In recent years ever greater numbers of the public have found themselves subject to the higher rates of income tax and therefore contributing to a pension has typically been the first port of call for those seeking to reduce a hefty tax liability.
Yet pension reliefs have undergone significant tinkering and this well-trodden path to reducing the burden of income tax has become progressively more restricted. This year alone the lifetime allowance (the amount you can accrue in pensions before a punitive tax charge will apply) has been slashed to £1 million from £1.25m, while a new tapered annual allowance has been put in place to seriously limit access to pension tax reliefs for higher earners.
Under the new regime, those impacted will see a £1 reduction in their pension allowance for every £2 of income earned above £150,000, with a maximum reduction of £30,000. Anyone with an income of £210,000 or more will therefore see their annual pension allowance this year tumble from £40,000 to £10,000.
A result of these raids is that some investors are simply going to have to look elsewhere for tax-efficient opportunities. ISAs are key and while the ISA allowance is set to be hiked to £20,000 in April 2017, this will not plug the gap for those who have just seen their annual pension allowance cut by up to £30,000.
Against this backdrop, expect to see greater interest in venture capital trusts. VCTs are a long-established scheme to encourage investment into small, unquoted or AIM-traded UK companies. They have grown in popularity after previous rounds of reductions in pension allowances and so there is every reason to expect interest to grow further this tax year.
In simple terms, VCTs are investment companies, listed on the London Stock Exchange, which invest in portfolios of qualifying small, UK businesses selected by their management teams. However, unlike conventional investment trusts, VCTs provide investors with a heady cocktail of tax benefits.
Subscriptions to new VCT share issues provide investors with a 30 per cent income tax credit off their tax bill so the real cost of a £10,000 investment for someone receiving this benefit is £7,000. However, there is a catch: to keep the relief the shares must be held for at least five years and the amount you can invest each year is limited, albeit to a thumping £200,000.
Not only do VCT share subscriptions attract an income tax credit, dividends and capital gains are tax-free too. When yields on many traditional asset classes are very low, the tax-free yields available on VCTs can be high.
While demand for VCTs is likely to be buoyant this year, supply of offers to invest in is limited because of the strict criteria around the types of businesses they can back. Various tests are applied for a business to be eligible for such financing, including a cap on the number of employees, the assets they have and their age prior to receiving the financing to ensure this tax-assisted support is targeted.
A number of types of activity, such as energy generation and farming, are specifically excluded. VCTs are careful not to raise more funds than they are confident they can invest, as they must be at least 70 per cent invested in qualifying investments within three years.
This year could see a particular squeeze on availability as after two healthy years of fund raising, many VCTs already have plenty of cash already so do not need to raise much, or any, cash at all despite potential demand from investors.
Above all, those contemplating VCTs should remember that there is no such thing as a free lunch. The tax incentives are provided for a reason: the companies VCTs invest in are high risk.
These schemes are not suitable for everyone, but for some they can have a valuable part to play alongside core investments such as pensions and ISAs.
Jason Hollands is managing director of Tilney Bestinvest
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