Venture capital trusts (VCTs) are often associated with tax-privileged but high-risk investments in fledgling companies rather than reliable sources of income.
However, for those willing to explore beyond conventional income-generating assets like bonds and dividend stocks, VCTs can offer unexpected yet substantial income opportunities. While we would never advocate VCTs as anything other than higher-risk investments and would note that they should never be adopted without advice, this short article seeks to explore how (as part of a well-balanced portfolio) they can add another level of diversification to a client’s income strategy.
Understanding VCTs and the associated tax reliefs
Introduced in the UK in 1995, VCTs are publicly listed companies designed to encourage investment in small, high-risk enterprises by offering tax incentives to investors. VCTs raise money from investors to buy shares in unquoted companies or those listed on the Alternative Investment Market (AIM). These investments aim to fuel the growth of these smaller enterprises, which in turn can deliver substantial returns if the companies succeed.
To encourage investment in these higher-risk ventures, there are several associated tax reliefs available:
- income tax relief – investors can claim 30% income tax relief on the amount invested in new VCT shares, up to £200,000 per tax year, provided they hold the shares for at least five years
- tax-free dividend – dividends received from VCTs are exempt from income tax
- capital gains tax (CGT) exemption – any capital gains from the disposal of VCT shares are free from CGT
In short, to encourage investment into these higher-risk assets, for every £10,000 invested, a client will receive £3,000 of income tax relief (providing they paid that level of income tax in the year) and all dividends and encashments received are tax free, subject to the investment being held for the minimum five-year qualifying period.
The income potential of VCTs
Contrary to the typical perception of VCTs as growth-oriented investments, they can indeed be a source of regular income. One of the primary ways VCTs provide income is through dividends. Many VCTs aim to deliver a regular income stream by distributing profits from their portfolio companies, indeed Maven Venture Capital Trusts target a 5% per annum dividend yield (% of NAV per share).
As noted, given these dividends are typically tax free for UK residents, they provide a strong diversification and tax-efficient diversifier to property rental income or banking interest. These tax benefits significantly enhance the attractiveness of VCTs as income-generating assets, particularly for higher-rate taxpayers, where a 4% income yield net, is equivalent to a 7% income yield gross of income tax.
Associated risks
VCTs invest in early-stage and smaller companies, which are inherently riskier and more volatile than larger, established firms. While the potential returns are higher, so is the possibility of capital loss. Investors must be prepared for the long-term nature of these investments and the associated risks.
VCT shares are less liquid than those of larger companies. Selling VCT shares within five years of purchase may result in the loss of income tax relief. Additionally, the secondary market for VCT shares is less active, potentially making it harder to sell shares quickly or at a desired price.
Who should consider VCTs?
Anyone considering VCTs should consult their financial advisers, as any investment of this nature needs to be considered as part of a well-diversified, suitably balanced, and considered financial plan, but typically these would be attractive to those:
- seeking tax-efficient income
- comfortable with higher-risk and longer investment horizons
- looking to diversify their portfolios beyond traditional income-generating assets
High-net-worth individuals and those in higher tax brackets might find VCTs particularly beneficial due to the significant tax advantages.
Summary
VCTs may not be the first asset that comes to mind when considering income-generating investments, but they can offer substantial and tax-efficient income opportunities for those willing to embrace their complexities and risks. With attractive dividend yields and significant tax reliefs, VCTs deserve consideration as a part of a diversified income-focused portfolio. As always, potential investors should seek advice from their financial adviser to ensure VCTs align with their overall investment strategy and risk tolerance.
Important information
As with all investments, your capital is at risk. VCTs are considered high risk and are not suitable for all investors. The value of your investments and the income from them may fall or rise and there are no guarantees. Past performance is not a guide to future returns. Tax treatment of investments and income depends on an individual’s circumstances and may be subject to change in future. The content of this article is for information only and does not constitute advice.
