COMMENT
Don't Be Tricked By Tasty Tax Breaks!

Financial watchdog the Financial Services Authority (FSA) has warned investors to take care when investing in Venture Capital Trusts (VCTs).

The FSA studied eleven websites which promoted VCTs and found "many shortcomings" in the way that information was presented to the public. It warned that firms were not giving a balanced view of the pros and cons of investing in VCTs. Thus, firms which promote VCTs are being told to include adequate risk warnings or be fined by the regulator.

As I explained in Tastier Tax-Free Investing, Venture Capital Trusts are stock market-listed investment companies which invest in smaller companies, including private companies and those listed on the Alternative Investment Market (AIM) and OFEX. Hence, as VCTs generally invest in high-risk fledgling firms, they are high-risk funds and, therefore, largely suitable only for wealthy and sophisticated investors.

To make up for their risk profile, VCTs offer seriously juicy tax breaks: a £10,000 investment into a VCT qualifies for an upfront tax rebate of £4,000, plus all capital gains and dividends are tax free, subject to a three-year holding period. Hence, VCTs are a "hot topic" among investors, and sales have rocketed since the government doubled the income tax relief for VCTs last year.

However, there are three main problems with buying shares in Venture Capital Trusts:

• Many VCTs have produced appalling investment returns, even after taking the tax relief into account. Why invest £10,000 only to end up with, say, £5,000 five years later, thanks to choosing the wrong fund manager?
• Only new VCT shares qualify for income tax relief, so the market for second-hand shares is very limited. Indeed, many VCT shares trade at a discount of between 20% to 40% of their underlying (net asset) value.
• Management fees for VCTs are much higher than those charged by mainstream funds. You should expect to pay a 5% initial charge, plus annual management charges of 2% to 4%, which will severely depress your returns over time.

As it happens, I've been studying VCTs for the last two years. Indeed, as I've already put the maximum £7,000 into a shares maxi-ISA for this tax year (as has my wife), I'm actively scouting around for another tax-free shelter. Then again, I don't let "the tax tail wag the investment dog", so I've yet to be seduced by VCTs. As someone who prefers cheap, simple, low-charging funds, such as index trackers, I can't bring myself to pay the eye-popping charges that VCT managers demand!

In summary, you should first decide which investment suits your needs and risk profile, and then look at the tax breaks which are available. Otherwise, you could end up investing in a high-charging, poorly performing fund, which will do you no favours at all!

More: Invest in a cheap index-tracking fund | Keep the taxman at bay with a cash or shares ISA!