Tax-free ventures into the unknown

THE Venture Capital Trust (VCT), a new type of tax-free investment trust, is still in its infancy. At the moment there is only one company that has finished raising funds, although others are in the midst of offering shares.

Any new product is bound to generate a mixture of scepticism and incomprehension. Reasonably enough, people do not want to use their own savings as a test- bed for City financiers. However, VCTs offer a certain sort of small investor an attractive, tax-free investment.

VCTs were introduced by the Government with the aim of funnelling capital into small, unquoted British companies. Small investors are offered tax incentives to provide medium- to long-term investment in VCTs. These trusts, in turn, will invest in a spread of smaller companies. The theory: investors make good money and smaller British companies are helped on their way by equity finance.

What about the detail? Everybody likes extracting money from the Inland Revenue, so let us start with the tax breaks. People who subscribe for new issues of VCTs gain two benefits:

q They receive back almost immediately 20 per cent of the money invested. If you subscribe pounds 1,000 to a VCT, you see your income tax bill reduced by pounds 200, making the real cost pounds 800.

q They can "roll over" unrealised capital gains into the VCT. Put very simply, if a 40 per cent taxpayer has pounds 10,000 of unrealised capital gains - on top of the tax-free capital gains tax allowance - he or she can invest this whole sum in a VCT. If this investor decided instead to invest in a conventional investment trust, or any other investment, they would only have pounds 6,000, with the remaining pounds 4,000 going to the Revenue. Bear in mind though that with the VCT, the pounds 4,000 of owed tax becomes payable when the VCT is sold.

These reliefs apply to investments of up to pounds 100,000 per person for each tax year. However, they depend upon the VCT being held for at least five years. VCTs are quoted on the London Stock Exchange, and so can be bought and sold like the shares of BT, but if subscribers sell before the five years are up, the two named tax breaks are forfeited.

The third relief, though, dubbed "PEP-style", goes to all holders of VCTs, whether they bought shares in a new issue or in the stock market afterwards, and are not subject to any minimum holding period. Again, for amounts up to pounds 100,000 per tax year, VCT investment returns are free of both capital gains and income tax.

For investors with substantial portfolios, VCTs provide the most obvious tax shelter there is once the full PEP allowances have been used up. As with pension plans, VCTs allow UK taxpayers to nail a "Revenue: Keep Off" sign to the door, but without the restriction of not being able to withdraw funds until at least the age of 50.

Why has the Treasury been so generous? Because the Government is determined to make a success of the concept. It was persuaded by the venture capital industry that a significant package of tax breaks was needed to tempt investors into what many regard as a highly risky investment.

To understand these risks better, it helps to look at the constraints faced by VCT managers.

First, companies invested in by VCTs must be pretty small - they cannot have gross assets of more than pounds 10m. Many such companies can go bust. Secondly, at least 70 per cent of the VCT assets must be invested in these "qualifying holdings" within three years of launch, and forever afterwards, for the investors to remain eligible for the tax relief.

Certain types of business are not "qualifying": this is basically intended to lead to investment in "real" venture capital, that is, where the investors are taking genuine equity risk. Lastly, VCTs are restricted to a maximum of pounds 1m in each company.

Do you really want to hold a portfolio of such minnows? Obviously you do not want to have all the family wealth tied up in one or two small unquoted companies. This may be a better bet than playing roulette, but it is still not a good idea.

However, this is not at all what you are doing when you invest in a VCT: a good VCT will offer a managed portfolio of companies. For example, Murray VCT expects to invest in upwards of 30 companies, spread across industry sectors and geographical locations.

Whatever VCTs are, they are not Business Expansion Schemes. In the days before the various property schemes came into vogue, investors were offered a rich variety of BESs, often investing in individual companies with scratchy track records. The tax breaks looked so huge that people did not really focus on the performance of the investments themselves. The thought that "It's only costing me 40p in the pound" lulled people into forgetting risk.

A VCT's risk is lower. They are bound to be bumpy rides, but overall the diversification means that one bad company in the portfolio will not wipe out a shareholder's investment.

The rewards should more than balance the risks.

How can you spot a good VCT? The quality of the fund manager is crucial. As ever, you should consult an independent adviser before taking the plunge, but a few of the things you, and they, should look for are:

q A record of investing successfully in venture capital.

q Strong "deal flow". A VCT will have to find a fair number of companies to invest in to satisfy the 70 per cent test after three years, especially given the pounds 1m per investment rule.

q Sufficient resources to allow deals to be evaluated.

q A willingness to get involved with investee companies. This is time- consuming, but without it performance will suffer.

With the right manager, though, and given a decent economic background, a VCT should perform well, and need not be over-risky. Add to these the tax breaks and you have an investment that the well-heeled investor should take seriously.