UNITED KINGDOM: VENTURE CAPITAL TRUSTS

Venture Capital Trusts (VCTs) were introduced in the 1995 Finance Act to encourage investments into the small and medium company sector. A VCT is a quoted vehicle similar to an investment trust, with an active manager and a spread of investments.

Investors receive an income tax deduction of 30% of an investment up to a maximum investment per tax year. In addition, the whole amount of the investment can be set against a capital gain. Dividends are not subject to further tax in the hands of the investor and capital gains made on the VCT investment are tax free. Investors must hold the VCT for at least five years to avoid losing the tax reliefs.

Costs are usually 5% on issue, running costs of about 3.5% per annum and some form of management incentive. Exit is via selling the shares

A VCT must invest at least 70% of its fund within 3 years. At least 70% of the total fund must be invested in unquoted companies trading mainly in the UK (AIM listings are included in this percentage). Certain asset-backed trades are banned and the company receiving the investment cannot have net assets of more than £15 million. Investments in companies listed on the Alternative Investment Market are allowed. 30% of these investments must be in ordinary shares but the balance can be in loans or preference shares. The 30% balance of the fund can be in low risk fixed interest securities.

For further information see the site of the British Venture Capital Association at www.bvca.co.uk.

Adverse stockmarket conditions in 2002 dented the VCT sector, with trust formations sinking to a low of just GBP45m in 2003. In February, 2004, the Treasury announced changes in the UK tax rules for venture capital trusts, which then Chancellor Gordon Brown hoped would revive the market and increase the amount of capital available to invest in small firms and start-ups.

The changes, which went into effect from April 6 of that year, saw the investment limit on trusts raised from GBP100,000 to GBP200,000, whilst income tax relief was increased to 40%, of which 20% is paid directly into the trust rather than to investors. That temporary rate of 40% applied to investments made before 6 April 2006, with the rate scheduled to revert to 20% thereafter. The rate of income tax relief that applied to VCT shares issued on or after 6 April 2006 is 30%, as detailed above.

Changes to the UK's Financial Promotion Order which came into effect in March, 2005, allowing unlisted firms to raise capital more easily from sophisticated investors, were cautiously welcomed by the country's venture capital sector.

Under the terms of the new rules, high net worth and other sophisticated investors were to be able to self-certify, and small or unlisted businesses were to be permitted to market themselves to "anyone they 'reasonably believe' to be self-certified high net worth or sophisticated".

In March, 2005, the British venture capital industry was in talks with the Inland Revenue (as it was then), seeking to prevent the introduction of a more stringent regime that would limit the level of tax deductions that could be made against the costs of borrowing.

The private equity sector faced restrictions on the tax deductions that portfolio companies can claim on their financing costs, after the Revenue began to argue in 2004 that extra measures were needed to limit the ability of firms to offset interest payments on loans from private equity investors under 1998 transfer pricing legislation.

Implementation of the proposed measures was postponed when they were removed from the Finance Bill to be more fully discussed after the May general election. Accountants fighting the corner of the UK's venture capital sector argued that the changes would cost the industry an additional £400m-£500m in tax every year.

In Gordon Brown's 2006 budget speech, he outlined a package of changes designed to improve the effectiveness of the country's three tax-based venture capital schemes - the Venture Capital Trust (VCT) scheme, the Enterprise Investment Scheme (EIS) and the Corporate Venturing Scheme (CVS).

This package included the aforementioned new rate of 30 per cent income tax relief for investments in VCTs, an increase on the 20 per cent rate to which the relief was due to return for the 2006-07 tax year.

"Growing companies need venture capital. So I will refocus tax incentives for venture capital, with a 30 per cent relief for investments in venture capital trusts. From today twice as much investment as before will be eligible for income tax relief in enterprise investment schemes," he explained.

In August 2006, HM Revenue and Customs backed away from its attempt to charge income tax on private equity managers' 'ratchet' gains, faced with a legal opinion that it was unsustainable.

In buy-out deals or IPO deals, private equity managers usually buy shares at the same price as other shareholders, but can benefit from a ratchet to acquire more shares if there is out-performance.

In August 2008, it emerged that HM Revenue and Customs (as the Inland Revenue later became) would be liable to make repayments of millions of pounds following its acceptance that fund management of venture capital trusts (VCTs) should have been exempt from VAT since January 1990.

Historically, HMRC had maintained that fund management of closed ended investment vehicles, such as investment trust companies (ICTs) and VCTs, should be subject to VAT. However, the previous year, the European Court of Justice (ECJ) had ruled that fund management should be exempt in a case involving investment trust companies (JP Morgan).

The judgment suggested that other collective investment schemes should also benefit from exempt fund management.

HMRC announced following the 2007 Budget that UK law would be changed to exempt fund management for ICTS and VCTs going forward with effect from 1st October this year.

The UK tax authority subsequently announced, however, that it accepted that fund management for VCTs should have been exempt since 1st January 1990.

HMRC revealed that it would limit its liability by applying the three year cap on claims – which means that claims will only be met if lodged within 3 years of the overpayment.

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