Investing in new entrepreneurial businesses before they have been floated on the stock exchange can be exciting. Just imagine how much your investment would have grown, if you had provided seed capital to Google, for example. But, while the returns can be outstanding, the risk is high too. If you are investing in unquoted businesses, then it's best if you spread your portfolio wide, and that requires a very substantial investment budget.
Instead of investing into individual companies, you might want to pool your money with lots of like minded individuals and let a fund manager make the investment decisions. And that, in a nutshell is what a Venture Capital Trust, or VCT is. The government is certainly keen on this type of investment. Entrepreneurism is, after all, the life blood of the economy's future growth. And to incentive you, the government has introduced many tax incentives for VCT investors.
WARNING!But, be warned. This is a minefield of complexity. Make a mistake, overlook a key point, and you might not get the tax breaks at all.And while we are in warning mode, also bear in mind liquidity in VCT shares is notoriously poor, which means that when you come to sell, it might not be so easy.
Whatever you do, don't let the tax tail wag the investment dog. Don't just invest in VCT because there are good tax breaks. Look at the potential for growth and income too.But, if you like the idea of investing in unquoted companies, but you aren't keen on letting a find manager make the choices, and would instead rather get much closer to the company you are investing in, maybe EIS schemes are for you.
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What is a Venture Capital Trust?
VCTs are companies listed on the London Stock Exchange, which are similar to investment trusts. They are run by fund managers who are usually employed by an investment group. Investors can subscribe for, or buy, shares in a VCT, which invests in trading companies, thereby providing these companies with the funds they need to help them develop and grow their businesses.
For an investment trust to be classified as a Venture Capital Trust, it must be approved by HM Revenue and Customs. And if, for some reason, that approval is taken away, you could lose all the tax breaks you previously enjoyed. These investment vehicles were first introduced in 1995, but have gone though many changes since their inception. Make sure you are up to date with all the investment regulations before you decide to invest in a VCT.
The tax breaks
The key tax breaks are as follows:
- 30 percent income tax relief on your initial investment into a VCT.
- No income tax on dividends
- No capital gains tax on sale.
- If you enjoyed a capital gain before April 6 2004, you may be able to defer all, or some of this gain, by investing into a VCT.
- For shares issued prior to the tax year 2006-07, 40 percent income tax relief is available.
The small print
If you are the type of person who ignores the government health warnings at the bottom of a cigarette packet, make sure you don't ignore the following:
- If you invested after 6 April 2006, then to qualify for the tax breaks you must hold the investment for at least five years.
- If you do sell before the five years expire, you will lose the tax benefits, including any income tax credits you have already received.
- To qualify for the tax relief incentives, you are limited to investing £200,000 in any one tax year.
- For deferring capital gains tax, there is a five year time limit from the year you received the gain. So if you enjoyed a capital gain of say £100,000 in March 2004, and wish to defer the tax by investing into a VCT, you must make this investment no later than the end of tax year 2008-09. This capital gains tax deferral allowance is limited to a £100,000 investment in any one tax year.
- WARNING! To obtain the deferral relief on a capital gain, you must also claim income tax relief on the investment. This is an important point, since some investors might have a large capital gains tax bill, but no income tax to pay at all. This is more common than you might think. These investors will not be able to defer the capital gain.
- If the fund loses its VCT status, then you lose the tax benefits.
Some more warnings
If your VCT investment makes a loss, you can't offset this loss against any other capital gains tax liabilities you might have on other investments.So in a way, from a capital gains tax point of view the news is either all good or all bad.If the VCT sees good growth, then you don't pay capital gains tax. The good news about the growth, becomes even better good news because you don't pay tax.
But, if on the other hand, the VCT performs badly and the capital value shrinks, then you get hit twice. Not only will you see the value of your investment fall, but you won't even have the consolation of being able to offset your capital loss against any other capital gains you might have made on other investments. Finally, liquidity in VCTs is notoriously weak, which means that when you come to sell, it might not be so easy. Bear in mind, too, that the spread between buy and sell price can be unusually high.
Valuing VCTs
VCTs, like all investment trusts, put a lot of weight on their net asset value, but bear in mind that the market valuation of your VCT may be less than the net asset value. When VCTs state their net asset value, they will provide two sets of values. First, there is the current net asset value, and secondly, this value plus any dividends that have been paid since the fund's launch.
Rules relating to the VCT
To obtain VCT status, the fund must meet certain conditions. The key ones are as follows:
- During the five year investment period, 70 percent (by value) of the VCT's investments must have been in 'qualifying holdings.
- During that five year period, the VCT's holding in any one company must not represent more than 15 percent (by value) of its total investments
What about the investee companies?
Of course the purpose of VCTs, and the reason for the tax breaks, is to encourage investment in fledgling UK companies that could eventually make an important contribution to UK plc. But there are rules as to which companies meet the conditions of a qualifying investee company These are as follows:
- The company receiving the investment must be unquoted, although HMRC defines companies listed on AIM or Ofex as unquoted and are therefore eligible for VCT investment.
- The company must engage in a 'qualifying trade.'
What is a qualifying trade?
There is a short and long answer. First the short answer.
Key trades that do not qualify include farming, accountancy, legal practices, hotel management, nursing home or property investments. But if you want the full list, here goes:
- Dealing in land, or financial instruments; financial activities, property development, or providing legal or accountancy; leasing or letting assets on hire, except in the case of certain ship-chartering activities; receiving royalties or licence fees, except where these arise from an intangible asset such as a patent or know-how, where most of it has been created by the company (or one of its subsidiaries); farming, market gardening, or forestry; or operating or managing hotels, guest houses, hostels, or nursing or residential care homes; providing services to another company in certain circumstances where the other company's trade consists to a substantial extent in excluded activities.
- For investment made from 6 April 2006, the investee company must not exceed £7 million (previously £15 million) immediately before the VCT makes its investment, and £8 million (previously £16 million) immediately afterwards.
- The company must not be controlled by another company, or another company and a person connected with that company.
WARNING! Remember that VCTs are high risk and that you should take independent financial and tax advice before entering into any of these investments.
Enterprise Investment Schemes
Perhaps you don't want a manager making the investment decisions for you because you would rather invest directly into companies of your choice, becoming involved with the company along the way. The government likes this idea too, and to help you, there's a scheme called EIS.
EIS stands for Enterprise Investment Scheme, and if you invest in an EIS registered company, just like with VCTs, you can enjoy impressive tax breaks. For example, if you invest in an EIS company, you can obtain CGT deferral relief on up to 40 per cent of any capital gain enjoyed from the disposal of other investments during the previous three years.
It can also work the other way. If you invest in an EIS company, you can receive capital gains deferral relief on any gain you subsequently make from other investments during the following 12 month period. You can also claim 20 per cent of the value of the EIS investment as income tax relief, but unlike VCTs, this is not a condition of deferral relief. If you don't claim income tax relief you are still eligible for capital gains deferral.So, combine the capital gains tax deferral option with income tax relief, and you could get 60p in the pound back. As with VCTs you have no capital gains tax to pay on sale.
Last edited March 2007
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