High risks, high rewards

Tax mitigation is highly topical. Clearly, some of the more controversial schemes that have recently been highlighted in the media are questionable, but tax mitigation in itself is entirely legal. In fact, the government has created several investment vehicles designed to achieve just that over the past few decades, and actively promotes their use.

Of these, pensions and Isas are the most widely understood and used. From this April, the former will become even more flexible, with withdrawal of pension pots as cash becoming possible, although the potential tax payable may discourage this. As for Isas, they offer tax-free capital gains and income on both cash and other investment savings.

What are less well-known despite their very preferential tax treatment are venture capital trusts (VCTs) and enterprise investment schemes (EISs).

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Introduced in 1994 as the successor to the business expansion scheme, EISs were designed to encourage investments into small unquoted companies trading in the UK. VCTs celebrate their 20th birthday this year, their longevity largely due to the attractiveness of their tax treatment and the support they provide to smaller companies. Such companies form the entrepreneurial element of our economy, and governments are therefore keen to incentivise funding for them.

VCTs are investment companies listed on the London Stock Exchange, thus their shares can usually be sold at any time. They are normally managed by specialist investment managers under the governance of an independent board of directors. An EIS invests in the ordinary equity of an individual company and hence can only be sold when the company is sold.

Both VCTs and EISs benefit from an income tax rebate equal to 30 per cent of the initial investment. VCTs pay attractive tax-free dividends which do not have to be included in a tax return. EISs can usually provide capital gains tax deferral and business property relief, and also benefit from loss relief.

Some VCTs offer dividend reinvestment schemes, enabling investors to compound their income further. The scheme allows investors to automatically reinvest dividends into new shares, allowing them to benefit from a further 30 per cent tax relief on the value of the dividend received and, with regular investment, the potential to compound capital growth. This is particularly useful for those who have yet to reach retirement and may not need tax-free income. Then as soon as they retire, or need extra income, they can re-elect to receive cash instead.

There are several types of VCTs. Generalist VCTs tend to be the most diverse and broadly spread. Aim VCTs invest specifically in companies that are quoted or about to be listed on the alternative investment market. Specialist VCTs focus on specific industry sectors such as renewable energy or technology. Increasingly less common are limited life VCTs which wind up after five years, selling all their investments to return cash to investors.

One of the main attractions of generalist VCTs is that they do not have fixed terms, paying out dividends on an ongoing basis and forming a fundamental and long-term part of a savings portfolio. Because of this they can also take a long-term view of the companies they invest in, which is conducive to better returns.