Should you venture into VCTs?

It's easy to see why high-earning investors are piling into venture capital trusts (VCTs) the tax breaks are huge. But should you follow them?

VCTs offer 30% income-tax relief on lump-sum investments of up to £200,000 per tax year, provided the investment is held for five years. What's more, some funds pay tax-free dividends and any gains are free of capital-gains tax. VCTs invest in small, unquoted firms.

Shore Capital's latest offering (Shorecap.co.uk) is typical. It's launching a new Puma VCT, aiming to generate a 7p annual dividend per 100p share, which will provide secured loans to small businesses. The income-tax relief means that if you invested the maximum £200,000 per year, you qualify for £60,000 off your income-tax bill.

That's attractive to high earners, given that pension rules already cap contributions qualifying for higher-rate tax relief at £20,000 for those earning £150,000 or more. That's why fund manager Albion Ventures forecasts that the VCT market could double in size to £250m to £300m from £150m in the tax year 2008-2009.

But you don't get the tax break for nothing. VCTs are risky. To qualify for tax relief, VCTs must invest in firms with assets of less than £7m and no more than 50 full-time employees.

And, when it comes to selling at the end of the fixed term, the market can be weak, warns Jason Butler at Bloomsbury Financial Planning. "I know from personal experience that when you want to sell these things the spreads are massive. I've been in this business for 20 years and I never saw a VCT make any of my clients any money."

However, a white knight is on the horizon in the form of 'protected' VCTs. These aim to invest (primarily in the form of loans) in relatively stable firms, such as utilities, that should generate steady cash flows. As such, they're more likely to be able to pay regular dividends. You still get the 30% income-tax relief, plus the chance to exit on fixed terms after five years.

"If you invested £100, in five years' time the return is the £30 you would have paid in tax," says Butler. He tips Octopus Secure VCT (Octopusinvestments.com). The fund will focus on firms that have a contractual revenue stream from lower-risk customers. So it doesn't invest in "lose your shirt businesses. Octopus is innovative and has a history of delivering."