may have if they want to sell their VCT shares. Usually, however, the fund will buy back their shares at a discount of 5% to Net Asset Value (which is usually higher than the share price). However, remember that any VCTs sold in the first five years would lose the tax relief and hence you should only invest in VCTs if you are sure you will not be touching the investment for a considerable length of time.
If you have already maxed out your ISA investments, investing in VCTs is a good way to obtain additional tax relief. The risks are higher than standard investments, but the rewards are also there too.
If you haven’t maxed out your ISA in the current year, but already have a fairly well diversified portfolio invested in tax wrappers from prior years, then VCTs could also be for you. Determine your tax liability and the cash you have to invest, weigh up the risks highlighted above and run the numbers. VCTs could be a great investment tool for you too given the 30% tax relief.
As a disclaimer into my own personal situation, I do not currently hold any VCTs as, following the maximum investment in market tracking ETFs in my ISA, my cash is being held for upcoming property investments. Therefore, given that I will need my cash in under 5 years, VCTs would not be suitable for me right now. Additionally, being self-employed means that I organise my income in such a way that my income tax liability does not make such an investment worthwhile at the moment.
However, if you are paying large amounts of income tax, have a diversified portfolio and have the cash which you can tie up in the long-term, then VCTs are definitely worth considering.
Want a second opinion? Here is Pete Matthew from meaningfulmoney.tv discussing VCTs on some cliffs!!