Last week, in the first of two articles on venture capital trusts, I looked at the qualifying conditions for VCTs and the companies in which they invest. I mentioned that HM Revenue & Customs has published draft legislation to implement changes to the enterprise investment scheme and VCT rules. This would affect which companies would and would not qualify for VCT treatment.
There are four specific changes made in the draft legislation, which are required to maintain state aid approval from the European Commission for the schemes:
l A new requirement that to qualify under either scheme (EIS or VCT), a company must not be in difficulty.
l The current requirement that to qualify under either scheme a company must carry on its qualifying trade wholly or mainly in the UK is to be replaced with a requirement that the company must have a permanent establishment in the UK.
l The current requirement for a VCT’s shares to be included in the official UK list is to be replaced with one that their shares must be traded on an EU regulated market.
l The current requirement that a VCT must hold at least 30 per cent of its qualifying holdings by value in qualifying ordinary shares is to be increased to 70 per cent.
Having looked at the qualifying rules for the VCT, let us now look at the tax treatment of the investor. There is currently income tax relief at the rate of up to 30 per cent on investments of £200,000 or less. The amount of tax relief obtained cannot exceed the amount of the income tax liability for the tax year in question. For example, if an investment of £150,000 is made, the maximum tax relief available will be £45,000 (30 per cent x £150,000). However, if in this example, income tax otherwise payable in the tax year is only £30,000, then tax relief on the VCT investment will be restricted to £30,000 – an average rate of relief of 20 per cent.
It is important to note that this relief operates to reduce tax and not taxable income. Investing in a VCT will not help to reduce relevant income below £130,000 for the purpose of avoiding the restriction of pension tax relief. Neither will it avoid the loss of the basic personal allowance nor the application of the 50 per cent additional rate of tax.
Investors should keep in mind that there is a clawback of income tax relief if shares are sold within five years of acquisition and in certain other circumstances. Observance of this minimum investment timeframe condition (to avoid tax clawback) is essential. Breaching it would significantly reduce the overall rate of return on the investment.
Staying with income tax, it is worth knowing that if any dividends are paid, there is no income tax payable by the investor to the extent that the dividends derive from shares purchased within the £200,000 limit for income tax relief. The 10 per cent notional tax credit cannot be reclaimed.
Turning to capital gains tax, the facility to obtain CGT deferral relief via an investment in VCT shares was withdrawn from April 6, 2004.
However, when shares that have been acquired within the £200,000 annual limit for income tax relief are disposed of, any gain is not chargeable (that is, it is exempt from CGT). This will be even more appealing if we experience the expected increase in the CGT rate above its current 18 per cent.
No one invests expecting to make a loss but, given the nature of the investment, a loss is a clear possibility. As the other side of the coin to CGT freedom on any gain, any loss will not be an allowable loss for CGT purposes as the gain would not have been a chargeable one for CGT purposes.
Looking at inheritance tax, business property relief reduces the taxable value of a chargeable transfer of relevant business property by either 100 per cent or 50 per cent. Relevant business property includes shares. The 100 per cent rate applies to any shares or securities in an unquoted company and the 50 per cent rate to a controlling holding of shares or securities in a quoted company (which can include shares in a VCT) but, in practice, this 50 per cent relief is unlikely to apply because a controlling holding is one that enables the shareholder to control the majority of the voting powers on all questions affecting the firm as a whole.
As well as the denial of BPR as a result of the likely inability to satisfy the controlling holding test set out above, there is also the fact that to qualify for BPR, the business of the company must be carried on for gain, that is, it should be trading. Shares in a business that consists wholly or mainly of dealing in securities, stocks and shares, land or buildings or making or holding investments are not eligible for BPR. In addition, the shares or securities must have been owned or be deemed to have been owned for at least two years before the transfers for which BPR is claimed.
Even if BPR were available – which seems highly unlikely – it should be noted that the full value of relevant business property may not qualify for BPR. This may be because an asset is what is termed an excepted asset. In general terms, an asset is an excepted asset if:
- It was not used wholly or mainly for the purposes of the business of the company throughout the two years immediately before the transfer; or
- It was not required at the time of the transfer for future use for the purpose of the business of the company (for example, cash sums).
In the case of a company where the value is reflected in its share price, it is more difficult to identify the value represented by an excepted asset than it would be in the case of a sole trader.
In summary, it is highly unlikely that a VCT holding would qualify for BPR. However, it is worth noting that all capital gains made within a VCT (that is, by the manager) are free of corporation tax and, uniquely, a VCT can distribute the realised capital gains in the form of a tax-free dividend payment.