Invest in VCTs: record-breaking year for tax-free investments

Record numbers of investors are benefiting from putting their money into venture capital trusts (VCTs), new data from HM Revenue & Customs (HMRC) has revealed.

VCTs offer a host of tax benefits to investors, including the ability to claim tax relief and sidestep the need to pay income tax and capital gains tax on returns.

And the figures suggest increasing numbers of investors are being enticed into supporting these trusts. According to the data, the number of investors claiming tax relief on VCT investment in 2021/22 reached 25,800, a jump of 32% on the previous year.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There was an even more substantial jump in the value of the investments on which the tax relief was claimed, rising 61% to £1.04 billion.

So what’s driving this increased interest, and what do investors need to consider before backing VCTs?

UNDERSTANDING VCTs

VCTs are collective investment funds that have a mandate to build portfolios of stakes in small, early-stage businesses. These are typically companies that have yet to float on the stockmarket, though some funds own companies that are listed on Aim.

The rules on qualifying VCT investments that the funds can make are extremely strict. Usually, VCTs may only invest in businesses worth less than £15m and with fewer than 250 staff. These businesses must be less than seven years old and certain sectors of the economy are off-limits, notably most financial services.

The fact that VCTs spread their money across a number of companies goes some way to mitigate the risks of investing in small, early-stage firms like these. However, investors should be under no illusions: these are immature and fragile businesses with plenty of potential for failure. 

This, of course, is why the Treasury offers investors a range of tax benefits for committing their money. These include up-front income tax relief of 30% – so investing £10,000 costs only £7,000 – as well as tax-free dividends and capital gains.

VCTs are listed on the London Stock Exchange, but income tax relief is only available on new VCT shares. This is what underpins the annual VCT season: each year, VCT managers launch new funds, or new share issues from their existing vehicles, to attract investors looking for that 30% benefit. Investors must then keep their VCT shares for at least five years, or repay the up-front tax relief.

WHY VCTS ARE APPEALING TO INVESTORS

Even with these generous incentives, VCTs were for many years considered a niche investment best suited to high net-worth investors who already owned extensive portfolios of more conventional assets. However in recent years it has become a more mainstream option.

This has in large part been down to the steady erosion of tax benefits open to wealthy investors who are planning their retirement, though these erosions are being walked back.

For example, the annual allowance covering how much can be saved within a pension each year has now increased from £40,000 to £60,000, while the lifetime allowance has been scrapped altogether, having been stripped back to a little over £1 million.

The tax implications for breaching these allowances had made VCTs all the more compelling, since VCTs come with a £200,000 annual cap on contributions, and no limits at all on how much you may build up in total. 

For growing numbers of wealthier savers worried about pension contribution limits, these funds have increasingly become a useful long-term financial planning tool.

ARE VCTS RIGHT FOR YOU?

While VCTs have obvious selling points for the wealthiest, it’s worth noting how strongly they have performed among smaller investors.

As Nicholas Hyett, investment manager at Wealth Club, points out over half of all VCT investors are claiming tax relief on less than £20,000 of investments.

However, the inherent risks in investing in start-ups are crucial for investors of all sizes to remember. Many of these businesses hit the wall; for every high-profile success story emerging from the VCT sector, there are also plenty of failures that you hear less about.

The tax relief on offer should only be part of the equation when determining whether to invest in a VCT, suggests Joshua Gerstler, owner of The Orchard Practice. 

“As the investments are in start up businesses, they are high risk and although the tax incentives are generous, there is a risk of losing all of your money. You should invest in a VCT because you like the investment, not just to save tax.”

VCTs certainly have their place, but there is every reason for investors to approach with caution.