Investing your hard-earned cash in the current economic climate can be a daunting prospect, but politicians and business-leaders are keener than ever for you to do so.

The drying up of credit since the banking crash of 2007 has meant businesses have sought alternative streams of investment, and Venture Capital Trusts (VCTs) [1] have provided an important vehicle for them.

With interest rates at an unprecedented low, investors may be tempted to choose a VCT investment [2] in order to make the best use possible of their capital. However, it is important that investors are in full possession of the facts regarding VCTs before making a commitment, as there are drawbacks as well as benefits associated with them.

What are Venture Capital Trusts?

First made available in 1995, these investment trusts were introduced as a way of giving people the chance to invest in small companies. They gave small businesses a viable and affordable alternative to finance, and gave investors the chance to share the risk of investment with other, like-minded individuals.

In much the same way as a standard investment trust, a VCT is listed on the stock market – allowing investors to buy in with relative ease. However, because they deal with start-ups in the early stages of their development, they pose an increased risk to the investor. New businesses – particularly in the current economic climate – have the odds of success stacked up against them, so the risk of financial loss is significant. That risk, however, is offset by the opportunity to reap high returns – the reward for investing at the early stages of a company's life.

The Two Main Types of VCT

Investors have an opportunity to select from two main types of VCT, depending on their tolerance for risk and their willingness to invest for the long-term. The general, open-ended investments offered by venture capital firms are most suited to those who want to invest for the long-term in start-ups. These are high-return investments, but they come with increased risk.

For those looking to minimise risk, a planned-exit VCT will usually be the best option. This type of fund targets established companies with proven revenue streams. While the returns may not be as high, the risk is greatly reduced, as the companies being invested in have already demonstrated their ability to make money. The real potential of a planned-exit VCT lies with capital preservation and access to possible tax relief but these funds are usually wound up after five years, and investments, along with any returns, are returned to investors.

The Main Benefits of Investing in a VCT

In exchange for investing in new businesses, something the banks are reticent about these days, the government rewards people with some rather generous tax breaks. Those paying income tax in the UK are eligible for a rebate of up to 30 percent when investing in a VCT. It is possible to invest up to £200,000 per year in a VCT whilst receiving 30 percent income tax relief on the full amount, provided the tax payer is not claiming back more tax than has been paid. This rebate is claimed when filing tax returns with HMRC.

As well as the highly attractive income tax benefits associated with investment in a VCT, any profit made from the sale of an investment will have an exemption from capital gains tax. Moreover, any dividends that result will also be exempt from tax, unless that tax has been deducted at source.

The Potential Drawbacks of Investing in a VCT

Unfortunately, an income tax rebate is only possible when buying new issues of shares; buying 'second-hand' shares in a VCT does not qualify the investor for income tax relief.

A VCT is regarded by the government as a medium to long term investment opportunity, so any tax benefits will only apply for investments of five years or more. Investors who sell their shares within five years will be required to pay back any tax rebates they have received. The VCT must also obey the rules for tax breaks as laid out by HMRC. At least 70 percent of a VCT's assets must be invested in qualifying businesses at all times, otherwise any tax rebates associated with the investment would have to be repaid in full.

There are also some relatively steep charges associated with investment in a VCT. A typical charge associated with buying into a VCT is around 5 percent of the initial outlay, and subsequent annual charges of up to 3.5 percent can also apply throughout the lifetime of the investment.

Factoring in annual charges and the risky nature of funding start-ups, investing in a VCT is fraught with potential for financial loss. However, with the right financial advice and a long-term strategy, this type of investment has the potential to deliver substantial returns.

[1] http://webarchive.nationalarchives.gov.uk/20140109143644/http://www.hmrc.gov.uk/guidance/vct.htm

[2] http://octopustitanvct.co.uk/

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