• Venture Capital Trusts
    Part Two: Investors - Eligible Shares

    By Satwaki Chanda


    This is the second in a series of articles on venture capital trusts. In Part One we looked at the tax breaks on offer for those brave enough to risk their capital. In this, and the next article, we shall take a closer look at the investors - who they are, how they can invest, and what are the strings attached to the investment.

    We are here on the roadmap:

    Venture Capital Trusts Roadmap

    A recap of the tax breaks

    We have already covered these in Part One, but a short recap will do no harm. There are three types of relief:

    • "Upfront relief" - an income tax relief of 30% of the amount invested, up to an annual limit of £200,000. Investors must subscribe for the shares and hold on to them for at least 5 years;
    • Dividend relief - no tax is payable on VCT dividends. The shares can be bought secondhand, and there is no minimum holding period, though there is an annual limit of £200,000 on the value of the shares that can be acquired;
    • CGT relief - no CGT is payable when selling the shares. Like dividend relief, the shares can be bought second hand, there is no minimum holding period, and the same £200,000 limit applies.

    All reliefs are lost if the tax status of the VCT is withdrawn.

    Before we go on ... a reminder and a summary

    The key to understanding the conditions is to remember that these investments carry a high degree of risk. The bargain between investors on the one hand and HMRC on the other, is that the tax breaks are awarded in exchange for taking on this risk. This bargain would be broken if it were possible to structure an investment in such a way that reduces the chances of investors losing their money.

    The following are the main conditions as they apply to investors:

    • Investors must be at least 18 years old;
    • There must be no tax avoidance motive attached to the investment;
    • The investment must take the form of equity - either eligible or ordinary shares;

    Three further conditions relate specifically to upfront relief:

    • The purpose of the investment is to raise money for the VCT. Recall that for upfront relief to apply, investors must subscribe for the shares. In this way, "new money" is made available to the growth companies that the VCT scheme is intended to benefit;
    • Investors may borrow to fund their share subscription, but certain types of loan - "linked loans" - are not permitted;
    • The rules on "linked sales" prevent VCTs from using share buybacks to enable investors to claim multiple amounts of upfront relief with the same funds.

    In the rest of this article we shall look at the requirement for the investor to take equity and the meaning of "eligible" and "ordinary shares". We shall look at the rules on linked loans and linked sales in the next article in the series.

    What form can the investment take? Eligible shares and ordinary shares

    Note that relief is only available for equity, rather than debt. In particular, the shares must be ordinary, as opposed to preference shares. This is the riskiest class of security - while the prospect of rewards is great, ordinary shareholders rank last in the line of creditors if the company goes bust.

    There are in fact, two types of ordinary shares that are relevant:

    • For the dividend and CGT reliefs, "normal" ordinary shares as defined in the tax legislation will suffice;
    • However, for upfront relief, the investor must subscribe for eligible shares - this is a special type of ordinary share, which carries greater risk than the usual ordinary share, as we shall see.

    So what's the difference?

    For tax purposes, ordinary shares are any type of share except for fixed rate preference shares. As the name suggests, the latter carry a right to a fixed rate dividend, but no other rights to the company's (income) profits.

    It makes sense to exclude fixed rate preference shares, as this type of security has more features in common with a debt instrument, and is therefore a "safer" form of investment. However, for tax purposes, ordinary shares can still be preferential in nature, without losing their "ordinariness".

    For example, we can structure a particular class of shares so that:

    • The shareholders are entitled to dividends in the usual way - that is, the entitlement depends on whether the profits and reserves are sufficient and a dividend declaration has been made. However;
    • The shares also carry preferential rights to assets on a winding up; and/or
    • The shareholders may have the right to early redemption.

    The class of investors holding these shares are clearly better off than the others who have to "wait in the queue". But in spite of the preferential nature of their holdings, they are still ordinary shareholders by virtue of the definition.

    However, for the purpose of upfront relief, this type of ordinary share is not permitted. Shareholders who have a preferential right to assets and/or can redeem early, have clearly mitigated some of the risk that attaches to a VCT investment. Accordingly, particular restrictions are placed on the ordinary shares when they are issued.

    In order to qualify for upfront relief, the shares must be "eligible shares". These are ordinary shares satisfying the following conditions:

    • They carry no present or future rights to dividends;
    • No present or future rights to the VCT's assets on a winding up; and
    • No present or future rights of redemption.

    These restrictions last for 5 years starting from the day that the shares are issued. Note that this coincides with the holding period applicable to upfront relief.

    The difference between eligible and ordinary shares can be summarised in the following diagram.

    VCTs - Eligible Shares and Ordinary Shares

    Rounding off

    This completes Part Two of our series on VCTs. In the next part, we shall take a closer look at the rules on linked loans and linked sales.

    The above article can be downloaded in PDF format at Academia.edu.

    Related Articles: Introducing Venture Capital Trusts: Part One - What Are The Tax Breaks?.

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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

Satwaki Chanda

Owner and publisher at Tax Notes, an educational site containing articles on UK taxation, with a particular emphasis on business and property taxes.

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