Shrink your tax

Increasing numbers of investors will need to turn to other tax-efficient means of investing, but in the current tax year, “you should first concentrate on your pension if you have got any capacity to contribute to these, and are not up against the lifetime allowance", says Jason Hollands, managing director at Tilney Bestinvest. "This is the last chance saloon to contribute on the current rates."

After you have used up your lifetime or annual pensions allowance the first port of call is individual savings accounts (Isas). These have no lifetime limit on the amount you can invest in them and in the current tax year you can put in £15,240, or £30,480 for a couple.

VCTs

If you still have money to invest after using up your pension and Isa allowances, the next area to consider is tax-advantaged schemes such as venture capital trusts (VCTs), Enterprise Investment Schemes (EIS) and Seed EISs (SEIS).

VCT, EIS and SEIS tax reliefs

Source: Association of Investment Companies and Enterprise Investment Scheme Association

VCTs offer 30 per cent income tax relief to offset against your income tax bill when you buy new shares and hold them for five years. They pay tax-free dividends and do not incur capital gains tax (CGT) when you sell the shares. The tax-free dividend stream makes them attractive for those in retirement wanting to supplement their pension income. There is no lifetime limit and the annual investment limit is £200,000.

VCTs typically invest in unquoted or Alternative Investment Market (Aim) companies that need a financial injection to grow further. These are typically higher-risk investments, hence the generous government tax breaks to compensate for this.

VCTs are listed on the stock exchange, but while there is a small secondary market for their shares, it’s illiquid and bid-offer spreads can be wide. One reason for this is that VCT shares bought on the secondary market do not qualify for the 30 per cent income tax relief available on a new issue. But the dividends are still tax-free and many can be bought at a discount to their net asset value (NAV).

There are three main types of VCT. Generalist VCTs mainly invest in unquoted companies across a variety of sectors, so are arguably lower risk than specialist VCTs focused on one area. Planned-exit VCTs aim to wind up as soon as possible after five years and protect rather than grow capital, although there is no guarantee as to how soon these will wind up, and it is unlikely to be the moment they hit their five-year anniversary. These are better for tax planning over a shorter period. Aim VCTs mostly invest in Aim shares but cannot invest across the whole of this market because of the restrictions VCTs face on company size and industries. They also have to put their qualifying money (70 per cent of what they raise) into initial public offerings (IPOs).

You could also use VCTs during pension accumulation while you are working if you incur high rates of tax, or invest in them after the sale of a business, when you cash in an investment bond or with-profits fund, or receive a bonus payment.

Detrimental changes

At the end of last year the government tightened up the investment rules for VCTs, EISs and SEISs. Since 18 November 2015 VCTs and EISs have not been able to invest in management buyouts (MBOs). While generally not a problem for EISs, a number of generalist VCTs had favoured this type of investment, including the Maven, Mobeus, Northern, Baronsmead and British Smaller Companies funds. These VCTs were also some of the best and most reliable dividend payers.

Although VCTs have not been able to put qualifying money raised after April 2012 into MBOs, they have been able to invest non-qualifying money into this kind of investment, as well as money raised prior to April 2012. And when a VCT exited an MBO the profits could be reinvested in another MBO.

Perhaps even more detrimental is the rule that VCTs, EISs and SEISs cannot invest in companies seven years or older after their first commercial sale took place, or 10 years or older for ‘knowledge-intensive companies’. However, this rule does not apply where the total investment represents more than 50 per cent of the company’s turnover over the preceding five years.

A knowledge-intensive company must have relatively high research and development or innovation spend, and require highly skilled staff or intend to develop new patents that will represent the greater part of its business activity.

There is also a cap on the total risk finance a company can receive from VCTs, EISs and SEISs of £12m, or £20m for a knowledge-intensive company. Knowledge-intensive companies eligible for funding from VCTs, EISs and SEISs will also be able to employ up to 500 people, unlike 250 for other companies.

This effectively pushes VCTs up the risk curve because they will have to focus on earlier-stage and potentially riskier companies. There is also a question over whether they can still make the returns they used to and pay attractive dividends.

However, advisers and analysts argue that wealthy investors seeking tax-advantaged investments should still consider VCTs – certainly for the time being. David Scrivens, director at discount broker Clubfinance, points out that some VCTs will feel the effects less. Not all VCTs targeted MBOs and some already went for younger, more growth-orientated companies that fall within the remit of the new rules. VCTs that do this are typically the ones with large offers this tax year, such as ProVen (PVN) and Octopus Titan (OTV2).

“The changes to the regulations will have minimal impact on the ProVen VCTs, whose qualifying investment strategy has for the past seven years been focused exclusively on growth capital investing,” says their manager, Stuart Veale. “We will continue to seek out UK small- to medium-sized enterprises with potential for rapid growth. Sectors of particular interest include digital media, software-as-a-service, disruptive online business models and branded consumer goods retailing.”

“Titan is established and has a broad portfolio with a mix of early-stage and later investments,” adds Paul Latham, managing director of Octopus Investments. “For large VCTs with existing investments the rule changes won’t make the portfolios riskier.”

Mr Hollands points out that the rule changes only apply to new investments rather than existing holdings. So for the time being investments compliant with the new rules will only account for a small part of mature VCTs’ portfolios, and in the short term won’t make much difference.

“The nature of VCTs will evolve over time to include more earlier-stage companies, but only gradually,” he says. “And just because a company is seven years old or younger doesn’t automatically mean it is riskier than an older one. In any case, VCTs and their investments should already have been considered to be high risk.” And in the longer term if VCTs do benefit from more growth, they may achieve greater upside, enabling good dividends.

The government also plans to introduce increased flexibility for replacement capital within VCTs and EISs, which involves purchasing the shares of existing shareholders. Being able to do this would reduce the impact of not being able to invest in MBOs, according to Mark Wignall, managing partner at Mobeus Equity Partners.

Mr Hollands also says that the new rules do not restrict asset-backed investments, which are one of the more cautious types of deal structure and can create recurring revenue, enabling dividends. VCTs pursuing these kinds of investment include Downing Two (DP2C) and the Puma funds.

“For us there will not be a big impact,” says Elliott Kaye, director of Puma Investments. “We analysed our portfolios and found that of the deals we did over the past 10 years only one couldn’t have been done under the new rules. Our average deal size is around £5m.”

VCT and EIS risks

Unquoted companies can be difficult to sell and you need to hold VCTs and EISs for a number of years to benefit from the tax breaks, as well as to give the underlying investments time to mature and be disposed of profitably.

Because VCT and EISs focus on early-stage companies they should only account for a small part of your portfolio, the overall value of which should be at least a six-figure sum. Advisers generally say you should not invest more than around 10 per cent of your portfolio in VCTs and EISs, which are only suitable for higher-rate taxpayers with a long-term investment horizon. If you are not paying much tax or working then you need to ensure that you pay as much tax in a given financial year as you get in terms of upfront income tax relief on VCT or EIS shares, as you can only set the income tax relief against tax you have paid or is payable.

VCTs and EISs tend to have high fees, which eat into some of the returns and your tax breaks. VCTs have high ongoing charges, typically well above 2 per cent. Returns from VCTs and EISs can be lumpy, with many of the gains coming later as the investments start to mature. Newer VCTs may pay little or no dividends. VCTs and EISs make their profits from selling their underlying investments, and if this is not possible for economic or other reasons, it will hit the funds’ returns. They are unregulated investments so they do not qualify for compensation under the Financial Services Compensation Scheme (FSCS) in the event of failure.

VCTs and EISs can take on debt, which can increase risk. And EISs are unlisted, so if you want to get out you have to wait until the underlying investments are sold, although the EIS manager will buy back your shares in some instances. Some EIS providers ask you to fill in a form that declares that you are a high-net-worth or sophisticated investor.

Don't delay investing

As a result of the rule changes some generalist VCTs that favoured MBOs, such as the Northern and Mobeus funds, are not raising money this year. Others such as the Baronsmead VCT (BVT) and VCT 3 (BMD) have only done small offerings, all of which have been taken up by existing shareholders who got priority allocation.

Other VCTs are holding back because at time of writing HM Revenue & Customs had still not provided specific details of how the new rules will work.

So what is coming out is flying fast and lots of small offers have already closed. But although there is less choice than in previous years advisers feel that what is on offer is of generally decent quality.

Among generalist VCTs a number of advisers favour ProVen, which is doing a £30m top-up offer into the existing VCT. It has 41 companies, about 60 per cent of which were profitable late last year. ProVen targets an annual dividend yield of 5 per cent and its latest dividend was 2.5p.

The ProVen VCTs have recently sold 60 per cent of their investment in jewellery brand Monica Vinader and realised 12 times their original 2010 investment. They retain an equity stake in the company.

Octopus Titan focuses on early-stage companies with typical deal sizes ranging from £250,000 to £5,000,000. It has around 50 holdings with a focus on technology-enabled companies. It is doing a £50m top-up offer and targets an annual dividend of at least 4p initially, increasing to 5p by 31 October 2017. Octopus Titan has recently exited from SwiftKey, the company behind an app for faster and easier typing on mobile phones and tablets. Current Titan investors will be paid a 5p special dividend in addition to the 2p regular dividend. The proceeds from the sale of SwiftKey will also be used to make further investments in existing holdings and new early-stage companies.

Colin Low, managing director of Kingsfleet Wealth, favours the Albion VCTs because they pay out twice a year so you get a dividend payment every month if you hold all six. These are jointly raising £25.5m, although investors can choose which funds to invest into. Investing equally across the six VCTs will produce a monthly dividend equivalent to 6 per cent a year.

These VCTs offer exposure to about 60 businesses, more than half of which are asset-backed, and focus on the healthcare, leisure, renewable energy and technology sectors. Albion Venture Capital Trust (AAVC) is the most conservative and around 80 per cent of its investments are asset-backed.

Mr Hollands suggests Unicorn AIM VCT (UAV), which Tilney Bestinvest awards its highest five-star rating. This is a top-up into the existing VCT, which has £150m in net assets following its recent merger with the Rensburg AIM VCTs. Unicorn AIM’s managers target Aim companies that are typically profitable prior to initial investment, have leading positions in growing markets, run sound operational and financial controls and have experienced management. They avoid start-ups and early-stage companies. However, at time of writing this VCT had already raised 60 per cent of its £10m target and was selling fast. If you don’t manage to get shares in this an alternative is Hargreave Hale AIM VCT 1 (HHV) and VCT 2 (HHVT), which are run by experienced smaller companies managers Giles Hargreave and Oliver Bedford. These are doing a top-up issue into established and diversified portfolios, and aim for a 5 per cent dividend yield.

For a lower-risk asset-backed strategy from a planned exit VCT, Mr Hollands suggests Downing Two VCT K Share, which Tilney Bestinvest gives its highest five-star rating. This will be invested in asset-backed investments and those with predictable revenue streams. It is targeting a total net return of £1.10 per £1 invested over the life of the K Shares. As this is a new share class it is unlikely that any dividends will be paid in the first three to four years.

Past Downing issues have targeted pubs; leisure, entertainment and hotels; development and construction; telecommunication and renewable energy. But rule changes mean the latter option will now not be possible.

Tilney Bestinvest also rates Puma VCT 12 five stars. This planned-exit VCT is raising £30m and has a conservative strategy focused on capital preservation. It mainly invests in asset-backed investments. As this is a new VCT proceeds will go into new investments, but its managers have a strong track record. For example, after fully distributing its NAV, Puma VCT 5 is the best-performing limited life VCT to date, having returned 106.3p to shareholders. Puma 12 intends to pay an average dividend payment of 5p a year, the first of which will be paid in April 2018.

Open VCT offers

Source: Tilney Bestinvest, Clubfinance, *Tax Efficient Review.

Long-term performance record of managers offering VCTs this tax year

Return based on £100 Lump sum with 3.5% expenses taken into account

Source: AIC using Morningstar as at 31 January 2016

Open EIS and SEIS

*These dates are intended as a guide and should be checked with the fund provider

Source: Clubfinance, Tax Efficient Review and provider websites