One of their most popular features also happens to be one of their most confusingby Andy Davis / December 10, 2019 / Leave a comment
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…