In last month’s Tax Insider, Daniel discussed how film partnerships are an excellent way of deferring a tax liability. This month, Daniel moves onto Venture Capital Trusts (VCT’s) which are another tax shelter that have been approved by the government and that are well worth considering if you have some spare funds to invest and want a way of saving income tax and generating tax-free income and capital growth..
What is a Venture Capital Trust (VCT)?
Put simply, Venture Capital Trusts are a tax efficient collective investment that invests in smaller businesses. They are similar to a unit trust, where an investment manager will take the funds and invest them in a variety of companies. The purpose of this is to try to spread and limit the investment risk for you.
VCT’s investments are supposed to be mainly for start-up companies. This means that you cannot go and invest in ICI or even some other sort of big public company that is trading on the Stock Market. Instead you have to invest in small, start-up businesses, that means there could be a significant risk to your investment.
However the risk is offset by the generous tax breaks, (which were even more generous until last month’s budget), and are typically aimed at medium to high net worth individuals. The VCT managers typically hold 30% of the investment in interest bearing accounts or bonds to reduce the investment risk. This means only 70% of the money is at risk and some income is generated from the interest bearing investments.
The types of VCT
There are considered to be three different types of VCTs:
- AIM (New shares issued on the Alternative Investment Market)
- Technology based VCTs
- General VCTs
The Benefits of a VCT
You can invest up to £200,000 a year in a Venture Capital Trust in any tax year and get the tax back on that. You do not necessarily have to invest the full £200,000 in order to get the tax back but this is the maximum that can be invested. Normally the minimum investment is between £3,000 and £5,000.
In the March 2006 budget the Chancellor reduced the amount of up-front relief that can be claimed from 40% to 30%. He also reduced the limit on the size of company that can be invested in from £15million gross assets to £7million. The holding period has been raised from 3 to 5 years to qualify for the tax relief. The combination of these measures appears to have reduced the attractiveness of VCT investment. AIM based VCT’s may now struggle to find companies small enough to invest in.
Claims for tax back will normally be processed under Self-assessment or if you are an employee under PAYE.
There are some other benefits and for medium term holdings of say 5 to 7 years these will still make a VCT an attractive investment:
No tax on dividends that are paid out
The first of these is that all the dividends that are paid out of the VCT are totally exempt from tax. Therefore, if you invest into a VCT that is successfully generating an income and paying out dividends then you have a zero tax liability on the amount of dividend you receive.
The only qualifying criteria to be observed in order to receive the tax-free dividend is that you must hold the shares in the VCT for a minimum of five years.
No CGT when you dispose of your VCT shares
If you sell the shares in the VCT after having owned them for a minimum of five years, then there is also no tax to pay on any profit made. In other words, the gain is totally free from any capital gains tax liability.
Therefore, if say for example you invested in a VCT and purchased 10,000 shares for £5 and then sold them 10 years later at a price of £20, you would have realized a gain of £150,000. This entire amount would be exempt from tax.
No CGT on VCT’s themselves
If a VCT realizes some gains on its investments then there is no capital gains tax due. The added benefit here is that if the VCT then distributes these gains back to the shareholders via a dividend, here again there will be no tax to pay the shareholder either. However, it is also important to note that if a VCT investment incurres losses, then there is no tax relief available on the loss incurred either.
Conclusion
A Venture Capital Trust makes a reasonable tax shelter post the March 2006 budget, but it does have a substantial investment risk. Therefore, choosing the right Venture Capital Trust from a good manager with good performance records is obviously going to be critical.
The VCT can provide huge tax free returns but on the other hand it can also provide you with a black hole for your money, if you don’t get it right. That’s why if the tax incentive is of interest to you, taking good independent investment advice on VCT’s from one of the specialist investment firms dealing with VCT’s is a must!
In the May issue of Tax Insider, I will look at the third and final Tax Shelter of Enterprise Investment Schemes (EIS)
