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VCTs in the news: How has regulation affected these tax-efficient vehicles?

02 March 2016

Octopus Investments’ Stuart Lewis explains why recent changes to the VCT regime have had little impact on the end investor and why the pension reforms could lead to increased interest in tax-efficient investments.

 

While venture capital trusts (VCTs) have been in existence for over two decades now, some advisers may be wary of recommending them to their clients, citing frequent rule changes as one of the reasons for this reluctance.

However, this may be too simplistic a view of the tax-efficient vehicles and the rules surrounding them. As Stuart Lewis (pictured), VCT business line manager at Octopus Investments, observed: “From the investor’s point of view, the structure of a VCT has only seen minor changes over recent years, and few of these changes have fundamentally affected the investment case for the products.”

“At the same time, a raft of changes to the pension system and dividend taxation could even be working to encourage more investors to consider VCTs, as advisers and their clients widen their search for the investment strategies that put investors’ money to work in the most efficient manner.”

In the following article, Lewis explains how rule changes in a number of different areas have impacted VCTs and how demand is evolving for these products.

 

Changes to VCTs

VCTs were introduced in 1995, around the same time as the Enterprise Investment Scheme (EIS) and the Alternative Investment Market (AIM), as part of a package of measures to encourage investment into the country’s small and entrepreneurial businesses.

Given their two-decade history, it is not surprising that there have been a number of changes to the regulation surrounding them. “Anything that is dependent to some extent on public policy is always going to be subject to the tinkering of legislation to ensure it continues to fulfil government policy objectives – VCTs are no exception,” Lewis said.

“The structure has been around for 20 years, it has passed through successive Conservative and Labour governments and it is still standing today – which shows how successful they are in continuing to meet their objectives. But that doesn't mean they don't need redirecting, steering or repurposing every now and again to ensure the government gets the maximum bang for its buck as part of those investments.”

Lewis notes that some significant changes took place in the early years of VCTs, such as moving the upfront income tax relief from 20 per cent to 40 per cent before settling on its present 30 per cent rate, or the move to end capital gains deferral for VCT investments.

But the past 10 years have seen changes focus on the types of companies a VCT can invest in, and the amount of any investments that can be made, which is mostly a problem for VCT managers and boards.

For example, the Finance Act 2015 recently introduced a rule that VCT investments cannot be used to fund management buyouts and acquisitions. This will have a profound impact on specific VCTs that have built their investment strategy around such activity.


 

But those VCTs whose mandates already fit with the new legislation have not needed to change their strategy and they have continued to carry out large fundraisings.

 

Changes to pensions

Some of the biggest changes to affect investors and the financial services industry over recent years have been to the pension system. Lewis said: “The changes to VCTs have been nothing like the magnitude of change we're seeing within the pension environment. The pension wrapper itself is being chopped and reformed – it's a sea change for the end investor.”

One amendment that could be helping to spark an increase in interest in VCTs is the lowering of the lifetime allowance, or the maximum amount that can be withdrawn from pension schemes without triggering any extra tax charges. In 2010, this was £1.8m, but it has since been brought down to £1.25m and will fall to £1m in April 2016.

“An allowance cap that at one point only affected super high-net-worth individuals is now a mass problem for the affluent,” Lewis added. “You see many doctors, lawyers and other professionals who are now having to consider this, even though they might be many years from retirement, because if they invest well and achieve good compound growth, they can be at risk of hitting that cap even with modest contributions and performance.”

This has led some investors to consider other investment options that can sit alongside their existing investment and retirement plans, especially those that are tax-efficient in nature. Lewis is keen to point out that some of these investment options, such as VCTs, may involve taking on a higher level risk relative to a typical pension investment; and like most investments, they do place investors’ capital at risk.

Another change that could be increasing interest in VCTs is the reduction to the annual pension allowance. This is how much an investor can contribute to a defined contribution pension scheme each year while still receiving tax relief. In 2010 it stood at £250,000 but is now down to £40,000. From April 2016, those earning over £150,000 per year will also see this reduced further via a taper system, down to a minimum of £10,000 for those earning over £210,000 per year. This has the potential to affect some investors close to retirement age, given the way in which people tend to build their retirement portfolio.

Lewis stated: “One of the things you historically saw with pensions is that people would be in the high-earning bracket for only a few years and would try to squirrel away as much money as they could during that time. That option has now gone.”

“Many high earners are going to be significantly constricted in what they can put into a pension. More and more advisers are coming to us and exploring how VCTs can complement existing retirement plans for those clients who are comfortable with taking on the higher associated risks of investing in smaller companies and VCTs.”

More generally, the pension freedoms that were announced in April 2015 – which scrapped the requirement for retirees to buy an annuity – have the potential to boost demand for products such as VCTs which, while not guaranteed, aim to generate a steady stream of tax-free dividends for investors.

A key attraction of VCTs is their ability to offer tax-free dividends and up to 30 per cent upfront income tax relief on VCT investments, which they can retain as long as they hold their VCT shares for at least five years. These tax reliefs are offered, in part, by the government in recognition of the higher risks investors take on when investing in VCTs. Investors should understand that tax treatment will depend on their individual circumstances, and may change in the future. The tax reliefs offered also depend on VCTs maintaining their VCT-qualifying status.


 

“The real difference is that the pension changes have opened people's eyes to a world of possibilities,” Lewis said. “Rather than just looking at a pension as the only retirement planning vehicle, people are looking much more broadly at how they use ISAs, pensions, property and VCTs, among others, to enable them to plan for a comfortable retirement.”

 

Changes to dividend tax

While it may not be as obvious in its relation to driving interest in VCTs, upcoming changes to how dividends are to be taxed could also prove to be a boon for the industry.

From 6 April 2016, the first £5,000 of dividend income in each tax year will be tax free, but sums above this will be taxed at 7.5 per cent for basic-rate taxpayers and 32.5 per cent for higher-rate taxpayers, with a 38.1 per cent rate for additional-rate taxpayers.

“It’s a great headline message that only people with a FTSE 100 portfolio of £100,000 will be paying dividend tax next year by the introduction of the £5,000 dividend tax allowance, but when you dig into the detail of it, the real target of this change is the small business owners who have been paying themselves via dividends in a tax-efficient manner,” Lewis says.

Some small business owners choose to pay themselves a minimal salaried income and take dividends instead as a tax-efficient way of extracting money from their business. However, the higher rates of tax on dividends could have a “significant impact” on their take-home earnings and have led some to consider other methods of protecting their earnings from tax and extracting surplus cash from their business in a tax efficient way.

“We’re seeing an increase in advisers and small business owners who are looking to take any surplus cash they have out of their business ahead of the change to dividend tax,” Lewis asserted.

“For people who are comfortable that this is genuinely surplus cash and not working capital, they are often happy to tie it up for five years or more. In this case, VCTs can provide a tax-efficient way to extract value from their business, assuming they fit the right risk profile.” Investors taking money out of their businesses in this way should remember that VCTs are high risk and not suitable for everyone.

 

The above article was prepared in partnership with Octopus Investments and should not be taken as investment advice.

Important Information:

We always recommend investors seek professional advice before deciding to invest. Past performance is not a reliable indicator of future results. Personal opinions may change and should not be seen as advice or as a recommendation. Octopus Investments does not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. This advertisement is not a prospectus. Investors should only subscribe for shares based on information in the prospectus, which can be obtained from octopusinvestments.com. Issued to Trustnet by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: February 2016.

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