High earners seek relief in VCTs

High earners caught by limits on pension tax relief are expected to double the amount of money put into venture capital trusts (VCTs) this year – but analysts warn that these investments in small businesses will become riskier under new regulations.

Between now and the end of the tax year on April 5, total investment in VCTs in 2009/2010 is on course to reach £250m, according to Tax-Efficient Review – 70 per cent more than in the previous tax year. But VCT manager Downing calculates that £56m had already been committed by the end of January – suggesting an annual increase of 93 per cent.

Demand is being driven by the limits on pension tax relief introduced in last year’s Budget, advisers say. Since last April, pension investors earning more than £150,000 have only been able to contribute £20,000 a year (or the average of the past three years’ contributions up to £30,000), and get tax relief at 40 per cent. However, VCTs offer 30 per cent upfront tax relief on annual investments up to £200,000 – giving a maximum annual tax saving of £60,000.

Matthew Woodbridge, head of investment products at Chelsea Financial Services, says: “The ‘Budget Bombshells’ dropped by the chancellor have made VCTs much more attractive to higher earners.” Martin Churchill, editor of Tax-Efficient Review, believes “the hike in the top rate of income tax” to 50 per cent from this April has also made VCTs’ tax-free dividends and capital gains more attractive.

In previous years, enterprise investment schemes (EISs) have been a more popular choice. Like VCTs, EISs invest in start-up businesses but they offer 20 per cent tax relief on annual investments of up to £500,000, as well as tax-free capital gains, and deferral of tax on reinvested gains. Hotbed, the private investor syndicate, recently said that EISs were still attracting more than £600m a year, while investment in VCTs fell to £150m in 2008/2009.

However, advisers believe the availability of lower-risk VCTs has been reversing the trend. “Planned-exit” or “limited-life” VCTs aim to wind up after their five-year term and return capital to investors – generating most of their gains from the 30 per cent tax relief. To protect investors’ capital, these VCTs invest in asset-backed businesses, such as pubs and nurseries, and often provide loans rather than equity investment. So, if one business failed, the property could be sold – with the VCT’s loan repaid ahead of shareholders’ equity.

But the availability of these lower-risk VCTs is now in question, under proposed rule changes. From April, the maximum investment that a VCT can make in the form of loans will fall from 70 per cent to 30 per cent – meaning 70 per cent will have to be in equity. This will make it harder for an asset-backed VCT to recover capital if a business it backs fails.

Jason Butler of Blooms-bury Financial Planning says: “It’s not that the ventures will be more risky, just the chances of getting egg on your face.”

Last year’s pre-Budget report also began a consultation process on further limiting VCTs’ investments to “smaller, high-risk businesses”. This consultation does not end until March, but Patrick Reeve of Albion Ventures warns: “Whatever happens, limited-life VCTs will be harder to raise, post consultation.”

As a result, Churchill advises private investors to consider lower-risk VCTs before any tax changes are introduced. “If you’re interested in planned-exit VCTs, you might want to do a bit more now.”