Some individuals wish to invest in smaller companies, but at the same time are looking to diversify their risk more than is possible with the Enterprise Investment Scheme (see EIS). If this is the case, then Venture Capital Trusts (VCTs) may provide a suitable vehicle for them.

What are VCTs?

VCTs are vehicles that provide capital finance for small expanding companies and at the same time aim to make capital gains for their investors. These were first introduced in the U.K. in the Finance Act 1995. Unlike their forerunners, the Business Expansion Scheme, VCTs are companies with shares traded on the London Stock Exchange, which have invested at least 70% (by value) of their funds in qualifying companies. However, the VCT need not invest all its money in year one. Their investments can be spread over three years from the initial fundraising to allow time to select companies with strong potential.

VCTs are similar to investment trusts in that they are run by fund managers who are generally members of larger investment groups. They also have to issue prospectuses that are approved by the Stock Exchange. Investors can purchase shares in a VCT, which in turn invests the money raised into several qualifying companies and will occasionally realise their initial investments and make new ones. One of the most important factors in selecting the most appropriate VCT therefore is the experience of the manager in investing in smaller companies.

Qualifying Holdings

Qualifying holdings are described as shares or securities, including loans of at least five years duration, held in either unquoted companies or those that are listed on the Alternative Investment Market (AIM). VCTs may invest up to £1m in each qualifying company although each individual investment must not represent more than 15% of the VCTs assets. Furthermore, at least 10%, by value, of the total holding in shares in any one company must be held as ordinary, non-preferential shares.

As with Enterprise Investment Scheme, the gross assets of a VCT investment company must not exceed £7m prior to the investment of £8m following the investment and their trade should be undertaken either wholly or primarily in the U.K. Before 6 April 2006, the figures were £15m and £16m respectively.

There are also similar restrictions on the trades that these companies are allowed to undertake. Companies excluded from VCTs include those where a substantial part of a company's trade (generally greater than 20%) is of one of the following activities:

• Companies dealing in land, commodities, futures, shares or other financial instruments
• Financial, banking or insurance companies
• Companies receiving royalties or license fees other than in certain cases, such as in connection with film production or research and development
• Professional organizations providing legal or accountancy services
• Property asset-backed companies, such as hotels, property development or farming
• Companies dealing in goods, other than in the course of an ordinary trade of retail or wholesale distribution
• Providing services to another company, in certain circumstances, where the other companies trade consists to a substantial extent in excluded activities

Tax Reliefs

Income tax relief is available to individuals aged 18 or over who purchase shares in VCTs acquired up to a maximum of £200,000 per tax year (a tax year begins on the 6th April and ends on the 5th April of the following year). The maximum investment in any tax year before 2004/05 was £100,000.

The rate is relief given to individuals is 30% for the tax year in which an investment is made in VCT shares, if the investment is held for at least three years after the investment date (five years for shares issued before 6 April 2000). For shares issued after 5 April 2004 and before 6 April 2006, the rate was 40%. It was 20% for shares issued before 6 April 2004. This relief is only available for new ordinary shares issued by a VCT and not for shares that are subsequently purchased by investors through the stock market.

E.g. If Mrs Adam invests £30,000 in 2 new VCTs in 2007 and has an income of £70,000 in the same financial year then she would be able to claim the max possible relief of £9,000 (£30,000 x 30%) if this was less than her overall income tax bill for the year

Furthermore, dividends received from ordinary shares in VCTs are exempt from income tax (the 'dividend relief')

Capital Gains tax deferral relief was available on all VCT shares subscribed to before 6 April 2004. However, the relief was abolished for all subsequent subscriptions.

Withdrawal of Tax Relief

In certain circumstances income tax relief can be withdrawn, and the original tax paid, if:

• Shares are disposed of less than three years after they are issued (unless they are transferred to a spouse in which case the transferee is treated as though he or she had subscribed for them for tax purposes)
• HM Revenue & Customs’ approval for the VCT is withdrawn within three years from the date of share issue

In such circumstances, the investor would normally have to pay the Revenue the smaller of the relief originally obtained for the shares disposed of or 30% of the amount received for the shares disposed of (40% for shares issued after 5 April 2004 and before 6 April 2006 and 20% for shares issued before 6 April 2004).

e.g. Mrs. Adam invested £50,000 in 50,000 new shares of a VCT in 2006/07 and obtained the max income tax relief of £15,000 (30% x 50,000). She then sold half her holding (25,000 shares) two years later for £35,000. The income tax relief to be withdrawn is the smaller of:

a. The original relief given on the shares disposed of = £15,000 x 25,000/50,000 = £7,500
b. 30% of the sale proceeds = 30% x £35,000 = £10,500

I.e. the amount of relief to be withdrawn in this case would be £7,500.

Summary

VCTs are a useful tool for private investors wishing to invest in the growth potential of smaller companies, but at the same time not willing to take on the higher risks of investing in just one or two companies through the Enterprise Investment Scheme. Venture capital trusts are good investments in themselves (even without the tax breaks) and the average net annual returns of existing Venture Capital funds to 1 November 1999 were reported to be One year - 20.3%, three years - 32.5% and five years - 38.4% (source: AITC).

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