A beginner's guide to Venture Capital Trusts

What is a Venture Capital Trust?

Venture Capital Trusts (VCTs) were created in 1995. They are investment trusts that invest in very small companies who are usually looking for money in order to further develop their business.

Like a standard investment trust, a VCT has its own listing on the stock market so investors can buy in. But because VCTs invest in very small companies which are in the early days of developing as businesses, they are inherently higher risk than a standard investment trust. For every start-up company that turns into the next Google (or failing that, at least turns a profit eventually) there are many, many more that fail. So these are not investments for widows and orphans you have to be able to live with a reasonably high chance that you might lose your money.

What are the tax benefits of a VCT?

So why would anyone buy into a VCT? Well, the government is keen for us all to invest in start-up companies (particularly as the banks currently won't) so there are a number of carrots dangled in front of investors in an attempt to offset the risks, in the form of generous tax breaks.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Given the recent changes to pension tax relief and how many more people will be feeling the sting of higher income tax rates, the tax benefits of a VCT will be looking very attractive to a lot of people. So what tax relief do you get?

Tax payers receive an income tax rebate of up to 30% when investing in a VCT. You can invest up to £200,000 a year in a VCT and receive income tax relief on the entire sum although obviously you cannot receive more in rebates than you have paid in income tax (so if you've only paid £5,000 in income tax that year, that is all you can get back). You can claim the relevant tax rebate on your tax return under the special VCT section.

Also, when you eventually sell your VCT holdings any gains you have made will be exempt from capital gains tax (CGT). Dividends received while you hold the VCT are also tax-free. Although, do note that, as is the case with individual savings accounts (Isas), tax deducted at source on dividends is not eligible.

What are the catches?

The income tax rebate is only available when you buy a new issue of shares in a VCT or a top-up, not on VCTs bought on the secondary market. Also, VCTs bought on the secondary market still count towards the £200,000 annual allowance, even although you don't get the tax rebate. (The CGT benefits and tax-free dividends mentioned above apply to both new-issue VCTs and ones bought on the secondary market).

And here's the biggest catch you have to invest in a VCT for at least five years in order to get the tax benefits. If you sell your VCTs less than five years after you bought them you will have to pay the rebate back. And if the VCT breaks the tax rules 70% of its assets must be invested in qualifying companies at all times, it can't just mind the cash for you while you enjoy the tax breaks then the tax relief would have to be repaid in full.

How have they performed?

As mentioned earlier, VCTs are risky. Some have delivered fantastic returns for investors. The ProVen Growth & Income VCT for example has achieved an average dividend of 14.7% a year, tax-free since its launch in 2001. "But for every VCT that is successful, there are two or three that have lost money," says Richard Allen of financial advisory firm Allenbridge, in The Daily Telegraph.

In an attempt to reduce the perception of risk around VCTs there is a trend at present towards top-ups. This is where existing VCTs with good track records offer new shares. But of course, a good track record is no guarantee that a VCT is going to continue to perform well. In short, they are both high-risk and relatively illiquid so despite the tax benefits, you should treat them very much as speculative investments and if you're going to put any money into them, make sure it's money you can afford to lose.

The two types of VCT

There are two different types of VCT. The generalist VCTs are open-ended vehicles which are best for investors who are looking for high-risk, high-return investments and therefore want to make long-term investments in start-up companies.

The second type is the lower-risk planned-exit VCT. These VCTs offer lower potential returns most of the growth in your capital tends to come from the tax relief. These funds invest in firms with proven revenue. The trusts tend to wind up after five years and return the original investment. So if you invested £1,000 in a planned-exit VCT, you would get £300 back in a tax rebate, and then if the fund makes 10% over five years, you would get £1,100 back.

But clearly, there's no guarantee that you'll get your money back even the lower-risk' VCTs can easily lose money so don't imagine that this is a way of getting the tax benefits without taking the risk.

Watch out for charges

The final thing to be aware of if you do decide to invest in a VCT is the charges. These tend to be quite high. The average initial charge is around 5%, with annual running costs typically being around 3.5%. And on top of that managers also tend to get performance fees if the VCT does well.

So while the tax breaks on VCTs are very attractive, especially now that the 50% rate has kicked in, you shouldn't let that blind you to the fact that these are high-risk, expensive investments. Only consider investing in one once you have exhausted all your other tax-efficient savings options, such as individual savings accounts (Isas) and pensions. And only invest what you can afford to lose.