Shelter from the taxman with VCTs

Venture capital trusts (VCTs) have been attracting a great deal of interest from investors this year for one key reason: tax.

The government's decision to restrict tax relief on pension contributions for high earners means well-heeled investors are seeking out other tax-efficient places to put their money.

Tony McGing, a director of Downing Corporate Finance, says he expects around £300 million to be raised in 2010; up from £135 million last year and £209 million in the previous year.

However, he warns that tax should not be the only driver: "Our general philosophy is that we are aiming for a positive return after tax relief, whatever the economic conditions.

"So if the net cost of investment is 70p we want to ensure that investors get at least 70p back. In our 12 previous issues, the lowest has been about 90p and the highest 140p."


Sadly, Downing's performance is not particularly representative of the sector. According to statistics from Morningstar, just 15 VCTs have made a positive return over three years.

Of course, that return is before tax relief but, using McGing's marker of returning at least 70p in every 100p, only 59 out of the 101 funds have achieved that objective over three years; 26 of them, or more than a quarter, have produced less than 60p.

This emphasises the importance of careful selection of VCTs. Patrick Connolly, head of communications at AWD Chase de Vere, warns that tax alone is not a good enough reason for investing:

"A few years ago, when there was 40% income tax relief, a lot of people invested in them without considering the underlying investment or how they would get their money back. A lot of [these VCTs] are now trading at a substantial discount to net asset value."

The tax relief now is a bit less generous, but it is still substantial. Investors are allowed to put in a maximum of £200,000 when VCTs are seeking new funds and claim a 30% tax rebate on their investment, giving a saving of up to £60,000.

Dividends and other distributions are tax-free, as are the gains on disposal. This also applies to investors buying in the secondary market.

But the tax breaks reflect the fact that VCTs are substantially higher risk than traditional private equity trusts. It can be hard to get your money out and losses can be substantial.


Like private equity trusts, VCTs are quoted on the stockmarket and they also invest in small and growing businesses.

However, share prices can trade at a substantial discount to net assets – Morningstar's statistics show that many trade at discounts of 20% or more – buyers are scarce and, for many funds, the return will come when the assets in the trust are eventually sold.

The companies that can be put into a VCT are at the smaller end, as the maximum net assets allowed is £7 million and they must have fewer than 50 employees. The money raised has to be invested within three years and at least 70% has to be put into qualifying investments.

Allenbridge, one of the longest-standing advisers in this area, has a good record of picking the better VCT funds.

Its Tax Shelter Report has four core recommendations for the current season: Baronsmead VCT 3 and Baronsmead 4 joint offer, Downing Structured Opportunities VCT 1, Albion Developments D shares and ProVen Growth & Income.

In a recent report, it says: "The Baronsmead series of generalist VCTs have been at the forefront of the VCT industry practically since its inception, which is well over a decade in terms of performance, consistency and diversity.

This latest top-up offer brings an opportunity for individuals to invest in two of the sector's more substantial portfolios."

On Downing, it says: "[Its] performance record to date has been good and individuals should be encouraged for two reasons.

"First, the ordinary shares of Downing Planned Exit VCT 2 & 3 have been almost completely wound-up, having returned 89p cash per share to investors a little over four and a half years after launch, and second, the ordinary share portfolio of this Structured Opportunities VCT has made very good progress in its first year with a marked increase in total return."

Connolly recommends buying a generalist trust, with a good spread of investments, or a planned exit one, which, as its name implies, has a specified date for winding up.

Among the former, his favourite is Albion Development and Downing issues 2 and 3 among the planned exit VCTs. "They are backed by assets so there is something there for investors even if the business does not go as planned." 

Enterprise investment schemes

EISs are even riskier than VCTs. While the tax relief is lower, at 20% of the investment, the maximum investment is higher, at £500,000. They can also be used to shelter capital gains, as the liability to pay them can be deferred if the gains are invested in a qualifying EIS.

Again, gains are free of tax and any losses, net of income tax relief given, can be set against income in the year in which they are incurred.

Ben Yearsley, investment manager at financial advisers Hargreaves Lansdown, says that because EISs are invested in individual companies and are unquoted, they are much higher risk.

"You may have a problem selling a VCT, but you can't sell an EIS. There is no liquidity so you cannot get out until they float or do something."

He thinks EIS and VCT schemes are only really suitable for high net-worth individuals with assets of at least £100,000 – and only around 5% of the portfolio should be invested in them.

Patrick Connolly, head of communications at AWD Chase de Vere, again plumps for a Downing fund: Downing Asset-Backed EIS Fund.

Bruce Macfarlane, founder of MMC Ventures, which runs EISs, says: "Investing just for tax is a bad reason to buy, you must evaluate the commercial benefits of the investment."

He says the state of the stockmarket, and Aim in particular, means he does not expect to sell companies in his EIS portfolios by floating them. "But the trade market is coming back.

Corporate UK balance sheets are in good shape so we expect to sell some assets later this year."

This article was originally published in Money Observer - Moneywise's sister publication - in April 2010

More about