With observers noting several new VCT share offers launching at the end of 2012, now seems to be a good time to look at the pros and cons of these products.

The initial attraction of VCTs to investors is often the tax breaks associated with them.

Subscriptions to shares in a VCT attract income tax relief of 30 per cent – meaning a £100 investment effectively costs just £70 – and dividends and gains are tax-free, so long, of course, as shares are held for the minimum period of five years.

It is important to remember, however, that the government allows such reliefs purely to stimulate investment in smaller businesses.

By definition, therefore, VCTs do focus on investments with an element of risk.

It is in part because some operators raised the suspicion that they were effectively in the tax mitigation rather than the investment business, that HM Revenue & Customs (HMRC) and HM Treasury reviewed the rules relating to VCTs in 2011.

The uncertainty caused by the introduction of the new regime helped depress the total amount of new money invested in VCTs to just £270m in 2011, more than 25 per cent lower compared with the previous year. Final figures for 2012 are yet to be announced.

This has been further exacerbated by the fact that, months after the new rules came into effect, HMRC has still yet to clarify how exactly they will be applied, and this uncertainty is likely to depress the amounts raised again this year for a type of fund which has a relatively short fundraising window prior to the end of the tax year.

The news is not all bad. The government has relaxed the rules governing the size of companies in which VCTs may invest.

These may now have assets of up to £15m (previously £7m) and the maximum number of employees an investee company may have has been increased from 50 to 250.

This, coupled with an increase to £5m in the amount which can be invested by a VCT in each investee company means VCTs can now access a much broader range of investment opportunities.

Investors considering a VCT should be aware of two key distinctions in the sector – between specialist or generalist providers and between so-called planned exit and evergreen funds.

Planned exit funds aim to allow investors to get their money out of the VCT within a defined timeframe after the minimum five year holding period.

Planned exit funds have been particularly affected by the uncertainty caused by the recent rule changes.

Evergreen funds have a longer lifespan than planned exit, and tend to focus more on delivering tax-free dividends, returning capital to shareholders over a longer period.

The specialist/generalist distinction refers to the approach of the investment manager – do they invest solely in one sector, or do they have a more general remit?

The best way to mitigate risk in VCT investments is to select a specialist fund management team which knows its sector inside out.

In the current environment where banks are still reluctant to lend, VCTs offer promising companies a compelling and relevant funding alternative.

For investors, they offer an opportunity to tap into exciting new growth opportunities – all underpinned by some very significant tax breaks.

David Glick is founder and a director of Edge Investment Management

VCTs

HOW THEY DIFFER FROM INVESTMENT COMPANIES

As with other closed-end investment funds, VCTs must adhere to a number of rules set out in legislation. However, in order for investors to receive the tax reliefs, VCTs must also comply with additional rules. The Association of Investment Companies highlights the main rules:

• At least 70 per cent of their assets must be in ‘qualifying investments’ – for example, shares in private UK companies which carry on certain qualifying trades.

• The 70 per cent must be invested within three years of the VCT’s launch. There may be additional investment risk incurred depending on how much of the VCT’s money is invested up to that three-year point and where it is invested.

• The maximum size of company that a VCT can invest new money in was increased from £7m to £15m from April 5 2012.

• Failure to meet these rules may mean that a VCT could lose its approved tax status. If this happened, an investor would also lose their income and capital gains tax benefits.

• The remaining 30 per cent can be invested in ‘non-qualifying investments’ which are essentially any other investment such as cash, listed equities, large company debt instruments, but may also include higher risk debt and equity investments.

This should be clearly explained in the VCT’s prospectus and literature.

All this may have the effect of increasing the overall risk of the underlying portfolio. Some forms of debt may reduce the risk in the underlying portfolio.

You should aim to establish the facts in order to compare different VCTs.