Tax breaks make venture capital trusts tempting

But there are still potential risks for investors, warns Julian Knight

'A grown-up dragons' den" is one description of investing in a venture capital trust; "high risk and illiquid" is another.

So what's the truth? What do these heavily tax-incentivised investments potentially offer you? The idea behind VCTs is straightforward. You invest money in a fund which in turn buys into small and medium-sized businesses. In effect, they provide investment and working capital for firms from start-ups to medium-sized businesses looking to make it big. VCTs stay invested for a while, and if they make a profit they pay this back to their investors in the form of dividends.

At the moment, in these austere times, calls on VCTs for cash from businesses is as great as ever. "The banks are lending only to prime customers and small businesses are far from prime, while the big collective investment funds have migrated from medium-sized firms to the blue chips," said Simon Rogerson, chief executive of VCT provider Octopus. "This leaves a real gap to provide funding for these firms."

But it's not just the prospect of making big profits from getting in on the ground floor that appeals. There are tax breaks that come with VCTs which, frankly, leave other investment vehicles in the slow lane. "There is an initial tax relief of 30 per cent on investment, combined with dividend payments and growth all tax free," said Mr Rogerson.

It doesn't stop there. "There is the opportunity to put a substantial sum into VCTs one tax year, garner the tax relief and then reinvest that," said Keith Taylor, managing director of TaylorFrost Wealth Management. But there is a big proviso with the tax relief: the money has to stay invested for five years or else every penny will have to be paid back.

However, so lucrative is the tax relief that some investors buy into VCTs on the back of it. "You can divide the VCT market into two," said Mr Rogerson. "There are VCTs which look to run for five years and then pay their investors back who would have the full benefit of the tax relief. And then there are those which use the money for long-term growth and to produce dividends. These tend to be more adventurous in their outlook: a bit like a grown-up dragons' den they try to spot the market leaders of tomorrow."

However, the mix of tying up your money for five years minimum and the risks associated with any sort of investment in start-ups and small business makes VCTs a heady cocktail probably best sampled by those with large amounts to invest. "First make sure it matches your risk profile. If you're cautious it may not be for you. Find a good manager with experience of picking the right firms to invest in, and only then does tax relief play a part in the decision," Mr Taylor said.

Darius McDermott, managing director of Chelsea Financial Services, sounds a note of caution. "Investors should use their ISA and pension allowance every year before they look at VCTs as they are very illiquid. You need to have them in your portfolio without the need to sell them for five years but more realistically 10 years."

Nevertheless, Mr McDermott thinks that VCTs do have a place, particularly for higher rate tax payers. "But go for experienced quality managers. I like the track record of the Octopus AIM VCT and the Hargreave Hale AIM VCT," he concluded.

Case Study

Siobhan Lund, 45, from Darlington invested £40,000 in venture capital trusts at the start of the tax year. "I'm a higher rate taxpayer and along with my husband Ian had quite a bit of money tied up in property and pensions. All this gave us a safe foundation from which to bear a little risk."

Ms Lund invested in the Octopus Titan VCT, Edge performance, Forsight, Albion Development and Acuity Environmental. "The initial tax relief gave a good head start for the return." However, she warns of the risks. "You can lose your entire investment because you are dealing with small companies that may go bust." But Ms Lund wishes she had caught on to to VCTs sooner. "I have bought shares in the past and lost money. People forget how risky the stock market can be."