Venture Capital Trusts – dividend reinvestment

They sound risky and they are – but, for many, the combination of tax breaks and potential returns makes venture capital trusts (VCTs) extremely attractive.

VCTs are generally promoted ahead of the end of the tax year, as the fund managers who provide the trusts seek to raise new capital in order to invest again. It is a cyclical business, but one that has done very well in the past.

The sector is said to offer especially strong potential: as they help smaller firms grow and more of these firms are looking towards venture capital trusts for investment as finance from banks and other traditional sources remains scarce. Added to this, investors are obtaining worsening returns from banks and hence the opportunity to obtain a better return, couple with significant tax breaks investors “considerable opportunities to provide finance”.

What are Venture Capital Trusts?

A venture capital trust is a vehicle that groups together investors to form a pool. The funds raised are then used by the fund managers to make investments. These investments then generate a return, either dividends up to the venture capital trust, or are sold and the proceeds are

VCTs are among a handful of investments given special tax status by the Government. The quid pro quo arrangement is that investors get tax concessions but in return have to put their money to a specific use, in this case financing start-ups. The VCT managers, the best of whom have long track records in private equity or other areas of small company finance, are the middlemen who pool investors’ money into funds or “trusts” and parcel it out to hand-picked, qualifying new ventures.

One of the attractive features of venture capital trusts (VCTs) is that their dividends are normally free of personal tax – something which will become more appealing from the 2016/17 tax year, when the new dividend tax rules begin (see here for more information)

Tax free growth

Many VCTs have automatic reinvestment schemes which allow you to use the dividend to buy more shares in the trust so your return compounds and growth becomes bigger year on year and hence the popularity of a venture capital trust dividend reinvestment policy.

With some exceptions, usually the shares are newly issued rather than bought in the market. Which brings a great tax incentive in that the amount reinvested qualifies for 30% income tax relief as a fresh VCT subscription.

However, changes to the rules for VCTs which were announced in the Summer Budget have prompted some trusts to stop their dividend reinvestment schemes at short notice.

The trusts involved typically say they want to consider the impact of the proposed changes on their investment strategies. One area which looks to be moving off-limits for VCTs is investment in management buyouts, a strategy that has proved popular with some schemes.

The actions taken by VCTs suggest that the end-of-tax-year offerings in early 2016 may be fewer in number and potentially higher risk than has been the case in the past (and VCTs have always been high risk). If you are planning to use VCTs to cut this year’s tax bill, make sure you let us know now, so that we can alert you to what is on offer as early as possible.