With additional rate tax now starting with earnings over £125,000, it’s more important than ever to maximise pension contributions as a way of reducing taxable income. However, once you have used your recently increased annual contribution allowance of £60,000, and also maximised unused allowances from previous tax years, options become somewhat thinner on the ground. 

As a result of this, tax efficient investments, such as Venture Capital Trusts (VCTs) will gain in popularity, with inflows already very much on the rise. VCTs provide a 30% tax rebate based on contributions, so this in part at least offsets some of the higher and possibly additional rate tax you are going to be paying this tax year, if you are a higher earner. It’s important to note that investing in a VCT doesn’t reduce your taxable income as such, but simply gives you a credit against your overall tax liability.

As its name suggests a VCT invests in small companies that require capital to achieve their growth potential. They were introduced by the UK government in 1995 as a way of encouraging investment in private UK businesses. By definition the investment risk if far greater than for FTSE 100 shares or for a collective fund that holds mainly larger cap companies. An early stage company tends not to have an established income stream and also the risk of failure is greater. If your attitude to investment risk is low for absolutely any investment you might make, then a VCT may well not be for you, whatever the tax advantages. 

Whilst the risk for an individual company is greater, the manager of a VCT typically holds anything up to a hundred companies. Certainly a number of these may well fail, but with the risk spread across so many companies, the ones that do well can more than compensate for the ones that fall by the wayside, with some of them in fact becoming household names. Zoopla would be a good example of a company that initially raised capital from VCT investors and then went on to greater things. Some of these companies in fact are ultimately bought out by companies such as google or amazon.

So, if you are prepared to take the plunge with a modest percentage of your capital, VCTs are well worth considering. A number of VCTs are set up to pay out a 5% dividend each year, which is a worthwhile return, as VCT dividends aren’t subject to tax. When one of the companies held in the VCT is sold for a profit there can also be substantial interim dividend payments, also tax-free. 

The rules for investee companies ensure that they are indeed small companies that are likely to expand and therefore employ decent numbers of people, as opposed to being say investment or property companies. Their qualifying status is reviewed annually and if the conditions aren’t met they can lose their ability to access capital from VCT investors.

As an investor you are allowed to claim the tax rebate on up to £200,000 in VCTs per tax year. If you are going to put this kind of money into VCTs, it is worth considering choosing a variety of fund managers of different fund types. There are for example VCTs specialising in technology, some that invest in Alternative Investment Market (AIM) companies and others that invest in healthcare companies. A generalist fund invests in a mixture of the above and can be AIM or non-AIM.

To retain the initial tax rebate you will need to hold your VCT investment for a minimum of 5 years.  This tends not to be a problem as there is usually limited liquidity in the first few years of a VCT’s life. In addition, after the five year qualifying period, many VCT fund managers offer to buy back shares at an advantageous price compared to the secondary market. If you are buying VCTs to supplement your retirement income however, why would you want to dispose of one at any time anyway? Having said that, this lack of liquidity is something you’d need to consider along with the market risk factors, when deciding on whether or not to invest.

If you have larger tax liabilities and are comfortable with the greater level of risk, you might want to think about investing in an Enterprise Investment Scheme (EIS) or even a Seed Enterprise Investment Scheme (SEIS). The tax treatment is similar in principle but there are distinct differences and as they are effectively single-company investments the investment risk is far greater.  This risk can be offset by assembling a portfolio of EIS, and possibly SEIS qualifying companies and there are investment managers that can do this for you.

Ideally tax efficient investing should form part of an integrated planning strategy with cashflow modelling an important part of the process. If you feel we can be of use in this process, please do feel free to get in touch with us for an initial chat, and we’ll do our best to help.

Joe Coten is a member of the Personal Finance Society. He may be reached on 0207 588 9626.