Tighter pension rules and high taxes are pushing investors into venture capital trusts – but can supply keep up?

 
Jason Hollands
Northampton Balloon Festival
When you squeeze a balloon in one place, the air pops out elsewhere (Source: Getty)

Middle class taxpayers will be hoping for some long overdue good news in today’s Budget after years of measures designed to extract more of their hard-earned cash to help pay down the deficit. Indeed, it is estimated that over the last five years there has been a 32 per cent increase in the number of people falling into the higher and additional-rate tax bands.

Contributing to a pension has long been one of the most obvious ways to reduce a liability to the highest rates of tax. However, the chancellor has repeatedly tightened the noose, with successive reductions to both the amount that can be contributed into a pension each year and aggressive cuts to the amount that can be accumulated in a pension without incurring a punitive 55 per cent levy on the excess – the lifetime allowance. Under George Osborne’s watch, the pensions lifetime allowance, a restriction first introduced by Gordon Brown, has tumbled from £1.8m to £1m from 6 April this year.

While the chancellor is believed to have backed off – for now at least – from plans for a full frontal assault on the long-established system of upfront pension tax reliefs to avoid provoking revenge by middle class voters in the EU referendum, we could yet see further cuts to the annual allowance announced today. The Conservative-leaning Centre for Policy Studies, an enthusiastic advocate of replacing the current system of pension tax relief, has also been calling for the annual allowance to be carved back.

Either way, the government is already set to taper the annual pension allowances of anyone with earnings of more than £150,000 from the next tax year, with those earning £210,000 or more seeing their allowance dwindle to just £10,000 rather than the £40,000 they currently enjoy.

Rising demand for VCTs

When you squeeze a balloon in one place, the air pops out elsewhere: the same is true when it comes to the search for legitimate ways to mitigate high taxes. The erosion of pension allowances has therefore prompted ever greater numbers of taxpayers to look beyond core tax-efficient investments such as pensions and Isas to other tax efficient investments, notably Venture Capital Trusts (VCTs).

VCTs are a long-established investment scheme, first introduced by the government in 1995 to provide a source of funding for UK small companies. VCTs are investment companies, listed on the stock exchange, which invest in small, unquoted or Aim-listed businesses that meet strict criteria on their size of assets, number of staff, and activities. Both Tory and Labour governments have long regarded these firms as pivotal to the growth and dynamism of the UK economy, so VCTs are provided with generous tax breaks to incentivise investors for the inherently higher level of risk involved when investing in small, illiquid companies.

The key tax advantages include a 30 per cent Income Tax credit on investments into VCT new share issues (but the investor must then hold the VCT shares for at least five years) and tax-free dividends and gains. The Income Tax credit has the potential to supercharge even a very modest underlying return on VCT shares into one that would be highly attractive on a taxable investment. Indeed, as a result of the Income Tax credit, just getting your original investment back would equate to a 43 per cent tax-free return. With the ability to invest up to £200,000 in VCTs in a tax year, investors can rake back a maximum of £60,000 through the Income Tax credits.

Looming supply crunch

Yet while demand for VCTs is buoyant and likely to remain so as the thumb screws tighten on the amount that can be invested in pensions, supply is inherently limited. There are only a finite number of underlying investment opportunities that meet the strict criteria over what types of businesses are eligible for VCTs to invest in. These include a requirement that a company cannot have more than 250 employees or £15m of gross assets at the time a VCT invests in it, and a long list of activities are specifically excluded, including energy generation, dealing in property or securities, and legal and accountancy services.

That situation has been further exacerbated by changes in last Autumn’s Finance Act, which further tightened the investment criteria in order to comply with EU State Aid rules. These changes include a new age limit on companies, which must normally be no more than seven years old from their first commercial sale; restrictions that will prevent VCTs from financing management buy-outs to re-focus VCTs on development and growth capital; and a new £15m lifetime cap on the amount of funding a business can receive from tax-advantaged schemes such as VCTs.

These changes are largely seen as a nuisance by VCT managers rather than a game changer, and importantly they affect new investments VCTs make not existing ones already held in their portfolios. The VCT industry has cut its cloth accordingly and, overall, less new cash is being sought from investors this tax year than last.

While many see VCTs as an increased part of the armoury for investors who have exhausted their pension allowances, the simple fact is that a supply crunch is coming. That mismatch between demand and supply is only likely to deepen in the 2016-17 tax year when further cuts to the pension lifetime allowance and the tapered reduction in the pensions allowance are introduced. At least the chancellor will be pleased.

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