Venture Capital Trusts (VCTs) have now been part of the investment landscape for the last 17 years.  In subscribing for shares in these investment vehicles, investors are able to gain a tax advantageous route to invest in venture capital.  This article briefly explains the framework  for VCTs and some of the recent developments to this framework, especially in light of the Government’s continuing support of VCTs as a way of channelling risk capital into smaller and medium sized companies (SMEs).

Creation and purpose

The first VCTS were launched in Autumn 1995 in an attempt to fill part of the “equity gap” that faced SMEs.  The Government’s approach was to offer tax breaks to individual income tax payers as an incentive for them to invest in funds which would, in turn, invest in smaller, developing companies which carried a higher risk profile.  As at April 2012, approximately £2.7 billion of funds were managed by VCTs.

Although there have been various changes to the VCT framework over the years (in particular, the amount of income tax relief and qualifying period for this), the fundamental nature of the VCT regime has not changed substantially since its introduction.

What form do VCTs take?

Although labelled “trusts”, VCTs are not trusts but are public limited companies which have obtained VCT status from HMRC, and which have had their shares listed.  To date, all VCTs have listed their shares on the London Stock Exchange’s Main Market, although recent changes mean that VCTs can now list their shares on other EU regulated stock markets.

VCTs are managed by external regulated fund managers, most of which now specialise mainly in VCTs and other tax efficient investments.  Since they are seeking rapid development, the fund managers take a pro-active approach in providing non-financial support after investment (for instance, business advice, contacts, etc).

What can VCTs invest in?

In return for the tax benefits VCTs and their investors receive, VCT legislation imposes a number of restrictions on the investments a VCT can make, and when.

VCTs cannot trade themselves – they should merely invest in smaller – and inherently riskier – unquoted companies (so-called “VCT-qualifying investments”) with the potential to grow quickly.  VCT qualifying investments must be in a trading company (however, certain trades are excluded –the investee company cannot operate nursing home, farming or forestry enterprises, cannot operate in financial services, etc).  For the purposes of VCT legislation, however, unquoted companies can also include companies listed on AiM and PLUS markets (subject to the other restrictions being met).

In order to provide its investors with significant returns on their investment, the investment manager will invest in, and further support, a number of investee companies to produce a diversified portfolio of companies, with some VCTs investing in investee companies in a number of sectors (generalist VCTs), others in specialist sectors (e.g. AiM companies, renewables, entertainment, etc).  To maintain VCT status, at least 70% of a VCT’s funds must be invested in VCT qualifying investments within three years.

As well as investing in shares, a VCT normally provides some of its investment in the form of loans (typically with some form of security).

Recent changes to VCT-qualifying investments

The Government has been seeking to increase the thresholds on the various size restrictions which are applicable to VCT qualifying investments, and, subject to EU State Aid approval, will increase these with effect from 6 April 2012.

So the limit on the number of employees will increase from 50 to 250, the limit on gross assets immediately prior to investment from £7 million to £15 million, and the limit on gross assets immediately after investment from £8 million to £16 million.  The limit on the amount that can be invested in an individual company will also increase from £2 million to £10 million, and the annual £1 million limit on the amount a VCT can invest in a VCT qualifying investment is to be removed.

In addition, to prevent perceived abuses of the VCT framework, a “disqualifying purpose” test has also been proposed, under which an investment will not be a VCT qualifying investment if the investee company has been set up for the purpose of accessing tax reliefs, although the details of how this will be implemented have not yet been published.  For VCT funds raised after 5 April 2012, it is also proposed that there be an exclusion on the use of VCT funds for the purchase of shares in another company.

As a result of other recent changes which took effect from 6 April 2012, investee companies which have a permanent establishment in the UK (even though its main trading activities can be elsewhere in the world) are now capable of being VCT qualifying investments.  VCTs can also even maintain a listing on other EU or EEA regulated stock markets, and not necessarily a UK one.

What are the tax benefits for investors?

Tax reliefs are available to individuals aged 18 or over who subscribe for “new” shares in the VCT (with more limited tax reliefs applying if VCT shares are purchased from a previous shareholder).

The current reliefs are, in summary:

Income tax relief – Income tax relief at the rate of 30% will be available on new shares up to a maximum investment of £200,000 in any one tax year, or that amount which reduces an investor’s income tax liability to nil.  This relief must be repaid should the shares be sold or otherwise disposed of within five years (other than in the event of death).

An investor who subscribes for shares (or purchases existing shares e.g. on the Stock Exchange) up to a maximum of £200,000 of shares in a VCT in any given tax year will not be liable to UK income tax on dividends paid by the VCT on those shares.

Relief from capital gains tax – A disposal by an investor of shares (whether new shares or existing shares purchased from another shareholder) in a VCT will give rise to neither a chargeable gain nor an allowable loss for the purposes of UK capital gains tax. This relief is limited to disposals of shares acquired within the limit of £200,000 for any tax year.

The future

The proposed changes to the VCT framework described above will be implemented within the next few weeks.  Since fundraising by VCTs has remained relatively resilient during the financial crisis of 2008 and its aftermath, the Government has continued in its support for VCTs (and its sister, the Enterprise Investment Scheme) as a way of channelling risk capital from retail investors into SMEs to produce the growth the wider economy needs.

This article is a general explanation of VCTs and is not intended to be comprehensive.  No action should be taken without obtaining specific advice from an independent financial adviser authorised under the Financial Services and Markets Act 2000.

Ian Scott is a senior solicitor in Howard Kennedy, which has acted as legal adviser and/or FSA regulated sponsor in over 70% of all Venture Capital Trusts (VCTs) launched in the 2011/12 VCT season.