Better Business: The pensions alternative

Patrick Reeve, managing partner of Albion Ventures, says VCTs have become the default tax planning investment for higher earners.

Venture Capital Trusts (VCTs) were created by the last Conservative Party Government back in 1995 as a method of channelling private investor money into smaller unquoted companies.

Today’s versions are tax efficient, UK closed-end funds, listed on the main stock exchange, similar to investment trusts. VCTs’ popularity rests on their twin attractions of income tax relief and the potential for tax free income; these have now increased as recent legislation has made pensions less attractive.

Assuming Gordon Brown does call the general election in May and loses, VCTs will once again come under the influence of Ken Clarke as he is likely to be appointed as the next Business Secretary. Ken Clarke created VCTs as the successor to 3i in the ‘equity gap’ private equity space. Now that 3i has completely left the sector, VCT managers have become the most active venture capitalists operating in the £1-£10m deal range.

While the Tory party created VCTs, they were seen as sufficiently important for the UK economy for Labour to continue government support. But there have been changes to the levels and nature of reliefs over the years and they now offer investors 30% initial income tax relief on investment in new VCT shares, along with tax free dividends and gains made on the VCT investment.

Small firms, big risk?

Smaller companies tend to be higher risk investments, as they are inherently fragile and prone to buffeting by strong economic winds. However, the risk controls employed by generalist VCT managers, including sectorally broad portfolios, have created a lower level of overall risk for investors than first impressions may create. That is not to say VCTs are for all investors; in my opinion VCTs are best exploited as long-term income investments to sit alongside pensions, where their tax incentives make them competitive and probably the best tax break around.

These relative advantages have been increased for savers seeking a degree of longer-term certainty with the removal of personal allowances, the introduction of a higher income tax rate and the tapering down of pension tax breaks to as low as 20%. The changes to tax relief on pension contributions, in particular, have highlighted the importance of alternative tax effective investments, such as VCTs, as high net worth individuals seek to shelter their increased tax burdens.

Compared to pensions, the tax treatment (30% upfront relief) and investment limits (£200,000 per tax year) of VCTs are more straightforward. In addition, the fact an investor does not have to buy an annuity (on which they pay income tax at their marginal rate) but has permanent access to capital along with a tax free dividend stream, further enhances VCTs’ position. VCTs and pensions are entirely different from an asset allocation perspective. But from the point of view of taxation, they could become the shelter of choice.

While the tax perks are a clear winner for VCT investors, now is also a good time to invest into smaller company private equity.

Historically, investments made in private equity and venture capital during recessions tend to drive the best returns. This is a function of better pricing resulting from a scarcity of competing capital. For instance, we have found many smaller companies are still frustrated by banks’ reluctance to lend to provide expansion capital. VCT investors, however, can capture the potential of such businesses since they can invest without the presence of banks, providing all the necessary funding themselves.

All this makes the case for VCTs seem compelling. The big uncertainty that has to be addressed, however, is whether a Conservative government would make any changes to VCTs. Initial indications are positive, as Ken Clarke has already expressed interest in the sector he created.

Nevertheless, he thinks “a more sophisticated” version of VCTs might be needed as a way to increase the availability of finance for new businesses, specifically in technology-based manufacturing. It is in this area design guru James Dyson is carrying out a review of funding options for the Conservatives. What seems clear is that for VCTs to continue, managers need to be able to demonstrate their ability to benefit ‘UK plc’, or the tax breaks could be removed. So the fact there is already strong proof of the link between VCT investment and job creation is particularly helpful.

Since we launched our first VCT in 1996, our investors have claimed about £65m in income tax reliefs, which compares favourably with our annual contribution to the nations coffers. We would welcome a discussion with the Conservatives on whether, and how, VCTs need re-focusing. We would also like to discuss how VCT tax incentives which, despite their attractions have been eroded over the years, could be enhanced at little upfront cost to the Government.

Inheritance tax relief wish

A year ago, we asked our shareholders what changes to VCT legislation they would be interested in seeing. Of the 1,700 responses, some 55% wanted greater income tax relief, but 58% wanted inheritance tax relief. The inheritance tax point is important since that would incentivise shareholders to invest for the long term, which we believe is in line with how the Tories view VCT investing. Because VCTs are ever-green vehicles whose investment portfolios turn over a number of times but which cost the Government only one set of tax breaks, this becomes a cost-effective way of boosting the economy.

While VCTs have become today’s default tax planning investment for higher earners, increasing the tax benefits to mitigate inheritance tax would both reinforce and attract a new form of shareholder. This would both help stimulate the sector and provide a further badly needed boost to business investment.