MARKET COMMENT
Tastier Tax-Free Investing

By Cliff D'Arcy
March 22, 2004

Here at the Fool, we've been moaning for ages about the chancellor's plans to withdraw the dividend tax credit from shares held in Individual Savings Accounts (ISAs). This will make investing in shares within one of these tax-free wrappers less appealing, especially for basic-rate taxpayers.

However, Gordon Brown has taken away with one hand while giving with the other: he has doubled the income tax relief allowed on investments into Venture Capital Trusts (VCTs) to 40% from 20%. He also doubled the annual limit to £200,000 per person per tax year, but removed the capital gains tax deferral.

VCTs were created in 1995 in order to encourage investors to invest in small companies (defined as those with under £15 million of gross assets). A VCT is a quoted investment company, similar to an investment trust, which offers income tax incentives to new buyers of new shares in it.

This tax incentive comes with a high degree of risk attached: VCTs can only invest in small private companies, plus those listed on the Alternative Investment Market and OFEX (where many small companies begin their lives as publicly listed companies).

The rules governing VCTs are horrendously complicated, but they boil down to:

• A VCT must be listed on the London Stock Exchange.
• A VCT's income must be derived mainly from shares, with not more than 15% of this income being retained.
• At least 70% of a VCT's investments must be in unquoted, AIM or OFEX companies. However, VCTs cannot invest in companies carrying out certain trades, as this article explains.
• VCTs have three years to invest up to this 70% level, which adds a margin of safety in terms of market timing.
• A single holding cannot be worth more than 15% by value of the VCT's total portfolio. Most VCTs have holdings in around thirty or fewer companies - far fewer than a typical investment fund. Again, this concentrates their risk.

Thus, VCTs are forced to invest in high-risk fledgling companies, which make them unsuitable for investors with a low appetite for risk. What's more, as investment trusts, their shares trade at a discount to their net assets, often 10% or more.

However, to sweeten the deal, the Treasury will now give income tax relief of 40% to investors buying new shares in VCTs. This means that someone investing £5,000 into a VCT will receive £2,000 back from the taxman, either by contacting the Inland Revenue or claiming it via his/her tax return.

Note that VCT investors don't have to be higher-rate taxpayers to qualify for this 40% relief - it is granted automatically. If an investor sells his/her shares within three years, s/he must repay any tax relief. However, spouses can transfer VCT shares between one another without losing this relief.

Another incentive is that neither dividends nor capital gains made by VCT investors are taxed, subject to a minimum three-year holding period, which is nice!

VCTs are only really suited to well-off investors, since the minimum lump-sum investment is typically £3,000 or more. Many mainstream investors would be better off filling up their ISAs before even considering a VCT. Another warning is that some established VCTs have proved to be complete disasters by losing a great deal of investors' capital, so you need to understand what you're getting into!

Finally, if you are considering buying into VCTs, please remember to do your homework and judge the qualities of each company itself - don't be seduced by the tasty tax incentives alone!

Here are two links to sites offering more information on VCTs: TrustNet | Tax Shelter Report.