VCT Dividends: The Tax-Free Income Stream Most Investors Have Never Heard Of

A dividend is money paid by a company to its shareholders from its profits.

If you’re the owner of a limited company, you’re usually both a director and a shareholder, which means that you can pay yourself both through:

• salary, and:
• dividends

Unlike a salary, however, dividends can only be paid if the company has made enough profit after Corporation Tax, so it’s not always guaranteed that you’ll be able to pay yourself this way.

The government wants investors to provide funding for smaller UK businesses. It gives a boost to businesses and helps the economy grow.
So to encourage this, the government incentivises investors with some valuable tax benefits.
One of those benefits is that dividends from qualifying VCT shares are free from Income Tax.
That means:

• You don’t pay Income Tax on the dividends
• They don’t use up your dividend allowance
• You don’t normally need to include them on your Self Assessment tax return

For investors who receive a significant amount of investment income each year, this can be particularly valuable.

Imagine you receive £8,000 in dividends over a tax year.

Ordinary investment

Let’s assume you’ve already used up your dividend allowance and you’re a higher-rate taxpayer, so any additional dividends are taxed at 33.75%.

• Your tax bill would be:
• Dividends received: £8,000
• Dividend tax: 33.75%
• Tax to pay: £2,700

Income you keep after tax: £5,300

Venture Capital Trust

Now imagine the same £8,000 is paid as dividends from qualifying VCT shares.

Because VCT dividends are free from UK Income Tax:

• Dividends received: £8,000
• Tax to pay: £0
• Income you keep after tax: £8,000

In this example, choosing a VCT leaves you £2,700 better off than receiving the same amount of dividends through taxable investments.

If you’re an additional-rate taxpayer, the tax saving could be even larger because dividend tax is charged at 39.35%).

This is one of the biggest misunderstandings about VCTs.

There is no limit on the amount of tax-free dividends you can receive through VCTs.

However, there is a limit on the amount you can invest into VCTs. That limit is currently £200,000 per tax year.

It sounds like a no-brainer, doesn’t it?

But this might be the most important point in this guide: Tax-free does not equal risk-free.

VCTs are investments in small companies.
Small companies are more likely to:

• Fail completely
• Experience large swings in value
• Find it difficult to raise funding
• Produce inconsistent profits

Although a VCT spreads your money across many different businesses, these are still high-risk companies and you could lose some, or even all, of your investment.

The tax benefits exist precisely because these investments are much riskier than investing in large, well-established companies.

No. This is another really important point to bear in mind: dividends are not guaranteed.

Many established VCTs aim to pay regular dividends, but there is no guarantee it will happen regularly, or even at all.

If investment performance is poor, dividends could be reduced or stopped altogether by the VCT’s board.

That said, many VCTs pay relatively high dividends. If a business in the VCT portfolio is sold, for example, some of the proceeds of that sale may be distributed as dividends.

That often results in dividend yields that appear higher than many mainstream investment funds. However, a high dividend yield doesn’t necessarily mean a better investment. It could simply reflect the way the VCT returns money to investors.

The government offers other incentives for investing in qualifying VCTs, beyond just tax-free dividends:

30% Income Tax relief

When you buy new VCT shares, you may be able to reduce your Income Tax bill by 30% of the amount invested, up to the qualifying annual limit, provided you meet the conditions.

One key condition is that you generally need to keep the shares for at least five years or the relief can be clawed back.

No Capital Gains Tax

If you go on to sell your VCT shares for more than you paid, the gains are normally free from Capital Gains Tax.

These tax benefits make VCTs particularly attractive to some higher-rate and additional-rate taxpayers.

No. Although the tax benefits are generous, VCTs carry much higher risks than most other investments, so are not a good starting point for beginners.