December 10, 2003 saw UK Chancellor Gordon Brown announce the proposed changes to the VCT subscription reliefs, as part of his pre-Budget statement. These changes have not been confirmed and may be subject to amendment. But it is probable that as of April 6, 2004 capital gains tax (CGT) deferral will be abolished and from April 2006 a new income tax-based incentive will be introduced of an equivalent value to CGT deferral. In addition, the government has proposed it will pay an extra 20% of the amount raised from investors directly to VCTs for the next two years. What does this mean for VCTs and is it likely to kick-start the industry opening doors to a whole new investor base? asks Angela Sormani
VCTs have long been promoted as a tax efficient vehicle for investors while at the same time allowing private investors to access the private equity asset class. The ordinary shares of a VCT must be listed on the London Stock Exchange and so a private investor has the added advantage of benefiting from a degree of liquidity, which would otherwise not be available if investing directly in unquoted companies. (Although with such poor returns in some quarters of the VCT sector in recent years and share prices depressed to as much as 40% below net asset values many investors may question the true value of liquidity as things currently stand.) As the regulations on VCTs currently stand VCT tax reliefs available on subscription for the tax year 2003/2004 are as follows:
David Cartwright, partner tax and legal service at PricewaterhouseCoopers, says: “The BVCA has been campaigning for some time to change the regulations for VCTs to make it more attractive to invest. Essentially what the Chancellor did on 10 December was put together a proposal for VCTs, which would carry on with the existing tax relief for investors with added benefits. The BVCA has convinced the government VCTs are important, but now we need to kick start them.”
The proposed changes have for the most part been welcomed by the VCT community and do include some innovative ideas that should further widen the industry’s investor base by shifting the tax incentives toward extra income tax relief. This is a positive development, says John Spooner of Quester. As far as the CGT deferral is concerned, this is a great benefit when investors have capital gains to defer, but when they haven’t, as is the case in the current market, it’s not much of an incentive.
One thing is certain, if CGT deferral is abolished on April 6 this may encourage investors who do have capital gains to shelter, to invest before they lose that benefit. But it is not yet clear what the replacement relief will be following the two-year period and, given that uncertainty, investors may be reluctant to part with their funds.
The revenue has also proposed to increase the limit you can invest in a VCT from £100,000 to £200,000. This will attract investors from the higher end of the spectrum because statistics show investors might commit £100,000 on the last day of the current tax year and £100,000 on the first day of the next. However, while it is a good proposal and will attract more money for VCTs, it won’t make a huge impact as statistics also show average investment in VCTs is significantly lower than £100,000, standing between £17,000 and £19,000.
But the main incentives proposed by the government to provide an additional boost in fund raising is an income tax reclaim whereby up to 20% up front on the amount subscribed will be enhanced by a 20% contribution directly to the VCT for the tax years 2004/05 and 2005/06.
Patrick Reeve of Close Ventures explains: “The use of an investment in a VCT to defer a capital gains tax liability ends on 5 April. This is made up for by having 40% rather than 20% income tax relief. Half of this relief goes into the company rather than directly back to the shareholder so the investor pays 100 pence for his share, gets 20 pence back from the government who also add 20 pence onto the value of his share by putting it into the company. Therefore his net cost is 80 pence and the value is 120 pence.”
Subhead] What next?
The VCT industry has reached a state of maturity and is starting to reshape itself. Since 1995 around £1.625bn has been raised by over 70 VCTs. Five major players dominate the VCT space managing over 50% of the total amount raised. They are Aberdeen Murray Johnstone Private Equity, Close Brothers, Quester, ISIS Equity Partners (Baronsmead) and Northern Venture Managers.
David Cartwright stresses the importance of attracting more funds to the marketplace. “The market is stagnant; it is unlikely to raise over £50m in the current year and so funds raised will be comparable to last year. There have been no new entrants in the marketplace. A number of established VCTs are doing C-share issues trying to raise between £10m and £20m. And the rest of the market is doing small top-ups of around 10% of their fund.”
According to Cartwright what the market needs is a form of tax relief/inducement that will encourage investors to commit long term. “Now CGT deferral is to be abolished there’s not the pressure on investors to stay the course after three years. And so there is a need to consider some form of longer term incentive either in the form of a CGT measure or possibly inheritance tax,” he says.
Among those seeking more funds before CGT deferral is abolished are: Northern 3 VCT, the generalist venture capital trust managed by Northern Venture Managers, which recently gained its independence from Aberdeen Asset Management and is issuing up to 1,760,000 new ordinary shares at 100 pence through a top-up issue; Close Brothers has launched a second C Share Offer to raise up to £13.2m; Sitka Health fund has launched an offer of subscription of up to £12m ‘C’ shares; Quester is marketing a top-up issue for Quester VCT 5; and ISIS Equity Partners has so far raised £23m for Baronsmead VCT 4.
With many of the smaller VCTs suffering from dwindling share prices, a consolidation of the industry is on the cards, but this will take time. There have been a few managers that have exchanged hands such as Gartmore (now Elderstreet, which was previously managed by NatWest Equity Partners) and TriVen and TriVest, now LICA, for which part of the management was taken over by Nova Capital Management. In addition, the industry has been negotiating with the UK Inland Revenue for the last three years to allow VCTs to merge with one another. At the moment there is no such legislation and if VCTs did merge they would lose their tax relief.
John Simpson of AMJPE says: “Merger legislation has not yet been finalised, but the consequences will be quite significant. First and foremost, the VCT managers will need to see what the final legislation will be. Until it’s on the statute book you can’t actually do anything.”
He adds: “You do need a certain amount of scale in terms of the size of the fund and number of investments. It is important to have the scale to invest not only in smaller companies, but also in larger companies and hence multiple VCTs that can invest in deals over £1m can help you spread the risk for your investors. The biggest challenges facing private equity managers are the economy, in particular currency strength, and having the resources to dedicate to managing the portfolio companies.”
The merger legislation, when it comes into force, is most likely to help managers running a number of VCTs to consolidate them into a larger product that can offer investors a bigger spread and more critical mass. But it is dubious whether it will encourage managers to take on struggling VCT funds.
John Spooner of Quester says: “Merging the VCTs in a manager’s portfolio would cut down administration costs. It would increase critical mass and give a better spread of investments. It would also make it easier for investors to understand the product.”
This, he says would present VCTs as an increasingly effective investment for retirement planning. “The good spread of investments would help the process,” says Spooner. “We already have investors who are making long term savings like a pension fund. I think the interest is there and if the government does give 40% income tax relief then it will encourage long term savings, which is what we want in this business. This is not a short term business; we want to be looking at a seven to ten year minimum investment.”
Michael Probin, VCT investor relations manager at ISIS Equity Partners, adds: “Increasingly advisors and investors are seeing the potential for VCTs in retirement planning. We know several IFAs who look at VCTs as a real part of what people should be investing in as part of an overall retirement planning package whether it’s instead of a personal pension plan or in addition to a pension plan.”
A flexible part of VCTs is that you can unlock your investments by selling your shares to the market whereas in a pension plan, you are locked in. Another positive aspect is that, as listed vehicles, VCTs are relatively transparent and may be easier for the investor to understand than pension funds, which are rarely transparent even to actuaries. In addition when investing in a VCT you are not just buying a share in one company. There could be upwards of 50 companies in a portfolio so it is a good diversification tool.
As part of an investment portfolio for a retirement scheme VCTs beat pension in that their income distributions are tax-free. Plus, VCTs can distribute capital gains as tax-free dividends. Patrick Reeve of Close Ventures says: “Pension funds and VCTs both attract income tax relief of up to 40% for higher rate tax payers. VCTs, though, pay tax free dividends, you don’t have to turn them into an annuity, and you can put in up to £200k per annum.”
Probin agrees: “The attractiveness of a VCT as a retirement planning vehicle is that it can provide very good tax free dividends; access to capital through sale of shares; and they are transparent and easy to understand thanks to regular reporting. In addition VCTs are shares that can be inherited.”
However, mangers see VCTs as a part of an overall portfolio and not an alternative to a conventional pension fund. For example, it might be possible to use some of an investor’s spare cash for VCTs rather than all of it going into additional voluntary contributions, which are then locked in until retirement and usually at a pre-determined rate of growth.
Alastair Conn of Northern Venture Managers says: “I think VCTs are a great tax-free way of enhancing pension provisions outside conventional methods. VCTs have no upper limit on the amount that can be held and their ability to pay dividends tax-free, including capital distributions, will become ever more attractive. A husband and wife will in future be able to invest £200,000 per year each, which over 10 years could build up to a very substantial fund.”
If VCTs do become larger vehicles through the new merger legislation rather than the £20m to £40m vehicles they currently are there may be more scope for incorporating VCTs into a pension fund model. However, as they currently stand there simply wouldn’t be enough shares available to fund a block allocation a pension fund would want to make. Simply being relatively small vehicles precludes VCTs from that market. Although, if IFAs promote VCTs, the piecemeal take up could be substantial.
However, the possible introduction of two pieces of legislation may open the door for VCTs to enter the pension fund arena. The introduction of Treasury shares allows a VCT to build a store of shares sufficiently large enough to meet pension fund allocations and, by merging, larger VCTs would have greater liquidity with a few larger shareholders. In addition, says Probin, the proposed 20% enhancement from the government for new subscriptions to VCTs may serve as an added attraction for pension fund investors. All of these changes to VCTs mean there could be some interesting opportunities in this area over the next year or so.
David Cartwright concludes: “The government has clearly come out and said VCTs are important and have added value. By creating this mixture of tax relief for the investor and cash contribution from the government to the fund, VCTs are becoming more attractive to the investor. The main priority now is to pick the right fund manager.”