The tax benefits
Investing in small businesses carries a higher degree of risk than investment in the shares of established, listed companies. So, in order to encourage private investors to invest in VCTs, and thereby provide valuable funding support to the SME sector, generous tax benefits are available:
- Up to 30% tax relief* at the outset on investment of up to £200,000 per tax year (only available on newly issued VCT shares)
- Tax-free dividends – with no requirement to declare VCT dividends on a tax return
- Tax-free growth – exemption from CGT on gains from sale of VCT shares
* Subject to having sufficient tax liability in the year of investment. Taxation rules and legislation may be subject to change, and the value of tax relief depends on personal circumstances.
Investor returns
At any given time, the overall asset value of a VCT is the aggregate value of its assets (portfolio companies and other assets such as cash), known as the Net Asset Value (NAV), and each share in the VCT has an equal share of that NAV (NAV per Share). For example, in a VCT with an NAV of £50m and 100m shares in issue, shareholders will have an NAV per Share of £0.50.
A VCT achieves growth in value through the profitable sale or capital appreciation of its assets – in the case of private companies the VCT manager will typically be invested in each for between two and seven years, and will look to directly contribute to their growth by playing an active role in the strategic management of the business, typically providing close board level support to help it professionalise and scale and ultimately become attractive to larger trade buyers or private equity acquirers. SME investment is a highly specialist area, so the expertise of the VCT manager in adding value to help each company grow is fundamental to the overall ability of the VCT to generate profitable realisations and pay dividends.
When a VCT sells an asset for a profit, or an asset increases in value, that increases the overall NAV (and therefore the NAV per Share for Shareholders). However, whereas the growth investors experience in other investment vehicles, such as Investment Trusts, is typically in the form of capital growth, alongside modest levels of dividends or income, VCTs are able to return a large element of their overall returns in the form of tax-free dividends*, and indeed many VCTs will target an annual yield of between 4 and 6%. For this reason, it can be the case that when the VCT is achieving positive returns the NAV per share may remain fairly level or even fall (if significant funds have been paid out as dividends), so the most relevant performance measure for a VCT is the NAV Total Return per share, which comprises the NAV per Share plus the value of any dividends paid to date.
* Dividends are variable and not guaranteed.
What does a VCT invest in?
VCTs offer investors the opportunity to gain exposure to portfolios of emerging UK private companies selected for their high growth potential.
Legislation governing VCTs has evolved significantly since 1995, to ensure that VCT funding is only provided to early stage, high-growth companies which, due to their risk profile, struggle to obtain growth finance from other source such as bank loans.
There are strict HMRC criteria governing which companies can qualify for VCT funding, including:
Age of company
VCTs are generally required to invest in companies that are less than seven years old (i.e. from the date of their first commercial sale). There are exceptions for ‘follow-on’ investments into existing VCT portfolio companies, where the age requirement can still be met if the follow-on funding is to a company for which the original investment was made inside the seven-year period.
Company size
A company must generally have no more than £15 million in gross assets immediately before investment and must have fewer than 250 employees at the time of investment (see below for ‘knowledge-intensive’ companies).
Investment amounts
A VCT must not hold an investment in any single company which exceeds 15% by value of the VCT’s total investments. Each company is generally allowed to receive up to £5 million of VCT or other tax-efficient funding in any twelve-month period, with a cap of £12 million over its lifetime.
Knowledge-intensive companies
In line with Government policy objectives, the VCT funding rules for companies that have invested in research, development, or innovation are more flexible. These ‘knowledge-intensive companies’ can have up to 500 employees, they can receive up to £10 million of funding per annum (with a cap of £20 million over its lifetime) and the basic age limit by which the initial relevant investment must be made is within 10 years of the company’s first commercial sale.
Allowable business activities
A company must have a permanent establishment in the UK and carry out what HMRC calls a ‘qualifying trade’. Most trades are allowed, but there are some exceptions such as land dealing, forestry, farming, hotels and energy generation.
There are also certain conditions that apply to how a VCT should construct and manage its investment portfolio in order to maintain its qualifying status. These rules are specific to the VCT and when it raised its funds. For example, a VCT has three years in which to fully deploy money raised from investors, regardless of whether it was raised through an initial share issue or a ‘top-up’ fundraising. A VCT must also have at least 80% of its portfolio invested in VCT-qualifying companies. The remainder can be held as cash or invested into cash equivalents which can be readily realised within seven days – such as money market funds or shares listed on the FTSE.