United Kingdom Venture Capital Trusts:

Venture Capital Trusts (VCTs) were introduced in the 1995 Finance Act to encourage investments into the small and medium company sector. A VCT is a quoted vehicle similar to an investment trust, with an active manager and a spread of investments.

Investors receive an income tax deduction of 20% of an investment up to a maximum investment per tax year of £100,000. In addition, the whole amount of the investment can be set against a capital gain. Dividends are not subject to further tax in the hands of the investor and capital gains made on the VCT investment are tax free. Investors must hold the VCT for at least five years to avoid losing the tax reliefs.

Costs are usually 5% on issue, running costs of about 3.5% per annum and some form of management incentive. Exit is via selling the shares A VCT must invest at least 70% of its fund within 3 years. At least 70% of the total fund must be invested in unquoted companies trading mainly in the UK (AIM listings are included in this percentage). Certain asset-backed trades are banned and the company receiving the investment cannot have net assets of more than £15 million. Investments in companies listed on the Alternative Investment Market are allowed. 30% of these investments must be in ordinary shares but the balance can be in loans or preference shares. The 30% balance of the fund can be in low risk fixed interest securities.

By 2001, more than sixty VCTs had raised about £1bn of funds for start-ups and SMEs. VCTs have turned out to be one of the success stories of the UK investment sector. VCTs are certainly higher risk than quoted equity investments but their attraction lies in the combination of a fund manager with a good track record, the spread of investments in a large VCT and the generous tax reliefs. For further information see the site of the British Venture Capital Association at www.bvca.co.uk.

Adverse stockmarket conditions in 2002 dented the VCT sector, with trust formations sinking to a low of just GBP45m in 2003. In February, 2004, the Treasury announced changes in the UK tax rules for venture capital trusts, which Chancellor Gordon Brown hoped would revive the market and increase the amount of capital available to invest in small firms and start-ups.

The changes, which went into effect from April 6, saw the investment limit on trusts raised from GBP100,000 to GBP200,000, whilst income tax relief was increased to 40%, of which 20% is paid directly into the trust rather than to investors. This means that for every GBP1 invested in a fund, investors will receive 20 pence in income tax relief, plus a further 20 pence will be placed into the fund by the Treasury.

What investors have gained in income tax breaks, they have lost in the removal of the ability to defer capital gains tax by investing in venture capital trusts, which the Treasury hopes will even out the “cyclicality of fundraising”. However, industry participants suggest the income tax breaks will more than compensate.

Furthermore, the twenty pence income tax relief is only a temporary measure aimed at stabilising the venture capital market, and will be removed after two years. Beyond this, the Treasury suggests offsetting the removal of capital gains relief by an increase of equivalent value in income tax relief. There are also question marks remaining as to whether the new rules benefit only higher rate taxpayers. Nevertheless, reports indicate that the venture capital industry is broadly supportive of the new measures, despite these uncertainties.

Changes to the UK's Financial Promotion Order which came into effect in March, 2005, allowing unlisted firms to raise capital more easily from sophisticated investors, were cautiously welcomed by the country's venture capital sector. Under the terms of the new rules, high net worth and other sophisticated investors will be able to self-certify, and small or unlisted businesses will be permitted to market themselves to "anyone they 'reasonably believe' to be self-certified high net worth or sophisticated".

John Blowers of private equity firm, Angelbourse announced that: "We very much welcome this move...VCTs normally put a proportion of their investors' money into unquoted companies so why not make it easier for the more financially aware or wealthy individuals to invest direct as well."

However, Gary Robins, the chief executive of investor network, Hotbed was more qualified in his response observing that "the concept of 'reasonable' belief that someone is certified is very vague. Individuals who are not certified may well receive promotional material for opportunities to invest in unlisted companies".

In March, 2005, the British venture capital industry was in talks with the Inland Revenue, seeking to prevent the introduction of a more stringent regime that will limit the level of tax deductions that can be made against the costs of borrowing. The private equity sector faces restrictions on the tax deductions that portfolio companies can claim on their financing costs, after the Revenue began to argue in 2004 that extra measures were needed to limit the ability of firms to offset interest payments on loans from private equity investors under 1998 transfer pricing legislation. This stricter regime could be applied retrospectively as far back as 1999.

Implementation of the proposed measures was postponed when they were removed from the Finance Bill to be more fully discussed after the May general election. Accountants fighting the corner of the UK's venture capital sector argue that the changes would cost the industry an additional £400m-£500m in tax every year. However, the Treasury disputes such figures, and has predicted that the cost will be just £5m in 2005, rising to £20m in 2007. The British Venture Capital Association has refused to actively participate in the debate on the matter, preferring to wait until after the May 5 election.

In Gordon Brown's 2006 budget speech, he outlined a package of changes designed to improve the effectiveness of the country's three tax-based venture capital schemes - the Venture Capital Trust (VCT) scheme, the Enterprise Investment Scheme (EIS) and the Corporate Venturing Scheme (CVS).

Version date: 07.05.06