More people than ever will need VCTs but will there be enough capacity to fulfil their needs in 2019, asks Paul Latham, Managing Director of Octopus Investments
The government introduced venture capital trusts in 1995 to encourage investment into Britain’s smaller companies.
They provide the benefits of 30% income tax relief, long-term potential for growth and tax-free dividends. While encouraging investors to take more risk with their wealth they have to be held for a minimum of five years.
Of course, VCTs won’t be for everyone. It’s important to remember VCT capital is at risk and investors may get back less than they originally invested. Tax treatment also depends on individual circumstances, the VCT maintaining its qualifying status and may change in the future.
Is VCT Fundraising Set To Decline?
Perhaps – but the reason why may surprise you.
It’s not demand but supply that could see recent trends begin to taper off.
The sector as a whole has seen two bumper fundraising years. Last tax year, VCTs raised £745 million, an increase of £175 million, or 30% on the previous year and the highest amount raised in more than a decade.
There are still plenty of factors expected to drive demand in 2019, but there could well be a shortage of high-quality VCTs fundraising. That’s because fundraises are always a balance between the needs of VCTs and the needs of the market.
Demand Remains Strong
In recent years we’ve seen the government make changes to taxes that impact investors, particularly around buy-to-let, pension contributions, and dividend taxation.
It’s likely that demand over the last two years has been boosted by this. And it’s expected that this combination of taxes on investment will continue to encourage demand for tax-advantaged investments in 2019.
The fact is, many more clients are now facing the kinds of tax problems that would compel someone to consider investing in a VCT.
For a start, clients who are buy-to-let landlords face the phasing out of mortgage interest relief.
Before the changes came in, landlords only paid tax on their net rental income after interest paid. We’ll see this continue to be phased out in the 2019/20 tax year, with just 25% of mortgage interest deductible (compared to 50% this year) and the remainder qualifying for a 20% tax credit.
From April 2020, landlords will be unable to deduct any mortgage interest and they will only receive the basic tax credit.
That means landlords that are higher or additional-rate taxpayers won’t get relief for their mortgage repayments, as the credit only refunds at the basic rate. It could also result in the landlord paying tax at a higher rate as their taxable income will be higher.
To give you an idea of the impact, a higher-rate taxpaying landlord receiving £950 rent a month and paying £600 towards their mortgage would have received a tax bill of £1,680 prior to April 2017. Yet from April 2020, the tax bill would be £3,120.
It’s clear to see that many clients with a buy-tolet portfolio facing this problem might find a VCT investment attractive.
Large Pension Pots Penalised
The tax treatment of pensions has also become less favourable. For clients with especially large pensions, continuing to make contributions to their pension could potentially become less tax-efficient.
The lifetime allowance (LTA), a limit on the value of a pension pot at the time it is drawn, is currently £1 million. But when introduced, the allowance was set at £1.5 million.
This might not seem like a big change, but the reality is that many more higher and additional rate taxpayers are exceeding their allowance. In fact, the tax revenue raised from those exceeding the LTA grew from £5 million in 2006/07 to £102 million in 2016/17.
Additional rate taxpayers now have their pension contributions capped at £10,000 a year so for those wanting to save tax efficiently, VCTs can be an option for long term investment for money they would otherwise have contributed to their pension. There are also those who have a pension pot that either is, or is expected to exceed £1 million where VCTs could be an alternative investment avenue. People may need to think about this well before their pension has actually reached £1 million due to predicted growth between now and the date of pension drawdown.
VCTs can be an alternative for people who don’t want to add to their pension pot, alongside ISAs to save tax efficiently for the long-term.
Tax On Dividends
For small business owners the rate of tax on dividends will be higher this year than it has been for a long time. This is because the rates of tax on dividends has been increased and a new tax free allowance brought in that increased the effective rate of tax for those receiving significant dividend income each year. On top of this, that new dividend allowance has been reduced from £5,000 to just £2,000 for the current tax year.
Reducing the dividend allowance has meant that clients who stand to receive a dividend now face a greater tax bill. And because of this, many business owners have starting looking to VCTs to extract profits from their business tax efficiently. For business owners the income tax relief from a VCT could offset the tax they pay on their dividends. Also dividends paid by the VCT over their investment period will not be subject to income tax, so will not compound the issue in the future.
VCT Capactiy Crunch?
Having fundraised large totals over the past two years, it makes sense that some VCT providers will have reduced capacity, or may even choose not to open for investment at all in 2019.
A VCT simply might not see sufficient opportunities for deals in the market to warrant a large fundraise.
Many VCTs take a prominent role with portfolio companies, often taking a position on the board of directors. Especially for smaller providers, there’s finite capacity to carry out this kind of work.
It’s also worth noting that, overall, the number of VCTs raising funds has been declining in recent years, and there were five fewer VCTs managing funds in 2017/18 than in 2016/17.
Impact For Investors
Given that VCT capacity could be more limited in 2019, while demand is expected to be further driven by a reduction in tax reliefs attached to other forms of investing, clients that leave it late may well be left disappointed.
This reduced capacity could leave clients with less time to invest in their preferred VCT. When Octopus AIM VCTs opened in 2017 with a fundraising target of £40 million, it filled in 21 weeks. Compare this to the following year, when its smaller fundraise of £30 million closed in just eight weeks.
So for those considering a VCT investment, it’s important to plan sooner rather than later. This way you maximise the chance to be able to invest in your preferred VCT.