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VCTs offer attractive benefits but it is essential to be aware of the risks of investing in small unquoted companies

I would like to invest some money in a venture capital trust this tax year. Can you tell me what the tax advantages are and how to go about selecting a suitable VCT?

Venture capital trusts invest primarily in new shares issued by unquoted UK companies, including those on the Alternative Investment Market or traded on Ofex.

Most private investors do not have access to these types of investments, which are often the preserve of institutional investors, or the expertise to assess the opportunities. Yet investors can benefit from getting in on the ground floor and reaping the rewards if the underlying companies increase in value.

As well as providing access to a portfolio of high-growth companies, VCTs also offer very generous tax reliefs. VCTs are ideally chosen for their tax-free income stream rather than for tax-free capital gains. Most private equity teams endeavour to distribute an attractive income stream of about 5 per cent of net asset value and maintain the share price at the original figure.

VCT managers are incentivised to deliver reliable income distributions by taking profits and collecting dividends as opposed to fattening up the VCT and increasing the share price. Again, a common misconception is that VCTs are involved in chasing speculative capital gains rather than the reality of their income credentials.

The principal tax reliefs which are available on a maximum investment of 200,000 per individual (400,000 for a married couple) in 2005/06 are:

  • Income tax relief at 40 per cent of the amount subscribed, provided the VCT shares are held for at least three years. Note that it is not necessary for an investor’s marginal tax rate to be 40 per cent for the investor to obtain 40 per cent income tax relief but relief will be limited to the amount which reduces the investor’s income tax liability to nil.
  • Tax-free dividends and capital distributions from a VCT.
  • Capital gains tax exemption on the disposal of ordinary shares in a VCT.

VCTs are deemed to be high-risk investments and the primary risks fall into two categories – investment and liquidity risk. With regard to investment risk, VCTs invest primarily in small unquoted companies which by their nature are higher risk than their bigger blue-chip counterparts.

In terms of liquidity risk, VCT shares must be held for a minimum of three years for investors to take advantage of the 40 per cent income tax relief. Even after the three-year holding period, VCT shares may not be easy to sell at full value as most trade at a discount to net asset value and have wide bid-offer spreads. Buyers of “secondhand” VCT shares will not benefit from 40 per cent income tax relief and, therefore, sellers tend to outnumber buyers.

Investors should take into account a number of factors when selecting a VCT. Look at the investment strategy as not all VCTs have equal levels of risk. Investors should consider the strategy for both parts of the VCT’s portfolio:

  • Qualifying portfolio. Is it a generalist, Aim or sector-specific VCT? Does the VCT invest in technology start-ups or focus on profitable established companies?
  • Non-qualifying portfolio. Does the VCT invest in unquoted companies, quoted equities or A-rated bonds?
  • A manager’s track record should also be examined. The key pointers to look for are relevant track record and deal flow:

  • Track record. What is the past performance of the manager’s existing VCTs and its other smaller company investments?
  • Deal flow. A good indication of the strength of the deal flow will be the investment rate of the manager’s existing VCTs.

Charges must also be looked at as they can comprise an up-front charge, annual fees and performance-related fees. These costs should be compared across all VCTs.

As there is a very illiquid market in most VCT shares, it is important that VCTs have a strong buyback policy in place to provide an exit for investors. Particular attention should be paid to how the VCT intends to deal with investors looking to sell shares after three years. The VCT’s buyback policy will be subject to the rules of the London Stock Exchange and VCT regulations.

As with all investments, potential investors should consider spreading their subscription across more than one VCT. Lower risk and potentially increased returns should be created from a portfolio approach, thereby ensuring risk/ reward optimisation.

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