Page last updated at 23:31 GMT, Tuesday, 5 October 2004 00:31 UK

Tasty tax break comes with big risks

by Ben Yearsley
Investment manager, Hargreaves Lansdown

Ben Yearsley
This week's expert Ben Yearsley

An investment expert explains the risks and rewards of Venture Capital Trusts (VCTs), where investors can enjoy a potentially tasty tax break by investing in small firms.

It is unusual for a government, of whatever political persuasion, to actually give money away.

But that is what Gordon Brown did when he increased the initial tax breaks on Venture Capital Trusts (VCTs).

A VCT is one of the most exciting and speculative areas for investment.

They provide investors with the opportunity to get in on the ground floor of an investment, a chance to invest in a young company and reap the rewards if it grows in size and value.

VCTs are a high octane investment and should be approached with caution

VCTs invest in unquoted companies (and firms quoted on the AIM and OFEX indexes) which can be some of the most dynamic and fastest-growing companies in the UK.

Tax boost

In order to encourage investment in these companies, VCTs were designed with generous tax breaks.

Investors receive an upfront 40% tax relief.

In other words if you put 10,000 in, this could only cost you 6,000 by the time you have had your tax rebate.

And the tax free boost doesn't stop there.

Any capital gain or dividend paid from the VCT is also completely free of tax.

But there are a couple of caveats.

Firstly, in order to keep this tax break, investors have to keep their money in a VCT for at least three years.

Secondly, the tax break is only available on initial investments.

Money go-round

VCTs invest in companies that are generally looking to raise between 500,000 and 10m.

My big fear is that people will simply invest in VCTs for the sake of securing the 40% tax break

The companies they invest in are very small and under Inland Revenue rules have total assets of less than 15m.

Generally between three and seven years after making the investment the venture capitalist will look to either float the firm on the stock exchange or sell the business.

Any profit that is made is paid back to investors as a dividend free of tax.

The venture capitalist will then look for a new investment and start the whole process again.

A VCT can only invest 1m per tax year in a company and when fully invested it will probably have between 30 and 40 different investments.

VCTs invest at an early stage and therefore the success of these companies is by no means guaranteed.

High risk

There are other aspects of VCT investment which should give investors pause for thought.

VCTs are very long-term investments and are not suitable for everyone.

There is a very limited market in VCT shares as the majority of investors tend to buy and hold.

Often shares in VCTs will trade at a large discount to the value of the assets.

Some VCT providers promise to buy back the shares of investors who want to sell up but, even so, this is an illiquid market where you may not get all your money back.

My big fear is that people will simply invest in VCTs for the sake of securing the 40% tax break.

VCTs are a high octane investment and should be approached with caution.

The views expressed are solely those of Mr Yearsley and are for general information only. They do not constitute financial advice as defined by the Financial Services and Markets Act and are not intended to be relied on for the purposes of making an investment decision. Always obtain independent advice from a qualified, registered financial adviser before making any investment decisions.

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