As the tax year-end draws near, Paul Latham, Head of Tax Products, Octopus Investments, outlines how the use of VCTs – and VCT ISAs in particular – can provide effective investment opportunities
The government has been working to help UK smaller companies access long-term finance (patient capital) to support them in scaling up.
Following the Patient Capital Review in 2017, that year’s Autumn Budget reiterated the important role venture capital trusts (VCTs) play in directing long-term finance to these early stage businesses.
The idea behind VCTs is to direct patient capital into UK businesses with high growth potential, so they can use that capital to scale up.
That’s why VCTs offer tax reliefs – including upfront income tax relief. It’s to give investors an incentive to take on the risks of backing early stage businesses, with tax-free dividends and growth being a reward to investors for taking the additional risk.
Research from the Association of Investment Companies (AIC) shows that 54% of VCT investee businesses have been held by those VCTs for longer than five years. What’s more, 20% of them have been held for longer than ten years. The research also shows that VCTs have boosted exports and research and development in investee companies.
VCTs are doing the job they exist to do, directing patient capital into early stage, knowledge-intensive UK businesses.
With the introduction by Octopus of the VCT ISA at the end of 2017, ISA money can also get in on the act. It provides an opportunity for more people to access the benefits of investing in early stage companies, all within an ISA tax-free wrapper via ISA transfer.
Because ISAs are long-term vehicles, they are already patient capital. A VCT, being itself a vehicle for patient capital, is a natural fit.
The Main Advantage Of A VCT ISA
The main advantage a VCT ISA offers is flexibility.
A lot of clients are asset rich but not necessarily cash rich. What a VCT ISA allows them to do is say “I don’t have spare cash, but I can use my existing ISA to invest into the VCT, claim my upfront tax relief and then use that cash for something else.”
VCT investors get tax relief on capital gains and dividends, which is also the case for ISAs, so in that respect it doesn’t matter if the VCT is within an ISA or not. In addition, VCTs also offer upfront income tax relief equal to 30% of the amount invested, on investments up to £200,000. That income tax relief comes directly back to the investor not the ISA.
ISAs are long-term investment vehicles, and VCTs are perfect for that time horizon for clients who have the right risk appetite.
So transferring to a VCT ISA is unlikely to be right for a client with a Cash ISA who is very cautious or wants to stay liquid. But for a client with a stocks and shares ISA who is willing to accept the additional risks of VCT investing, it could be a great way to achieve the following goals:
- Add exposure to early stage companies with high growth potential.
- Claim upfront income tax relief, which they could put towards other uses.
- Diversify their ISA by giving them access to unquoted companies.
A More Diversified ISA
Technically speaking, anything you add to a portfolio will add diversification, unless it’s completely identical to an existing holding.
The type of companies VCTs invest intend to be fundamentally different to every other type of asset:
- They have a unique risk/reward profile.
- Smaller companies can be less prone to getting pushed about by stock market sentiment. This is especially true of unquoted companies whose shares don’t trade on the stock market.
Probably the main attraction of smaller companies is that they offer the kind of growth potential that’s relatively rare among larger companies.
There’s a popular perception that to target this higher growth, investors must enter into a trade-off. Specifically, if you follow this line of reasoning, they must put their money into businesses that are vulnerable to shocks.
That can certainly sometimes be the case. It takes time for a business to build up its profitability and establish a strong balance sheet. Sometimes, however, this received wisdom is just plain wrong. Far from being vulnerable to shocks, in many cases smaller companies are the shock.
Today’s technology means a small number of staff can reach millions of people – not just in this country, but worldwide – and sell to them directly. It allows smart businesses to benefit from economies of scale that, in a previous era, were the preserve of giant multinationals with thousands of employees.
Smart use of technology means that the best smaller companies tend to be very nimble. They can switch and focus on more promising regions or sectors much more quickly than larger competitors.
This is real diversification. For investors willing to take more risk, by adding a VCT to their ISA, they are holding something genuinely different. If that VCT invests in unquoted equity, then they’re adding something they won’t already have in their ISA.
Risks Which Clients Need To Keep In Mind
It’s important to point out that VCT ISAs are high risk and inherently different to stocks and shares and cash ISAs.
VCTs invest in smaller, less established companies. This type of investing is considered high risk and won’t be right for all clients. The value of a VCT investment, and any income from it, can fall as well as rise and clients may not get back the full amount invested.
Clients should also be aware that the share prices of VCTs can change more than other companies you’ll find listed on the London Stock Exchange’s main market. They can also be harder to sell.
Tax treatment depends on individual circumstances, and tax rules could change in the future. Tax reliefs also depend on the VCT maintaining its VCT-qualifying status.
They are an investment that requires a long-term mindset, which makes them potentially a good fit for some ISA investors. But remember, investors need to hold VCT shares for five years in order to retain the upfront income tax claimed.
The Bottom Line For Investors
To sum up, a VCT ISA is all about giving investors more flexibility. This could be a good solution for an asset-rich, cash-poor client who is comfortable with the risks, wants to nlock capital in their ISA so they can invest in a VCT, and claim tax relief for supporting growing UK companies.
About Paul Latham
Paul Latham is Head of Tax Products at Octopus Investments and is responsible for the development and management of its tax efficient investments (IHT and VCTs). He joined the company in 2005 and is also part of the Executive Committee for Octopus Group. Prior to Octopus, Paul had an extensive general management and internal consulting career stretching over 30 years in multiple organisations, the most recent of which have included Brakes, CapitalOne, NatWest and Kingfisher.