Nothing ventured: venture capital trusts

Venture capital trusts (VCTs) have been an established part of the investment landscape for the last 17 years. In subscribing for shares in these investment vehicles, investors are able to gain a tax advantageous route to invest in venture capital.

Filling the gap

The first VCTs were launched in autumn 1995 and were an attempt to fill part of the equity gap that faces smaller and medium-sized companies (SMEs) in seeking funding to develop. Although there were other sources of venture capital from investment companies and pension funds (like 3i, Electra, Cinven, etc), there was a perceived lack of equity funding available to SMEs, and in particular from retail investors.

Therefore, the government’s approach was to offer tax breaks to individual income taxpayers as an incentive for them to invest in funds that would invest in SMEs which carried a higher risk profile. As at April 2012, approximately £2.7bn of funds were managed by VCTs.

Although there have been various changes to the VCT legislation over the years (in particular the amount of tax relief given and the holding period to secure such relief), and the characteristics of the companies in which VCTs can invest (including their size and trading activities), the fundamental nature of the VCT regime has not changed substantially since its introduction.

1. What form do VCTs take?

VCTs are public limited companies which have applied to HMRC to obtain VCT status, and which have their shares listed. To date, all VCTs have listed their shares on the London Stock Exchange’s main market (although they can now list their shares on other EU regulated stock markets).

Although labelled ‘trusts’, VCTs are not trusts as such and are like any other public limited company on the stock exchange, with the important proviso that they need to obtain VCT status from HMRC, and that they cannot trade themselves (merely invest).

After receiving VCT status, VCTs must comply with the various technical restrictions imposed on VCTs as a quid pro quo for the tax advantages they and their investors receive.

A VCT itself does not have employees, and is managed by specialist regulated fund managers, most of whom now specialise mainly in VCTs and other tax efficient investments (like the Enterprise Investment Schemes).

In view of the smaller size and nature of investee companies, and the fact that they are seeking rapid development, the fund managers typically take a pro-active approach in providing non-financial support after investment (other business advice, contacts, etc).

2. What can VCTs invest in?

There are many forms of venture capital investment (from ‘seed capital’ in start-ups, to ‘development capital’ in more mature companies), with different sources of funds (individual Angel investors, specialist buy-out funds, etc).

However, in its most well-understood form it is an equity investment made by a company or a fund to provide smaller – but inherently riskier – companies with the capital they need to rapidly develop their businesses, with the intention that those companies can be floated on a stock market or sold to another company (a ‘trade buyer’, maybe even to a competitor) in each case, hopefully, at a substantial profit.

In view of the riskier nature of investee companies, many of them will fail. To counter this, the investment managers will undertake a detailed due diligence of the investee company (looking at the financial, commercial and legal aspects of its activities, ownership, etc) in an attempt to reduce the risk of making a bad investment.

In addition, as well as investing in shares, the VCTs will normally provide some of the investment in the form of loans (typically with some form of security).

Although it is unlikely that an investee company will become tomorrow’s Facebook, the aim of a VCT and its investment manager is to provide its investors with significant returns on their investment (seeking greater returns than those available by investing in larger, more established companies, say, FTSE listed companies).

Principally the investment manager of a VCT will attempt to invest in, and further support, a number of investee companies to produce a diversified portfolio of companies, with some VCTs investing in investee companies in a number of sectors (generalist VCTs), others in specialist sectors (like AiM companies, renewables, and entertainment).

In return for the tax benefits VCTs and their investors receive, VCT legislation imposes a number of restrictions on the investments a VCT can make, and when. For instance, for ‘VCT qualifying investments’ the investee company must be a trading company (with certain trades excluded – for example, it cannot operate nursing home, farming or forestry enterprises), it must have a permanent establishment in the UK (although its main trading activities can be elsewhere in the world).

On raising new funds, few VCTs will be able to invest all of the new funds it has received immediately in VCT qualifying investments, so HMRC allow a VCT three years to invest at least 70 per cent of the funds in VCT qualifying investments. Therefore, the VCT will initially hold its funds in cash and other readily realisable assets, such as gilts, bonds and listed shares, which can be sold to provide funds for investment in ‘VCT qualifying investments’.

3. What are the tax benefits for investors?

Tax reliefs on a VCT investment are available to individuals aged 18 or over who subscribe for ‘new’ shares in the VCT (with more limited tax reliefs applying if VCT shares are purchased from a previous shareholder). Such reliefs currently include:?

• Income tax relief. Income tax relief at the rate of 30 per cent will be available on new shares up to a maximum investment of £200,000 in any one tax year, or that amount which reduces an investor’s income tax liability to nil. This relief must be repaid should the shares be sold or otherwise disposed of within five years (other than in the event of death). An investor who subscribes (or purchases existing shares for example on the stock exchange) up to a maximum of £200,000 of shares in a VCT in any given tax year will not be liable to UK income tax on dividends paid by the VCT on those shares.?

• Relief from capital gains tax. A disposal by an investor of shares (whether new shares or existing shares purchased from another shareholder) in a VCT will give rise to neither a chargeable gain nor an allowable loss for the purposes of UK capital gains tax. This relief is limited to disposals of shares acquired within the limit of £200,000 for any tax year. An investor can transfer their shares to their spouse without triggering the repayment of the initial income tax relief, and without prejudicing capital gains tax relief and income tax relief.

Significant return

The aim of VCTs is to produce significant returns to investors. During the course of its life, the VCT will be seeking to use income it receives from its investments (in gilts, bonds and other income producing investments) to fund a regular flow of tax-free dividends to investors.

Some VCTs will have a non-binding policy regarding the amount of dividends they will aim to pay out and how frequently. The VCT may also use the proceeds received on the sale of its interests in investee companies to pay out special dividends.

Although all VCT shares have to date been listed on the London Stock Exchange, traditionally there has not been an active market for VCT shares. Therefore, many VCTs have a regular programme of share buy backs on a limited basis to encourage such a market, or make from time to time a general offer to shareholders to buy some of their shareholding. However, shareholders will not be able to sell or realise the value of their shares for prolonged periods of time.

As stated above there have been a number of recent changes proposed to the VCT framework which will be implemented within the next few weeks. Fundraising by VCTs has remained relatively resilient during the financial crisis of 2008 and its aftermath, and the government has continued in its support for VCTs as a way of channelling risk capital into SMEs in the coming years to produce the growth the wider economy ?requires.