50% income tax is fuelling renewed interest in Venture Capital Trusts.
I haven't given venture capital trusts (VCTs) a second glance for years. The investment limits seemed quite high (at least for me), the annual charges of between 3% to 4% looked too pricey, and performance was worryingly erratic.
Plus I always felt I was breaking the golden rule of letting the tax-break tail wag the investment dog.
And that was before the credit crunch, which made it hard for VCTs to cash in on their successful investments by floating their success stories, because as Owain Bennallack points out here, there was diminished appetite for acquisitions.
I assumed that all but a handful of die-hards had abandoned the sector, and VCTs would quietly slide out of history. But Labour's punitive new attitude to higher earners is firing a comeback.
Woof and wag
I would like to report that VCTs are returning to favour because of top recent performance, but no, it's that fluffy, waggy tax break.
Martin Churchill, editor at independent VCT specialist adviser Tax Efficient Review, has seen a resurgence of interest and expects demand to top £250m this tax year, a 70% increase on last year.
He pins this on three factors: "The initial tax break has allowed most VCTs to weather the credit crunch, successful VCTs are producing a respectable annual tax-free income stream, and VCT tax relief looks increasingly attractive to high earners."
Higher earners now face a triple tax whammy, courtesy of the Chancellor. From April, income over £150,000 will be taxed at the new top rate of 50%, while anybody earning more than £100,000 will gradually lose their personal allowance. From April next year, higher rate pensions tax-relief will be scrapped for those earning more than £150,000.
Many higher earners will be looking for ways to claw that tax money back. So should they give VCTs a break?
What relief!
VCTs offer a punchy 30% income tax relief (reduced from 40% in 2006). So if you invest £10,000 in a VCT, your income tax bill will fall by £3,000 in that tax year. You can get this on up to £200,000 worth of VCT investments, giving you a maximum £60,000 tax break.
You can also use a VCT to earn tax-free income, because you don't pay any tax on any dividends you receive. Plus you also escape capital gains tax on any profits (although this also means you can't use any VCT losses to offset CGT gains elsewhere).
The drawback is that VCTs aren't very liquid. To qualify for your income tax saving, you need to hold onto your investment for five years.
Wealthier investors who have already used up this year's full ISA allowance are unlikely to be put off by that. In fact, their tails should be wagging. But could they still find themselves at the wrong end of a dog?
My AIM is true
VCTs invest in start-up and embryonic businesses, many quoted on the junior markets of AIM and PLUS, so you have to make sure that fits in with your risk profile, and your wider portfolio.
To limit your exposure, you probably shouldn't invest more than 5% or 10% of your portfolio in this area, although young, wealthy risk-takers may fell a little more ambitious.
As well as balancing your VCT exposure against wider portfolio, you should also measure your exposure to different types of VCT.
There are four basic types: generalist VCTs, which invest across a range of sectors, including management buyouts; AIM-based VCTs; specialist VCTs focusing on sectors such as technology; and limited life VCTs, which last for a specific period of time, typically five years.
Many investors wisely spread their money across different sectors, and different funds within their sectors.
Volatile capital trusts
The tax breaks are good, the risk profile is high, but what about the returns?
The VCT generalist sector contains 10 funds from six managers, including Downing Protected Managers, NVM Private Equity, Matrix, Chrysalis and Shore Capital. It is up on average 10% over the past 12 months, but down 21% over three years, according to figures from Trustnet.com. Within that, there is wildly varying performance, with Downing Planned Exit VCT 2 (LSE: DPV2) up 86% over three years, and Elderstreet VCT (LSE: EDV) managing a meagre 1%.
The VCT AIM Quoted sector is up 20% over the past 12 months, but is down nearly 40% over three years. Noble AIM VCT is the top performer and that has still fallen 17% over three years. Ouch.
The further you stray from the generalist sector, you more you take your life in your hands.
The VCT Specialist Healthcare & Biotechnology sector contains just two trusts: Hygea (LSE: HYG) -- up 112% over three years -- and Proven Health (LSE: PHV) -- down 24%.
Different VCTs from the same manager can also suffer wildly different fates. Foresight 3 VCT (LSE: FTD) tops the Specialist Technology chart over three years after growing 38%, but Foresight VCT (LSE: FTV) props up the sector in 10th place after falling 42%.
Down in Albion
With one or two exceptions, VCTs haven't exactly delivered raging performance, even taking into account the difficult investment conditions. And you are clearly taking pot luck on your choice of fund. That's the nature of investing in start-ups.
Some argue that the risks involved mean that VCTs are only for the very wealthy. Patrick Connolly at AWD Chase de Vere tells me he wouldn't recommend them to anybody with less than £500,000 to invest. He wouldn't put more than 10% or 15% of their portfolio in VCTs, and no more than 5% in any individual trust.
Investors with less money shouldn't necessarily shun the sector altogether, he says, but should have even less exposure.
Connolly currently recommends Albion Development VCT (LSE: AADV), Downing Structured Opportunities VCT 1 (LSE: DO1O) and Downing Planned Exit VCT 2&3 (LSE: DPV3).
If you've used up your ISA allowance, you are still going to be tempted by those juicy VCT tax breaks, but there is no guarantee you will be salivating over the investment returns. And don't forget to trawl our discussion board for VCTs.
More from Harvey Jones:
