How to venture into the high-flying world of 20 per cent tax relief

The popularity of Tessas and Peps speaks volumes for public appetite for legitimate tax avoidance. However, the more generous tax breaks of venture-capital trusts have yet to strike a similar chord.

By the end of the tax year, half a dozen trusts will be up and running, but demand so far has been slow. One reason is that Tessas and low-risk Peps are suitable for everyone with a bit of spare cash. VCTs are not.

Designed by the Government to fill the funding gap for smaller companies, VCTs are turbo-charged personal equity plans for the wealthier investor. They have an annual investment ceiling of pounds 100,000 per person against pounds 9,000 for Peps.

The up-front tax breaks are income tax relief at 20 per cent and capital gains reinvestment relief at 40 per cent, although income tax relief is forfeited if the investor sells VCT shares within five years of issue.

Stuart Dyer, investment marketing director of Friends Provident Asset Management, says: "Anyone with less than pounds 50,000 in equities should not be in VCTs." He suggests 5 per cent of a portfolio be allocated to VCT qualifying investments: unquoted companies whose gross assets do not exceed pounds 10m.

Memories of the ill-fated business start-up and expansion schemes of the 1980s dog the new VCTs, although they are very different animals. VCTs are pooled vehicles, with risk spread across many companies. The maximum investment per company is pounds lm, and 70 per cent of a VCT's funds must be invested within three years of launch. Few VCT managers intend to invest in start-ups. Most prefer established companies generating healthy profits.

Managers launching VCTs so far are experienced venture-capital players. Baronsmead, which raised a modest pounds 8.66m with its offer, which closed this week, has invested in 36 companies in the past three years, many of which would be VCT-qualifying. The return, measured by dividends, redemption of preference shares, asset revaluations and realisations, was 26.5 per cent per annum to the end of June.

Three of Baronsmead's investments have gone bust, but star performers include Stoplock, the West Sussex company making the ubiquitous yellow car steering-wheel immobilisers, and Edwin Trisk Systems in Sunderland, which can respray a car door in four minutes.

David Thorp of Baronsmead says the VCT will only invest in established companies able to generate a good income. The yield element of Baronsmead's 26.5 per cent return is 11.1 per cent a year. Add the VCT tax breaks and the return can be tripled, says Richard Hargreaves, managing director.

Baronsmead shows that an investment of pounds l,000, paying an annual gross yield of 4 per cent and notching up five-year capital growth of 20 per cent, would after five years be worth pounds l,240 to a higher-rate taxpayer in a conventional investment trust, pounds 1,400 in a pepped trust and pounds 1,600 in a VCT because of the up-front income tax relief. Capital gains tax relief on the gains reinvested in a VCT makes the figures even better.

Mr Hargreaves points out that while few pay CGT, many are locked into equity portfolios because of potential tax. Sellers of businesses often accept loan stock as payment, which would produce a CGT liability if redeemed. Both are ideal VCT investors.

A pounds 100,000 capital gain, which would be reduced to pounds 60,000 through tax, can grow to pounds 120,000 if the gain is rolled into a VCT, and the 20 per cent income tax credit claimed to boot. The CGT is payable on disposal of the VCT, whether it has doubled the initial investment or halved it.

VCT managers are confident they can produce a decent return and would be disappointed if the underlying investments did not outperform the stock market over five years.

The tax breaks of VCTs will exert a big influence on both fund-raising and the trading of VCTs. The share price of the first VCT from Murray Johnstone, which has raised pounds 18m since September out of a hoped-for pounds 30m, has gone to an instant premium to net asset value. Iain Tulloch, investment director of Murray Johnstone, reckons VCTs will be tightly held because of the five-year requirement to qualify for up-front income tax relief, and will only go to a discount to NAV if underlying investments,fare badly.

Friends Provident launched its VCT on Wednesday. At least half a dozen more VCTs are reported to be in the pipeline for early next year to catch the tax window.

Investors must pick their managers with care. Emerging company investment is a highly specialised area involving higher costs and a more practised eye. Sir David Cooksey, chairman of Advent, which is launching its VCT in the new year, says: "You must work at investments to make a success of them."

Running costs are therefore higher than in other pooled investments and are expected to average 2.5 per cent a year.

VCTs are untried and untested investment vehicles, but their tax breaks should make even pedestrian underlying performance look good. Richard Twydell of stockbroker Henderson Crosthwaite says that higher rate tax payers with broadly based portfolios should seriously consider VCTs, especially if they have used up their Pep allowances.

Alison Eadie