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Venture Capital Trusts: Tax Breaks But Risk Hikes

posted Jan 9, 2010, 11:20 PM by Scott Smith   [ updated Jan 11, 2010, 12:22 PM by Yale ReiSoleil ]
London (Thomson Reuters) -- Despite the Christmas excess, UK investors are developing a ferocious appetite for venture capital trusts. Recent months have seen British investors hungrily moving out of pension schemes and into venture capital trusts in an attempt to maximise their tax relief. These moves are prompted by the latest present to come out of the UK government’s Pre-Budget Report – a reduction on the tax relief available to pension investors. But not all Christmas tidings are positive for venture capital trusts. The new changes to venture capital trusts in the Pre-Budget Report could make these trusts a riskier investment in the future.

VCTs are interesting (and we’ll give you a quick primer on them below), but they’re even more interesting as they are now in flux.  VCTs benefit from a unique tax treatment in the UK, even more so than pension plans, due in part to the social utility they have supported in recent years by providing small and medium sized businesses with valuable capital. But times are hard for small companies and their shareholders (including VCTs), and new government regulations will make things even harder for them. VCTs in particular face a slew of challenges related to tax benefit restrictions, buy-back provisions, and regulatory changes.

Primer on VCTs

A venture capital trust is a highly tax efficient, closed-end collective investment scheme designed to promote private equity for small and expanding companies. They are quoted on the London Stock Exchange and are similar to investment trusts, with an active manager and a spread of investments.

The UK VCT scheme was started on 6 April 1995 by the Finance Act 1995 to encourage venture capital investment in small expanding companies. Despite their name, VCTs are actually public companies that are listed on the London Stock Exchange, comparable to business development companies in the United States. VCTs create portfolios of investments in a number of smaller high risk trading companies, whose shares are not listed on a recognised stock exchange. According to Downing Absolute Income 2 VCT in its recent IPO, approximately £3.5 billion has been raised by over 100 VCTs since their inception.

There are broadly speaking four different types of venture capital trusts, namely; AIM, generalist, specialist and hybrid VCTs. AIM venture capital trusts invest in companies that are listed on the Alternative Investment Market (AIM) of the London Stock Exchange. Generalist VCTs invest in non-AIM companies and give money for company growth and management buyouts. Specialist VCTs focus on particular industry sectors, whilst Hybrid VCTs have a flexible approach to investment and consider applications for funding from all qualifying companies.

Startup Corporate Finance


VCTs play an important role in providing venture capital to small start-up companies. VCTs are essentially funds, in which investors take an equity stake, similar to a real estate investment trust. Unlike their cousins, venture capital firms, VCTs do not generally get involved in the management of companies but provide a means by which investors can gain exposure to smaller untraded companies. Venture capital trusts are run by fund managers who are usually members of a larger investment group. The fund managers choose which companies to invest in depending on the VCTs investment criteria. The VCT will then take equity and debt stakes in small unlisted companies.

A company must be awarded VCT status from HM Revenue & Customs (HMRC) in order to qualify for the requisite tax relief. As part of its VCT status, the HMRC stipulates that VCTs may only invest in companies that:
  1. Are unquoted – i.e. have not listed either debt, shares, stocks or other securities (except for AIM and OFEX listed companies);
  2. Are carrying on a qualifying trade- most trades qualify but the following are excluded; dealing in land, financial activities, leasing or letting assets, receiving royalties or licence fees, farming, forestry, hotels, providing services to another company where the company’s trade consists of an excluded activity;
  3. Have gross assets that do not exceed £7 million;
  4. Are independent- ie not controlled by another company.
All of this has elevated VCTs to a particularly important role in funding small startups in recent years.

A Period of Flux


The last 18 months, however, have been a period of flux for VCTs, however, which have investment strategies that are heavily reliant on the success of small unlisted companies. Small companies have been badly hit by the recession, as they have been starved of credit from banks and larger companies. This in turn has affected VCTs, as their investments have gone bad or have reduced in value.

VCTs have also been hit by falls in stock markets. In particular, AIM venture capital trusts have suffered significant falls in net asset values, as the AIM markets were hit hard by the recession -- Baronsmead AIM, an AIM Venture Capital Trust, announced a loss of 43% on opening values in the first quarter of this year.

Falls in stock markets also hit the ability of VCTs to raise funds, with VCTs collectively raising £290 million in the tax year 2007/8 but only managing to raise £135 million in the last tax year. In recent months though, things have looked a little better for venture capital trusts. In fact, VCTs have become the retirement plan of choice for many high earners, as tax relief on pensions gets increasingly squeezed by the UK government. The generous income tax relief of 30% for all investments up to £200,000 in VCTs means that many high earners are better off investing in venture capital trusts than in pension plans.

Why Invest in a VCT?


VCTs are attractive to investors because of the tax relief they carry. Investors may subscribe for up to £200,000 new shares per tax year and receive income tax relief at the rate of 30% on the amount invested, if the shares are held for at least five years. A disposal of shares in a VCT is also exempt from capital gains tax and dividend payments are exempt from income tax.

The favourable tax treatment that VCTs attract makes them appealing to many investors, especially when compared to pension plans. Although pension plans benefit from an upfront tax relief of 40%, payments out of pension plans are subject to tax at 20% (assuming the individual is a basic rate tax payer). The result is that many high earners are better off investing in VCTs than in pension plans.

For example, say you contributed £10,200 to a VCT. This would be worth £14,571 after 30% tax relief. Invested over 25 years with 4% growth, the pot would be worth £631,095, producing a tax free income of £31,553 a year (assuming a dividend yield of 5%).

Alternatively, you could put your £10,200 into a pension, where it would be grossed up to £17,000 with 40% tax relief. This would be worth £736,299 after 25 years at 4% growth, giving an income of £36,814 (assuming a 5% yield). However, this income is subject to tax at 20% as a basic rate tax payer, reducing your take home pay to £29,451 a year -- £2,102 less than with the VCT.

Limited Tax Relief


VCTs have, however, suffered from an inherent problem: that income tax relief of 30% is only available to those investors who subscribe for new shares in a VCT. Those investors who acquire second hand shares in a VCT (i.e. on a secondary market) are not able to claim tax relief, although they may still benefit from tax free dividends and capital gains. This means that investing for new shares in a VCT is much more attractive than acquiring the shares in a secondary market. This has resulted traditionally in a restricted market for second hand VCT shares, which makes VCT shares highly illiquid.

New Market Developments: Buy-Backs

In an attempt to make VCT shares more liquid, many VCTs, such as Octopus Vct Plc, Proven Growth and Income and Ingenious Entertainment Vct 2 Plc, have recently announced plans to introduce buy-back provisions.

A buy-back scheme allows a VCT to purchase shares from investors at a discount to their face value, should an investor wish to sell their shares in the VCT. This obviates the need for a secondary market as an investor will be able to sell back their shares to the VCT should they be unable to find a secondary market buyer.

So far so simple, but corporate governance in the UK provides a further problem. Capital maintenance requirements state that a company may only buy-back its own shares out of its distributable reserves (realised profits less its accumulated, realised losses). This means that VCTs may only purchase its own shares so far as it has realised profits that exceed its realised losses. Ingenious Entertainment VCT announced a particularly ingenious solution to this problem in its recent open offer this year. By applying to court to cancel its share premium account, Ingenious Entertainment will be able to create a special capital reserve to finance share buy-backs. By effectively re-designating its share premium account as a buy-back capital reserve, Ingenious will be able to create a pool of cash to fund buy-backs without recourse to its distributable profits.

Many VCTs have followed Ingenious Entertainment’s lead, including: Downing Absolute Income VCT, Octopus Secure Venture VCT and Proven VCT. Proven VCT even upped the stakes recently by promising to buy back shares from investors at a discount of no more than 5% of the net asset value per share. Recent volatility has even lead some VCTs, such as Acuity VCT, to announce the suspension of share buy-back policies in an attempt to stop its financial hemorrhaging, as investors sort to liquefy their investments. But as the financial markets bounce back VCTs are once again proposing buy-back programmes to make themselves more attractive to investors.

Regulatory Challenges


Venture capital trusts may also benefit from some further bad news for pension funds in the Pre-Budget Report. Earlier this month the Chancellor of the Exchequer announced the introduction of a 50% tax rate for those earning more than £150,000 a year earlier this month. In conjunction with the new tax band, there will be a cut in the rate of tax relief on pension contributions to 20% for those earning £180,000 or more, from April 2011. Compared to a 30% tax relief on VCT investments up to £200,000, VCTs suddenly look very attractive to investors.

But there is a sting in the tale for VCTs as well. Under the new proposals, VCTs will have to hold larger equity stakes in the companies they invest in. Under section 842AA Taxes Act 1988 (as modified by the Finance Act 1995) at least 70% of the value of a VCT’s investments must be invested in qualifying companies within three years. Prior to the Pre-Budget Report, only 30% of this had to be in equities, the remainder could be in debt. But starting from April 2010, a VCT must invest 70% of its funds in company shares.

Investing in debt rather than equity puts a VCT in a better position in the event of an insolvency. Debt can be secured against assets and will rank in priority to any equity stake held in a company. By requiring VCTs to invest more heavily in equity, the UK Government is effectively reducing the likelihood that VCTs will be able to recover capital in the event of an insolvency of one of the companies it invests in.

The new rules are not retrospective, so VCTs that have already been set up under the old ratios can continue to receive investments. But all new VCTs will have to take the added risk of investing more heavily in equity.

The effect of the new rules may be to create two tiers of VCTs, with those that were created before April 2010 able to reduce risk in investments by taking debt as well as equity and those that are created after April 2010 only able to make equity investments. This may mean that those VCTs today are more attractive than their future offspring.

With the favourable tax treatment of VCTs when contrasted with pension plans, and a potential deadline of April 2010 for the safest investments, it isn’t difficult to see why many investors are piling into VCTs while they still can. This will be good news for many small and medium sized UK companies, which may seek to tap a valuable source of funding from VCTs in the near future.
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