Nothing ventured...

If you have a capital windfall on the way, investing in a venture capital trust could ease your tax burden

The appeal of investing in smaller companies is clear. Catch a successful company early and the potential is huge. But many once-promising businesses have flopped and for a part-time investor, the chances of picking a winner are low.

The appeal of investing in smaller companies is clear. Catch a successful company early and the potential is huge. But many once-promising businesses have flopped and for a part-time investor, the chances of picking a winner are low.

Investing through a Venture Capital Trust (VCT) is a way of sharing in the growth of smaller companies, while leaving the decisions to the experts. VCTs are quoted investment trusts, collective investments run by managers who invest in the shares of smaller companies. Some of those firms may be existing or early-stage companies while others are management buy-outs.

But probably the main reason anyone invests in VCTs is the whopping tax breaks they offer. If you have a large capital gain from the sale of assets, including business assets, you can defer paying tax on the proceeds by investing it in a VCT. Up to £40,000 of tax can be deferred in this way. This tax deferral is only available if you are investing at the initial subscription of a VCT, and the investment must be made within 12 months of selling the taxable assets.

You get tax relief at 20 per cent on your original investment but only if you invest at the start. This means someone investing £10,000 will receive £2,000 in tax relief. But you must hold the shares for five years or the relief is clawed back.

There is no income tax payable on dividends paid by VCTs, and no capital gains tax on VCT profits. And the VCT itself pays no capital gains tax when it sells stakes. The most you can invest in a VCT for tax purposes in any tax year is £100,000, which can be spread across more than one VCT.

Investors can buy shares in VCTs directly from the manager of the trust, or through a stockbroker. There are usually several VCTs on offer at any one time, but investment groups tend to open VCTs for new subscriptions around the end of one tax year and the beginning of the next. At the moment, BWD's AIM VCT is open for additional funds, and newcomers the Pennine Downing Ethical VCT and the Foresight Technology VCT are looking for fresh investors.

Investing in new companies with little or no track record is risky, and VCTs are high-risk investments. But David Thorp of the British Venture Capital Association (BVCA) points out that the broad spread of investments held in a VCT lessens the risk.

One off-putting aspect of VCTs is that it is hard to tell exactly how your investment is performing during the first five years. This is because there is very little demand for shares in VCTs past the initial subscription because the best tax breaks are only available right at the start.

Martin Churchill, head of research at the Allenbridge Group, an independent performance analyst, says VCT investors should not even look at the performance figures in the press for five years. He says: "The underlying investments are valued very conservatively, it's absolutely natural and is how these things go. They take a long time to mature." And since the first VCTs were only launched in 1995, none has yet matured, so there is no final performance figure.

The secondary market for VCT shares may be weak, but Mr Thorp of the BVCA says it is always possible for investors to sell their stakes. He says: "The shares are quoted every day and can be sold at any time. Most VCTs have now got a buy-back provision."

So with no past performance, how do you choose a VCT? There are several commentators on VCTs and their views are worth hearing. Allenbridge produces its Tax Shelter Report which rates VCTs by a number of factors. Best Investment and the David Aaron Partnership also produce reports on the sector.

Ask about the track record of the investment managers, and find out what success they have had, says David Thorp. Consider a VCT's investment policy, some invest only in a particular business sector, others specialise in companies quoted on the alternative investment market (AIM), the junior stock market, and some have a broader reach. Read the annual report to find out how much information the trust gives shareholders

So who is a VCT suitable for? David Porter, of the broker Best Investment, says: "We don't recommend anyone should invest in VCTs unless they have a capital gains problem." The tax breaks, for higher-rate taxpayers, mean the investor may only have to come up with 40 per cent of the initial investment. So the VCT would only have to perform in a mediocre way to give a good overall return. But this in itself is not a reason to choose a VCT.

Mr Porter says: "Unless it's an investment which makes sense as part of your overall portfolio, it is to be avoided."

The British Venture Capital Association can provide information on the industry and on particular VCTs, call 0171 240 3846. The Allenbridge Group can be contacted on 0171 409 1111, or their website: www.tax-shelter-report.co.uk. Best Investment publishes a guide to VCTs, call 0171 321 0600. The David Aaron Partnership is at Shelton House, Woburn Sands, Milton Keynes, MK17 8SD

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