Venture capital trusts are income choice

High-earning private investors are turning to venture capital trusts (VCTs) as an alternative source of retirement income, following Budget changes that limit the tax relief on pension contributions.

This week, fund manager Albion Ventures forecast that the market for VCTs would double in size from £150m in 2008/2009 to £250m-£300m in the current tax year – driven by next April’s 50 per cent income tax rate and the £20,000 pension contribution cap already introduced for those earning £150,000 or more. Patrick Reeve, managing partner at Albion Ventures, said: “The 2009 Budget worked in our favour with the negative changes to pensions and income tax.”

Allenbridge, the specialist advice firm, already reports greater reliance on venture capital holdings. “Our private investors have decided to increase the amount they normally invest via VCTs,” says Priti Patel, investment consultant.

Martin Churchill, editor Tax Efficient Review, believes that more investors will buy over the coming months. “This year will see renewed focus on VCTs as pension changes and tax rates loom into view,” he predicts.

From April 2011, tax relief on pension contributions is to be tapered down from the higher rate of 40 per cent to the basic rate of 20 per cent for those with incomes over £150,000, under measures announced in this year’s Budget. But to prevent high earners making substantial contributions before then, while tax relief is still available at 40 per cent, the government has introduced “anti-forestalling” rules. These limit irregular lump-sum pension contributions with higher-rate tax relief to £20,000, or the average of the past three years’ contributions up to a maximum of £30,000.

By contrast, VCTs – which invest in portfolios of small, unquoted businesses – still offer 30 per cent tax relief on lump-sum investments of up to £200,000 every tax year, provided the investment is held for five years. Unlike pensions, VCTs can also pay a tax-free income in the form of dividends, and can be sold on the stock market with any profits free of capital gains tax.

“There is no doubt, in the present climate, about the attractiveness of VCTs delivering annual income in the 5p to 8p range, tax-free, on an after-tax relief cost of 70p,” says Churchill. New VCTs are now targeting this level of income.

Shore Capital, the investment banking and asset management group, is launching a new limited-
life five-year “Puma” VCT that will aim to generate
a 7p annual dividend per 100p share, by providing secured loans to small businesses.

Graham Shore, managing director, says: “We thought if we could come up with a product that pays out high income over the life of a VCT, it would be attractive. You put a pound in and get 30p tax relief, so it costs you 70p. If you get 7p per annum in dividends, that’s 10 per cent.”

Shore acknowledges that for a high-income VCT to be attractive, capital cannot be put at too much risk – and argues that a VCT offering loans secured on business assets offers some reassurance. His Puma VCT will secure its loans on businesses’ property, debtors or stock. “If you have a charge over those assets, that limits your risk,” he says. “If it
all goes wrong, at least you can recover something. It’s not like a binary investment in equity.”

Downing has launched three VCTs this year, which all aim to pay 5p per year in tax-free dividends on every net 70p invested. “A 40 per cent taxpayer would have to earn 10.5 per cent gross a year on other taxable dividends to match this rate,” points out director Tony McGing. “When this 40 per cent taxpayer becomes a 50 per cent taxpayer, the gross equivalent rate becomes 12.3 per cent.”

He believes this gives VCTs advantages over pensions. “Downing’s current VCT offers a tax-free yield of 7 per cent. Pre-retirement, pensions don’t provide any income,” he says, “The exit [lump sum] is tax-free for VCTs, versus 25 per cent tax-free for pensions with the balance taxed at your marginal tax rate.”

But higher earners still need to quantify the risks before signing up for VCT tax breaks, warns John Davey of Bestinvest, the advice firm: “The underlying companies are smaller and, generally, VCT portfolios are more concentrated – often with as few as 20 underlying holdings.” VCTs that are not set up on a limited-life basis can also prove difficult to cash in at anything like their net asset value.

“There is a very small market in secondary market VCTs. Exits may not be possible at all if the market conditions do not allow,” says Davey.

For those willing to take the risk, he recommends VCTs capable of paying steady dividends. “Examples include the Ventus series that have long contracts to produce electricity,” he says. “Other VCTs suitable for producing income will structure qualifying investments, largely as loan stock. Downing, Albion and Puma VCTs make a large amount of qualifying investment as loan stock with a first charge over an asset.”