Tax Tips: Venture into trusts

Generous tax breaks mean VCTs are being hyped as PEP substitutes. But, writes Tony Lyons, they're not without risks

Many investors with large sums standing in their personal equity plans (PEPs) are being inundated by their advisers with details of new venture capital trusts (VCTs) as an alternative home for their money.

The marketing men at management groups specialising in smaller companies have unwrapped a number of VCTs to tempt you to part with your money. While they all extol the tax benefits of their investment vehicle, ordinary investors should be wary of plunging in. And the tax benefits are so generous that Gordon Brown may even be tempted to rein them in when he delivers his Budget speech on Tuesday.

The rules about VCTs are quite complex. They were introduced in the 1995 Budget to stimulate investment in small companies, either new start-ups or ones too tiny be listed on the Stock Exchange.

Currently, if you invest in VCTs, you will receive all the income from and growth in the value of the shares tax free. Up to pounds 100,000 a year per person can be invested in VCTs. In addition, you will qualify for 20 per cent tax relief on the money you put in providing you hold the VCT shares for at least five years. You will, however, only benefit from this tax relief if you invest in new shares. And the tax benefits don't stop there. Wealthy investors also benefit from what is called roll- over relief. This means that if you have made a healthy profit from investments elsewhere, if you invest this money in a VCT you can defer the gains until the time when you sell the trust's shares.

So it's not surprising that new VCTs are currently on offer from the likes of Murray Johnstone, which already runs two other funds; Guinness Flight; Elderstreet; Oxford Technology and some six or so other groups. In particular, they are trying to woo investors with significant sums already saved in PEPs who are worried about the proposed lifetime cap of pounds 50,000 on Individual Saving Accounts (ISAs) when they are introduced next year and PEPs go out of existence.

But don't rush into buying a VCT just because of its tax benefits. These are high-risk investments. The managers can only buy into companies worth less than pounds 10m. They may well be new enterprises in innovative hi-tech or biotechnology areas. By their very nature, small and start-up companies are more likely to go belly up than their larger competitors.

It can take a manager time to find a range of suitable investments for his fund. He or she may well want to have 20 or 30 companies in the portfolio to give a reasonable spread and protection against any possible failure. Under the rules, they must invest 70 per cent of their assets in qualifying shares within three years, which can include companies on the Alternative Investment Market, or investors lose their tax breaks. In fact, none of the existing funds are yet fully invested.

If you are keen to invest in this area, you must be prepared to lock in your money for at least the five years to get the tax reliefs. Picking the right fund is crucial. If you pick a dud investment, selling the VCT shares can be problem. If it's within five years of purchase, you will have to repay any income-tax relief. And since only new VCT shares qualify for full income- tax relief and the right to defer capital gains tax, it will be difficult to find a buyer. This is why the shares in existing VCTs trade at well below net asset value.

Management groups with expertise in funding start-up companies may not be generally well-known household names with private investors. This is why you will probably need expert independent financial advice to find them. If you need a financial adviser, IFA Promotions (0117 971 1177) can put you in touch with some in your area. Among the management groups with VCTs who have plenty of experience in venture capital and have large enough funds are Advent (0171-630 9811), Baronsmead (0171-600 6655), Murray Johnstone (0800 289978) and Guinness Flight (0171-522 2111).