Tax breaks make VCTs worth a look

Has there been an amazing turnaround in expectation for the growth potential of unquoted and AIM-listed shares? The answer is no, yet we are still likely to see venture capital trust (VCT) sales up about 600 per cent on the previous tax year. This is because people are being lured by increased income tax benefits.

For the 2004/05 and 2005/06 tax years, the rate of ‘up-front' income tax relief has been increased from 20 per cent to 40 per cent, while the maximum annual investment that can benefit from this tax relief has risen from £100,000 to £200,000.

This coupled with tax-free income and gains means that venture capital trusts should at least be worthy of consideration, particularly for those with higher incomes. They have the opportunity to avoid paying up to £80,000 in income tax for each of the next two years.

There is, however, a danger that an upsurge in interest could have some undesirable consequences. The basic rules of supply and demand suggest that if there is a peak in demand coupled with a limited supply then prices are likely to rise.

My understanding is that after two years, the 40 per cent income tax, benefits are unlikely to be extended and as a result demand for VCTs will be significantly curtailed. While fund managers will stagger the bulk of their investments over a three year period, there is a real fear that we will see a spike in prices, particularly in AIM-listed companies, while people are buying and then a fall off when they may be looking to sell.

We all remember the boom in technology stocks not so long ago that then culminated in a subsequent bust. While demand was high, a number of new product providers entered the market, companies with little specialist experience in that arena. Private investors enticed into these products are still counting their losses. The similarities with the new VCT providers, launching predominantly AIM listed trusts, should not go unnoticed.

The established product providers are worried that we will see a great deal of short-term thinking, perhaps both from investors and product providers.

A VCT investor should have a time horizon of at least 10 years in mind. However, the current tax regime will not encourage that approach.

One suggestion is that VCTs should be given the same inheritance tax benefits as Enterprise Investment Schemes (EISs), whereby they would qualify for 100 per cent relief. The Inland Revenue is unlikely to agree to this carte blanche. However, there may be scope for discussion, and one leading provider is known to be in talks with the Revenue hoping to secure inheritance tax benefits once VCTs have been held for a particular length of time.

In the absence of such legislation, we could see investors trying to capitalise on the initial tax benefits and then look for the earliest opportunity to make for the exit. It is not sensible for people to adopt a three-year time horizon to investing in equities, yet how many would still be tempted by a VCT if they were denied access to their money for 10 years?

For high net worth people, the initial tax benefits coupled with long-term tax-free income, tax-free gains and the possibility that these products could even be effective for inheritance tax purposes at some stage in the future, means that VCTs are certainly worthy of consideration and could sit very nicely alongside pensions, PEPs and ISAs as part of a longer-term investment strategy.

However, for short-term investors the decision to invest in a VCT may not prove to be so fruitful. They may buy when demand is high and sell when it is low. Investing in small companies is a volatile pastime. The AIM market rose by 140 per cent in 1999, but then fell by 81 per cent between March 2000 and March 2003.

There is also a very limited secondary market for these investments. This is why many existing trusts stand at a discount to their underlying net asset value. A discount of 30 per cent is not unusual and means that the selling value of the trust is 30 per cent less than what the underlying investments are worth. Again, in three years time, with the prospect of many sellers and few buyers, these discounts may increase further.

A product provider offering a buyback policy is an advantage but may not be the answer. Why do no providers offer a buyback guarantee? It is because they do not know that they will be able to honour them. It is not as easy for product providers to sell their stakes in unquoted and AIM listed companies to repay investors as it is to sell shares in, say, more liquid FTSE-100 companies. Any provider could offer a buyback policy now, safe in the knowledge that investors are unlikely to utilise it for at least three years. By this time the amount of new money going into VCTs may be at much lower levels and so, if the buyback policy proves problematic, it can be withdrawn at short notice without a major impact on new business levels.

So, while certain parts of the industry may be gung-ho over the potential of VCTs, a sensible investor should not believe this hype. Rather, they should take a step back and ask whether VCTs are really the most appropriate investments for them. If they do not already have a significant and diversified portfolio, understand and accept the risks involved and have a long-term outlook, then the answer is likely to be no.

Patrick Connolly is research and investment manager at John Scott and Partners, the financial advisory firm