Ben Yearsley: VCTs make investment less taxing

Venture Capital Trusts are a promising area of investment that, although high risk, can save an investor a great deal of tax. Clearly, there is no point making investment decisions purely because they are tax efficient. If you don't think the investment stands up in its own right then you shouldn't invest – any tax benefits should just be the icing on the cake.

So, for the uninitiated, what is a VCT? A VCT invests in very small companies, in fact, those with no more than 50 employees and £7m in assets (at the time the VCT invests). In addition, the company can only receive £2m in funding from VCTs every year.

These are small companies indeed. They might be in the early stages of development, perhaps with little or no sales, or a product they have only just developed.

On the other hand they could be more mature businesses, profitable and with good cashflow where the management require finance in order to buy out the company from an existing owner. Both of these tend to be high-risk investments, the former especially so.

An alternative approach, which has proved popular over the last few years, aims to minimise risk as far as possible (within the VCT framework) and return investors' money after five years. This breed of VCT often invests in companies with large asset backing, such as a nursery or leisure facility, and is primarily designed for the tax break. I can see these being popular with higher earning individuals over the next few years as they seek to reduce their tax liabilities.

In light of the super-tax rate of 50 per cent on income coming next year, the removal of personal allowances for those with incomes over £100,000 and the restriction in pension investments for high earners, VCTs look remarkably interesting from a tax point of view.

You can invest up to £200,000 per tax year in a VCT and receive a tax rebate of up to 30 per cent of the amount invested (i.e. up to £60,000). Remember, this is a rebate – you cannot claim back tax that you never paid in the first place. So if you are due to pay £20,000 tax in a given year, that's the most you can reclaim regardless of how much you invest in a VCT.

This in itself could bring problems unless investors know exactly what they're in for. VCTs are higher risk investments and are not suitable for everyone. They are also illiquid, meaning that buying and selling isn't always simple. VCTs have to be held for a minimum of five years, otherwise you need to give the Government back your tax rebate. However, they can provide tax-free growth and tax-free dividends. After five years you can sell your VCT shares (they are quoted on the London Stock Exchange) without incurring a tax penalty.

The last two years have been clearly hard for everyone, especially the banks. However, it has a potential upside for VCTs. Banks are far less willing to lend money to small businesses in the current climate, presenting a golden opportunity for VCTs. As the economy starts to recover and companies start to prosper, they are standing in the wings with capital ready to help them grow in future. Where banks fear to tread, VCTs are keen to invest.

VCT managers have spent the last 18 months waiting for the end of the credit crunch and for the economy to turn around, itching to invest in these great companies at the right price. After talking to many in the last few weeks, they are now finally starting to make some new investments. They may well be a bit too early, but they see the opportunity is nigh.

The next three to four months will see many VCTs launching seeking new funds for investment. Notable names to look out for include Downing, Foresight, Maven and Northern.

Ben Yearsley is investment manager at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent.