Venture capital trusts explained

What are VCTs?

VCTs were established by the UK government to encourage investment into emerging UK companies – and in turn support innovation, employment and the wider economy. In exchange, they offer investors generous tax reliefs, as well as the opportunity for investment returns if these companies prove successful.

VCTs are companies listed on the London Stock Exchange (LSE), which invest in a portfolio of smaller, unquoted businesses. Investee companies must meet specific criteria – on size, number of employees and the trade they undertake, in order to qualify. VCTs are managed by specialist portfolio managers, who typically work with these businesses over several years to help them grow – and ultimately create returns for investors.

The VCT market has grown substantially since its launch in 1995. In the tax year 2022/23, VCTs issued over £1 billion in shares, with 44 VCTs raising funds, and more than 26,000 VCT investors claimed income tax relief on £985 million of investment, according to HMRC.¹

What are the benefits of VCTs?

Return potential

Investing in small, emerging businesses can provide exposure to exciting new innovations and technologies, and with it, new sources of potential return. While the risk of failure in early-stage companies is high, so too is the opportunity for growth compared to more established firms.

Venture capital can be a vital source of funding to enable entrepreneurs to transform their ideas into scalable businesses. For those that succeed, growth can be significant – there are more than 1,400 venture-backed unicorns (private companies valued at $1 billion or more) globally, 47 of which are based in the UK.²

VCT managers typically aim to distribute investment returns in the form of dividends, which can be useful for investors looking for additional income.

Portfolio diversification

An allocation to VCTs can bring diversification benefits to a portfolio of traditional investments, such as listed equities and bonds. Early-stage companies may respond differently to macro and micro-economic drivers compared to larger, established firms.

VCTs invest in a portfolio of holdings to help diversify risk, typically 30-50, which may be from across various sectors and industries (Generalist VCTs) or more focused on a specific sector or theme (Specialist VCTs). There are also AIM VCTs, which invest mainly in smaller companies listed on the Alternative Investment Market (AIM), a sub-market of the main LSE with fewer regulations (but considered riskier).

Tax reliefs

VCTs offer generous tax reliefs, outlined below, which are intended to incentivise and compensate investors for the higher risks involved.

• Income tax relief: Investors can claim 30% income tax relief on a VCT investment of up to £200,000, provided shares are held for five years. Note the amount of income tax you claim cannot exceed the amount of income tax due.
  
• Tax-free dividends: Dividends are tax-free on the first £200,000 of shares acquired in a tax year, with no minimum investment period.
• Tax-free capital gains: Any capital gains are tax-free, even if you sell your shares within five years.

What are the risks?

Risk of loss

Early-stage businesses are intrinsically riskier investments, given their smaller size and lack of track record. Analysis from Experian suggests that around one-third of start-ups fail within two years, rising to 50% within three.³ Failures within a VCT portfolio could result in lower returns and dividend payments, and/or loss of initial capital.

Investing across different VCTs, and ensuring your broader portfolio is well-diversified, can help mitigate the potential impact but won’t remove it entirely. Choosing a portfolio manager with the specialist skills and experience in this area of the market, who can conduct appropriate due diligence on any potential investments, is another key consideration.

Limited liquidity

Investments in a VCT are generally considered to be medium to long-term investments. Indeed, they must be held for five years in order to quality for income tax relief. VCT shares can be traded in a secondary market, but liquidity tends to be limited – and income tax relief is only available if you invest in a primary share offer.

Investors typically sell their holdings after the five-year holding period through a share buyback, subject to the manager’s discretion and ability to fund the buyback. However, there is no obligation to sell at this time and you can remain invested to continue receiving tax-free income.

Tax relief changes

A company must meet a number of requirements to gain HMRC approval as a VCT. If it does not meet ongoing qualifying requirements, it could lose its VCT status, which would mean investors lose their tax reliefs.

The UK government recently reconfirmed its commitment to VCTs, extending the scheme until April 2035.⁴ However, tax rules and reliefs are subject to change, and may depend on your individual circumstances.

Investing in VCTs

VCTs are often referred to ‘seasonal’, typically raising funds during the second half of the tax year. Subscriptions are limited and will close when sufficient capital has been raised.

Investors need to invest in newly issued shares to qualify for income tax relief, as noted above. These may be shares issued by a new VCT or, more commonly, new shares in an existing VCT. With an existing VCT, the manager will likely already have an established investment portfolio, whereas a new VCT may need longer to invest and allow companies to grow.

For longer-term investors willing to accept the risks, VCTs offer both tax benefits and the opportunity for investment returns. Depending on your financial situation, they can be used alongside pensions and ISAs, to help you manage your assets as tax-efficiently as possible. However, rules around taxation are complex, and any decision to invest should be considered in the context of wider investment portfolio and goals.