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When it comes to finding out what tax relief is available for investors using a venture capital scheme, it's important to understand what the scheme is first.
Essentially, a venture capital trust, or VCT, encourages investment in unquoted, small trading firms. The aim is to support entrepreneurial small companies because they need investment capital to help them develop and grow.
As a result, the UK has created the world's most successful market for this purpose.
An investor in a VCT will enjoy:
- Up to 30% upfront income tax relief
- Tax-free dividends
- Their investment is capital gains tax (CGT) exempt on the rise in the share's value.
The bottom line is that venture capital trusts support entrepreneurial companies, but they may not be successful or may take several years to achieve success.
It is the tax incentives that help compensate an investor for taking a higher risk with their money.
Venture Capital Trust Schemes
A venture capital trust scheme will see an investment being spread over several companies to help reduce risk.
This will see investors subscribing for shares in a VCT which will be a company that has a London Stock Exchange listing.
A VCT will be run by fund managers, and they are generally members of a bigger investment group.
There are some rules for unquoted small trading companies to qualify and they are recognised as:
- Having up to 249 employees
- Total gross assets of up to £15 million before investment
- Total gross assets of up to £16 million after investment
- The amount raised annually by a company is restricted to £5 million.
Most of these changes were introduced in April 2012 which is when the £1 million cap was removed for investment by a venture capital trust in a single company.
Rules for VCT Investment
However, the rules were changed slightly for VCT investment in the 2015 budget to include:
- For a knowledge-intensive company, the total amount of investment is capped at £20 million
- For a knowledge-intensive company, the limit on employees was raised to 500.
The budget also saw a new cap being applied on the total investment a company can raise under a VCT for a knowledge-intensive company of £15 million.
This was also the budget that determined that the generation of renewable energy and the provision of reserve energy generating capacity were no longer qualify activities.
The Principal-Based Test
And because VCTs were so popular, new qualifying conditions were brought in by the UK Government in the 2017 budget, including the principal-based test.
This is to determine whether the company seeking finance is a genuine entrepreneurial firm, or not.
It was this measure that also led to the rules excluding investments that are ‘tax-motivated’ - this is where the tax relief provided most of an investor's return but limiting the risk to their original investment.
The new rules take a 'reasonable' view on whether an investment has been deliberately structured to offer a low risk.
This rule sees two parts being introduced with a company having long-term objectives to develop and grow, and whether the investor faces 'significant risk' of losing their capital.
What VCT Income Tax Reliefs Are Available?
Tax relief for investors in a VCT is a 30% income tax credit of the new ordinary shares cost, up to a 'permitted maximum' of £200,000.
This can be set against an investor's income tax liability in the year of investment when the shares were issued.
This annual limit will apply to the taxpayer's VCT acquisitions for the tax year concerned so their maximum income tax liability reduction in any given year will be £60,000 - but only if there is sufficient income tax liability.
We can explain how the system works with this example:
- The investor subscribes £20,000 for shares
- The maximum income tax relief for the investor will be £6,000
- If their actual liability in the year before there is any VCT tax relief was £5,000, then that's the relief they would receive.
- The £1,000 difference cannot be set off against their income tax liability in any other year.
It's also worth noting that to qualify for VCT income tax relief, the subscribed shares must be held for five years at least.
However, the VCT share dividends are exempt from income tax if they have been bought within the permitted maximum of £200,000.
It is here that VCTs offer the prospect of a tax-free dividend - for example, a dividend of 5% equates to a taxable dividend of 7.41% for a higher rate taxpayer, and 8.1% for additional rate taxpayers.
For those considering VCT investments, a well-established and diverse portfolio could deliver dividends throughout the year.
How To Claim VCT Tax Relief
Normally, an investor can claim their VCT tax relief when they file their tax return.
They would either reduce their tax bill for the year, or they will receive a refund for the tax they have already paid.
VCTs and Inheritance Tax
For those who are looking at the prospects of a VCT, you may be wondering whether a VCT is subject to Inheritance Tax (IHT).
Essentially, a VCT will not qualify for inheritance tax relief, but the VCT's underlying holdings may do. To explain this, when an investor buys their shares in a VCT, you do so in the VCT plc, and not in its underlying holdings.
It's only when an investor holds shares directly in a particular company that they will be IHT free.
Front-end income tax relief for VCT withdrawal
Having mentioned that the subscribed shares need to be retained for five years, what happens if the shares are disposed of within five years of them being issued?
The front-end income tax relief, in part or in whole, will be withdrawn under the circumstances.
Also, disposal between civil partners or spouses who live together will not give rise to a withdrawal.
And should a VCT lose its approval, the front-end relief may also be withdrawn.
The rules also make clear that death does not give rise to the withdrawal of front-end income tax relief.
Why invest in a VCT?
A VCT offers great investment potential for many investors and there are tax benefits to be enjoyed.
However, a VCT may not be suitable for all investors and it's important to speak with a financial adviser before investing in a VCT to see whether this type of investment is the right one for you.
Indeed, the Financial Conduct Authority (FCA) treats VCTs as designated investments.
So, anyone advising on VCTs - just like advising on most other investment types -is doing so on a regulated activity and the financial adviser must have the relevant permissions from the FCA to do so.