Warning: these trusts can turn either way

Tax breaks have whipped up sales in the venture capital market. Don't buy in if you can't afford to lose, says Jenne Mannion

Home invest in burgeoning pop stars, others in wind farms or cutting-edge technology.

Home invest in burgeoning pop stars, others in wind farms or cutting-edge technology.

The grey-sounding name of "venture capital trusts" (VCTs) might not conjure up such exciting images. But these projects and other fledgling enterprises, as well as small companies listed on the Alternative In-vestment Market (AIM), are all attracting finance from VCTs.

However, while some small outfits may turn into big success stories, rewarding investors who get in at the start, others will fail even to get off the ground and leave investors empty-handed.

In the run-up to the end of this tax year, independent financial advisers (IFAs) and wealth managers are reporting a surge in the number of people putting money into the trusts.

The revamped tax break on VCT investments - 40 per cent relief as long as they are held for three years - is behind this rush, says Matthew Woodbridge at IFA Chelsea Financial Services.

For example, it would cost you only £6,000 to make a £10,000 VCT investment - you get the rebate from the Inland Revenue in the year that you invest your cash. On top of this, any dividends received from your stake in the VCT (you buy shares in the vehicle) are tax free. And when you come to sell on the London Stock Exchange after three years, you won't have to pay capital gains tax on any profits made.

But while the tax incentives are attractive, there are concerns that a tax tail may be wagging the dog. The market for VCT shares in the years ahead will remain uncertain.

The theory is that you buy the shares today and see your investment soar thanks to the trust manager's sound judgement on which businesses to invest in. Three years on, you cash in your shares and bank the profit.

But can you count on being able to offload your VCT investments at this point? What if the so-called "secondary" market for VCT shares proves flat - or worse? Even if your investment does well, lack of demand for the shares could lead to you getting a lower price than the one you paid at the outset.

One expert who remains confident of the case for investing in VCTs is David Knight of Tax Shelter Research, a division of IFA Allenbridge. He admits the secondary market may be untested but says: "There will be a demand for the shares of better-quality VCTs."

To counter concerns, though, most VCTs offer a share "buyback" policy, meaning the fund manager will buy back shares for a predetermined sum. However, the price you will be offered won't usually reflect the true value of the VCT's assets - typically, it will be around 10 per cent less.

And the offer of a share buyback cannot be set in stone. "If half the VCT shareholders were to sell out, it would cripple [the vehicle]," explains Mr Woodbridge. "Managers can therefore change their policy at any time."

The complexity of the investment, coupled with its speculative nature, makes a VCT a high-risk product. If you are interested in investing, you will need an IFA to help you choose the right kind of VCT for your attitude to risk. You can back up this advice by doing your own research on adviser websites such as bestinvest.co.uk, allenbridge.co.uk and www.har-greaveslansdown.co.uk.

Although most VCTs let you invest for as little as £2,500, IFAs recommend that no more than 5 per cent of any portfolio be given to a VCT. Note, too, that no more than £200,000 can be invested in a tax year, and your income tax relief must not exceed the amount of income tax you've already paid.

There is a wide choice of VCTs to invest in, but specialist trusts are particularly popular right now, says Justin Modray of IFA Bestinvest. "For example, Ventus is the first VCT to specialise in financing wind farms; Univen will finance spin-outs from university research departments; and Ingenious Music invests in budding pop stars with record deals."

So far, £224m worth of VCT shares have been sold to investors in this tax year - barely a quarter of the stock available, though it is expected around £500m will eventually be raised. Even if this level is reached, however, many VCTs will be left inadequately capitalised.

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