Venture capital trusts (VCTs) are collective funds that take stakes in small companies that investors would generally regard as high-risk (with gross assets of no more than £15 million), and that have been hard pressed to access funding in the absence of bank lending over recent years.
VCT shareholders get a variety of generous tax breaks in return for committing their cash to those high-risk investments.
To begin with, there's upfront income tax relief of 30 per cent on investments of up to £200,000 in new VCT shares. That means it costs just £70,000 to put £100,000, say, into a VCT, with the investor's total income tax liability reduced by £30,000 in the year of investment.
This tax relief must be repaid if the VCT shares are not held for five years, and there is no relief on second-hand shares.
Dividend payments from VCTs do not count as taxable income (though the 10 per cent tax credit paid at source can't be reclaimed). Dividends on second-hand VCT shares are also tax free.
Finally, there is no capital gains tax to pay on profits on the disposal of VCT shares. Bear in mind, however, that this may not be as valuable as it seems, since most funds seek to provide returns to investors via dividends rather than capital gains. Losses on VCT shares, on the other hand, are not allowable for either income tax or capital gains tax purposes.
But while the tax breaks may be compelling, they shouldn't blind investors to the dangers of the underlying assets. They suit investors who have already used other tax allowances, such as Isas, argues Danny Cox of independent financial adviser Hargreaves Lansdown.
'VCTs are long-term speculative investments that provide the opportunity to get in on the ground floor of fledgling investment opportunities,' he points out. 'This speculative nature means they are aimed at sophisticated investors and are unlikely to be suitable for mainstream investors.'
However, many VCT managers expect to attract broader inflows as a result of the reduced cap on annual pension contributions, down from £50,000 to £40,000 - particularly since pension schemes have such restrictive rules on how benefits may be taken.
'This cut in pension tax relief will increase the drive by many higher earners towards other tax-efficient routes to build their retirement nest eggs,' says Patrick Reeve, managing partner at VCT provider Albion Ventures.
'With VCTs there's no need to buy an annuity. We have already seen a steep rise in enquiries from investors looking to supplement their pension pots through VCTs.'
There are three different types of VCT for investors to choose from.
Aim VCTs build portfolios of stakes in companies listed on the Alternative Investment Market, though they are only permitted to buy new shares issued by such businesses.
Since relatively few Aim companies pay dividends, there's no guarantee of Aim VCTs doing so either, though they do have the option of taking profits in order to fund distributions to shareholders.
Generalist VCTs invest in unquoted companies - typically established businesses not start-ups - from a range of sectors. But their holdings are likely to be more illiquid since there is no secondary market for trading.
Specialist invest in companies from a particular industry or sector - biotech, media or healthcare, for example. Those companies might be Aim-listed or unquoted, but the focus on a single area of the market makes them more risky.
What to be aware of
Which type of VCT makes the best investment? There are no hard rules. Aim companies may be larger and better established than the majority of unquoteds, but their valuations fluctuate with the volatile Aim market.
Size may be important too. The smallest funds - those of less than £6 million or so - may not have sufficient assets to properly spread risk, whereas larger funds may have quite sizeable portfolios at the end of the three-year investment period after launch (by which time they must be 70 per cent invested in assets).
There are some other characteristics unique to VCTs to consider. In particular, there's the question of what VCT managers opt to do with the 30 per cent of the portfolio that doesn't have to be invested in qualifying assets.
Some opt for safer assets such as gilts and highly rated corporate bonds, or even cash, which provide a cushion in the event of losses on the fund's smaller company investments. Others go for racier investments, including equities, which don't offer downside protection but may be performance-enhancing.
Finally, do not invest in VCTs unless you expect to be able to hold on to the shares for the long term.
If you want to invest in a VCT please consider Interactive Investor, our sister site and award winning brokerage.
We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.
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