COMMENT
Tastier Tax-Free Investing

By Cliff D'Arcy
February 1, 2005

Despite the recent recovery of the stock market, sales of share ISAs fell sharply at the tail end of 2004. Part of the reason for this could be that some wealthier investors are turning their attention to Venture Capital Trusts (VCTs), following the Chancellor's decision to double the income tax relief allowed on these investments in last year's Budget.

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 (AIM) and OFEX (where many small companies begin their lives as publicly listed companies). Most of the larger VCTs are classified as general VCTs, however there are some which just invest in AIM shares and others which specialise in certain sectors.

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

To sweeten the deal, the Treasury is giving income tax relief of 40% to investors buying new shares in VCTs for both the 2004/05 and 2005/06 tax years (tax years run from April 6 to April 5). 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. (The maximum you can invest in each tax year and still get this tax relief is £200,000.)

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. 

So far this tax year, around £170m has been invested in VCTs. However, by April 5, this total is expected to exceed £500m and possibly even £700m. This 'wall of money' creates its own problems, as it could result in too much VCT cash chasing too few decent investments. And it could also result in trouble if you want to sell your shares soon after the three-year relief period has expired. As tax relief is only given to new shares, there is a limited market for 'second-hand' VCT shares, so discounts can be very large, especially for those VCTs that have performed badly. For example, a third of existing VCTs now trade at discounts of between 20% and 40% to their net asset value, and some VCTs have lost three-quarters of investors' money!

Finally, management charges for VCTs are much higher than for most funds. Typically, there is a 5% initial charge (less through a discount broker however) and annual management charges in the region of 2% to 4%. These can create a serious dent in your returns if you hold for several years. Smaller funds tend to the worst offenders, due to the high fixed-cost nature of managing VCTs.

So, 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!

More info on VCTs at Trustnet | More info on ISAs.

A version of this article was originally published in March 2004.