Economics and investment: Venture Capital Trusts—navigating complex terrain

Venture capital trusts have become a favourite “pension proxy” for better-off savers in danger of maxing out their retirement fund. But as I mentioned last month, they are complex beasts, and one of their most popular features—generous, tax-free dividends—also happens to be one of their greatest sources of complexity.

VCTs invest in risky, early-stage companies, which makes the fact they pay dividends at all rather odd. Companies usually pay dividends out of surplus profits, but most early-stage companies do not produce a surplus. How can they pay a dividend?

The answer, of course, is that they can’t. These are not dividends in the conventional sense. The money to pay them comes from the gains the VCT makes when it sells shares in a company for a profit. This is a vital point for would-be investors to understand: a VCT “dividend” is a capital gain dressed up to look like income. Instead of paying out ad hoc lump sums when they exit a successful investment, the VCT smooths these one-off gains into regular payouts—great if you’re looking for steady, tax-free income.

Why labour this point? Because it is important to understand that if “dividends” come out of your capital, they are eating into the amount you have invested in the trust. To offset this, the VCT must on average generate capital gains on investments and other income worth at least as much every year as the “dividends” it pays out—plus its management fees and costs.

The best VCTs have a history of doing this. But what if you like the VCT tax breaks but you’re not looking for regular income immediately? The answer is to choose the option that many VCTs offer to receive additional shares in the fund instead of a cash dividend. There’s a lot to be said for this. Reinvesting your dividends steadily increases the number of shares you hold—and therefore the number on which you will receive a dividend in future. This virtuous circle compounds the value of your capital over time, and prevents it being eroded as you take chunks of it as income twice a year.

There’s another benefit too: when you opt for new VCT shares instead of cash, you can deduct 30 per cent of the value of the new shares from your income tax bill. So you pay less tax as well as increasing your holding in the fund. Later, when you want to switch to receiving income, you can change your preference and take cash dividends instead. You will start eating into your capital, but at least you will have a larger pile of VCT shares to fund those payouts.

There is more to know than I’ve been able to cover here. But the main message is that if you buy VCTs purely for the tax relief, you risk missing a big part of their upside—the ability to reinvest dividends and achieve faster capital growth.