Could pension tax relief cuts spur VCT growth?

Tax relief on the block?

The Sword of Damocles once again hangs over pension tax relief. Investors are by now well used to the usual pre-Budget/Autumn Statement newspaper speculation over the future of the UK’s current system, whereby contributions and investment growth are tax-free and withdrawals are taxed at the saver’s marginal rate.

Former Chancellor George Osborne (remember him?) set in motion reforms that, at the extreme end, could flip the UK’s pension tax architecture on its head, with contributions – rather than withdrawals – taxed. However, these plans were shelved (but not killed) ahead of the EU referendum on 23 June that ultimately precipitated the Osborne and David Cameron’s downfall.

In the wake of the Brexit vote, and with policymakers potentially needing to raise cash if investment and growth stall, tax relief could once again be in the crosshairs of the Treasury. 

Since 2010 politicians have had a nasty habit of cutting back pension tax perks, with the annual allowance hacked back from £255,000 to just £40,000 and the lifetime allowance chopped from £1.8m to £1m. There’s also the horrendously complex annual allowance ‘taper’, designed to steadily reduce the yearly allowance from £40,000 to £10,000 for those earning above £150,000.

And the nuclear ‘Pension ISA’ option has also not been ruled out.

Given this environment, investors may well be considering alternatives to pensions if Chancellor Philip Hammond does take the axe to tax relief in his Autumn Statement on 23 November.

VCTs – an attractive alternative?

One option that may attract savers is investing in smaller businesses through Venture Capital Trusts, or VCTs. VCTs allow investors to tap into the growth of small firms – although businesses can, of course, fail as well as succeed.

According to the latest data from the Office for National Statistics, the number of UK business “births” increased by 1.2% from 346,000 to 351,000 between 2013 and 2014, a birth rate of 13.7% compared with a rate of 14.1% in 2013.

The 351,000 business births in 2014 were the highest recorded since comparable records began in 2000.

The number of UK business “deaths” increased by 3.5% from 238,000 to 246,000 between 2013 and 2014, compared with the decrease of 5.9% in 2013 (from 252,000 to 238,000). So a slight reversal in fortunes, but still over 100,000 more businesses created than killed off.

The VCT structure is designed to tempt investors to invest in small and medium-sized enterprises – the engines of economic growth.

VCTs could be suitable for those investors who are seeking capital appreciation, income or both, especially if there is a good chance they will bump up against the £1m lifetime allowance for pension savings (or the Government reduces this allowance yet further). They also come with some tax advantages. 

How VCTs work

VCTs are closed-ended funds that are quoted on the London Stock Exchange. They invest in small, up-and-coming businesses in need of extra cash to grow. There are a variety of VCT structures to pick from:

• generalists who invest across a range of companies and are in effect publicly-traded providers of private equity
• vehicles which target AIM-quoted firms (since these companies are treated by the tax authorities as ‘private’ since the platform is exchange-regulated) 
• specialists who focus on certain industries such as renewable energy, technology and healthcare

Investors who invest in VCTs could potentially generate substantial returns. If the fund managers’ portfolios of fledgling firms survive and then thrive they will churn out the profits and cash which in turn enable the fund to grow its net asset value and pay dividends to its investors.

Several VCT specialists can point to strong track records of value creation – but this is by no means an easy money-making machine. Many hours of research, professional experience of the sectors in which they are investing and a good legal team are just three of the ingredients offered by successful VCTs, besides the ability to raise and effectively allocate capital.

Investing in very young firms is, as I mentioned earlier, a risky business. Things can, do and will go wrong, so you need to have your eyes well and truly open before taking the plunge.

As well as investment risk, investors need to be aware of the fee structures of VCTs. VCTs tend to have higher running costs than standard investment companies and also charge performance fees, so it is important investors are made aware of the expenses involved. 

Tax incentives

To encourage savers to use VCTs and thus provide capital to the smaller firms who are so vital to the UK’s overall economic health, the Government does permit investors to glean some tax benefits in recompense for the risks involved. If an investor subscribes to new VCT shares:

• ​the maximum investment is £200,000 
• is 30% tax relief on the initial investment, if the VCTs shares are held for five years
• no higher rate tax on dividends
• no capital gains tax

The £200,000 annual cap on investment will interest some investors considering alternatives to a traditional SIPP. However, its important investors are comfortable with the VCT as an investment in its own right and aren’t just following the tax breaks.

It’s also worth remembering that, as things stand, tax relief on pensions remains extremely generous, particularly for higher earners. Charges are also usually much lower, depending on your choice of tax wrapper and investments.

Furthermore, just as pension tax relief could well come under pressure at the Autumn Statement, so too could VCT relief. 

The Government has previously sought to crack down on what it termed ‘abuse’ of the VCT system by investigating whether they should be allowed to invest in industries which receive subsidies. 

In addition, VCTs can now only hand out dividends within the first three years of their life if these payments come from profits on investments, rather than the cash initially handed over by investors. This means patience is required and investors must be prepared to lock up their cash for at least five years.

Growing in popularity

The latest figures from the Association of Investment Companies show VCTs have grown in popularity in recent years. The VCT sector raised £457.5m in the 2015/16 tax year, compared to £429m in 2014/15. VCT funds under management were £3.6bn at 5 April 2016.

Well-known firms operating in the VCT arena include Octopus Investments, Unicorn Asset Management, Octopus and Amati Global Investors. The track records of VCT fund managers, and details of their fees, can be found on the website of the AIC, at www.theaic.co.uk

The secondary market

It is also possible to buy VCTs on the stock exchange in the so-called secondary market. Since most investors who buy VCTs do so to hold them for at least five years, this is not the most liquid arena.

VCT shares can be sold or bought at any time, but initial income tax relief is only available on the new issue of shares and must be kept for five years to retain the relief. Secondary purchases of shares, created from existing shareholders exiting, lose their right to initial income tax relief – although these investors can still enjoy tax-free income and growth.

Also, because the secondary market in VCT shares is limited, investors can expect to dispose of their holdings on the open market only at a, sometimes substantial, discount to the underlying net asset value.

For this reason, many VCTs have a policy of buying back their own shares so as to control the extent to which their shares are discounted. The operation depends on the VCT having generated sufficient liquid returns from its investments, and they are only able to do so for certain periods during the year.
 
The majority of VCTs are run with the expectation that they are a going concern and continue to operate (potentially raising more funds and making more investments). However, a VCT board may decide that this is no longer viable in which case (following shareholder approval) the VCT would normally sell the assets it has and distribute the returns as tax-free dividends to shareholders, decreasing the NAV, and look to wind up the VCT.

With illiquid, unquoted assets this may take a number of years, especially if the VCT manager wants to ensure a good price for each asset it sells. This is one of the challenges with ‘limited life’ VCTs – it is not always easy to sell assets quickly after the five-year minimum holding period, and often the ‘good’ assets will sell and investor will be left with a long tail of ‘less good’ assets that may take years to offload.

Alternatives are for the VCT to be merged with another, combining their assets, and providing additional cash to help exit any investors that then want to leave.