Nothing ventured, no tax gained

Nic Cicutti on the advantages and pitfalls of investing in Venture Capital Trusts

Tax avoidance is a sport often favoured by those who earn so much money that they could probably afford to donate a few pounds to the Inland Revenue. But if you don't have to hand the taxman a chunk of your savings, why should you? Especially when there are ways of avoiding tax and making even more money at the same time. This is where Venture Capital Trusts (VCTs) come in.

VCTs, introduced by the Government two years ago, are similar to investment trusts. Their aim is to promote investment in relatively small, unquoted companies. Companies that qualify for investment must not be quoted on any stock market, except the Alternative Investment Market (AIM).

The beauty of VCTs is that, compared to investment trusts focusing on smaller companies, subscribers for new ordinary shares in the trust receive income tax relief set at 20 per cent, as long as they are held for at least five years. In effect, a pounds 100,000 investment costs pounds 80,000.

Income from the trust itself is tax-free, plus all gains at disposal. Furthermore, if shares are bought with the proceeds from the sale of an existing asset which may be liable to capital gains tax (CGT), this will allow the investor the right to "roll-over relief" - deferring payment of tax - on the asset.

While all capital gains made in the trust itself are tax-free, minimising those transferred into it involves selling the trust at a time when other losses can offset the original gain. Or, funds can be dribbled out after five years, up to the investor's annual CGT exemption.

Minimum investment in some trusts is just pounds 3,000. The maximum investment against which full tax relief can be claimed is pounds 100,000 per tax year. It is possible to invest in more than one trust, with tax relief applying to the combined investment. To receive the 20 per cent tax relief, shareholders must send the tax certificate they receive from the VCT company to the Inland Revenue. If the trust is sold within five years, the tax relief granted is repayable. There are also stringent criteria as to the qualifying areas trusts can invest in.

The question remains: which VCTs should investors be looking at? Last year, 12 trusts raised more than pounds 160m and, according to the Aaron Partnership, a firm of financial advisers based in Milton Keynes, 10 of these are raising more money. David Aaron, a senior partner, says the key factor in picking the right trust is the experience of the manager investing in the smaller companies. Managers should also be in a position to choose between - and reject the majority of - deals offered to them.

Mr Aaron says: "Avoid companies that invest in too many start-up ventures because these have much higher risks. It is wise to spread the risk over three or four trusts. Choose the larger trusts for most of your investment, as they will give a bigger spread."

For investors who are prepared to accept high risks in return for potentially high returns, the Aaron Partnership recommends Guinness Flight and Murray Venture Trust VCTs.

The first is managed by Guinness Mahon Development Capital Flight, which has a proven record in unquoted company investments. From March 1984 to December 1995, GMDC achieved a compound return on realised investments of 39 per cent a year.

Murray Venture Trust VCT2 is managed by Murray Johnstone, which also has a long history of investing in small and medium-sized companies. Its management team places pounds 1m a month in firms selected from hundreds of offers received.

Also recommended is British Smaller Companies VCT, a regional fund manager. Managed by Yorkshire Fund Managers, the firm has 10 years' experience in the sector and has consistently figured in the top quartile within its sector.

More conservative investors are pointed towards the Enterprise VCT and Close Brothers Protected VCT.

Both have 50 per cent of their assets guaranteed by high street banks, Enterprise additionally has 25 per cent of its funds invested in gilts.