Venture Capital Trusts: You will love the tax-free income

To encourage investment in this higher-risk area, the Government offers generous tax relief to those who invest in new issues of VCT shares

The ways in which we can invest capital have expanded dramatically over the years.

The options range from owning individual company shares, perhaps one of the most simple and well-known forms of investing, to more unfamiliar territory. At the niche end of the spectrum are venture capital trusts (VCTs).

VCTs are similar to investment trusts in that they trade on the London Stock Exchange (LSE) alongside other publicly listed companies. They aim to make a profit by investing in very small, often unquoted, companies usually seeking further investment to help them develop their business. VCT managers tend to be extremely experienced at this – they seek to use this experience to help the business grow and take a hands-on approach, generally appointing a chairman to the investee company and taking a seat on the board.

A common misconception of VCTs, which probably stems from the fact they target smaller companies, is they invest purely for growth. This couldn’t be further from the truth. VCTs often provide part of their investment as a loan to the underlying business with a smaller amount in shares. Such loans can help generate an income, which is paid to investors in the VCT. When underlying businesses are sold, a portion of any gains is also paid to VCT investors as a dividend.

Many VCTs pay a tax-free dividend of around 5 per cent. Occasionally they will also pay a larger or a special dividend, following the sale of a particularly successful company within the portfolio. The majority of returns from VCT investment therefore come in the form of dividends, rather than capital growth. However, the fact remains that investing in smaller companies is higher risk and VCTs are aimed at more sophisticated investors.

To encourage investment in this higher-risk area, the Government offers generous tax relief to those who invest in new issues of VCT shares. An income-tax rebate of up to 30 per cent is available on the initial investment, meaning a subscription of £10,000 in effect costs you £7,000 (providing you have already paid the relevant amount of tax). Up to £200,000 can be invested each tax year, and there is no capital gains tax to pay on the disposal of VCT shares. Any dividends are also paid free of tax.

To qualify for the 30 per cent income tax relief, you must remain invested for a minimum of five years. Personally, I would suggest investing with at least a 10-year timeframe in mind as it takes a while to nurture and develop smaller business and prepare them for onward sale. By and large, the opportunity to invest in VCTs arrives once you have filled your pension and Isa allowances, given the tax breaks on offer. That said, the tax benefits should be seen as the icing on the cake rather than the reason for investing.

So, where do they fit in an existing portfolio? Personally, I look at VCTs as a pre-retirement plan to help build up tax-free income until retirement. It seems many investors consider VCTs as very high risk and, as such, they are often completely avoided or overlooked.

It is true there are risks, but you are at least spreading it by investing in a portfolio of companies. In addition, those looking to invest in VCTs now have a number of highly experienced managers to choose from. My preference is to purchase a number of “generalist” VCTs – those which consider investing in any type of company, rather than focusing on a specific sector, thus spreading your risk further.

Since VCTs were introduced in the mid-1990s, we have seen many inferior managers fall by the wayside and we now have what I would call a survival bias. Together, a number of highly regarded companies offer a good core of VCTs. These include Maven, Mobeus, Foresight, Baronsmead, British Smaller Companies and Northern. They’ve been around a long time and have developed immensely experienced teams who I believe are in it for the long haul. Most managers also have a vested interest; by investing their own capital alongside other investors, they have their own skin in the game.

To conclude, if you have utilised your Isa allowance and contributed fully to your pension, I suggest taking a closer look at VCTs. You will love the tax-free income – take it from me.