Tax-free dividends

Welcome to the world of venture capital trusts (VCTs) and Enterprise Investment Schemes (EIS), both of which are structured to allow those who understand the risks to invest in fast-growing smaller companies. Very few vehicles offer better tax breaks; conventional pensions may attract tax relief on contributions, but the income eventually secured is subject to tax and there are lots of limits and restrictions. VCTs and EIS offer up-front tax relief with tax-free profits and dividends too. There is no lifetime limit on contributions, you don't have to wait until you’re 55 to access your funds and there is no requirement to buy an annuity.

They can certainly be risky, because of their bias towards smaller companies, and you should always be wary of letting the tax tail wag the investment dog. But if you've already reached your pension pot's lifetime limit (£1.5m in the 2012-13 tax year), or you've used other key allowances like the individual savings account (Isa) and capital gains tax, they are an obvious next step. You need to make sure you understand the different characteristics of each, though, before you can make an informed choice. Below, we run through the characteristics of each and outline some key picks.

VCT & EIS vs pension

Tax-free dividends

To be clear, it is only VCTs that offer these; EIS are a capital-growth investment. And some VCTs have delivered very strong dividend streams. At the end of December 2011, generalists on average yielded 7.6 per cent and Aim-traded yielded 8.1 per cent. Dividends held up well during the 2008-09 recession, with 93 per cent of VCTs paying a dividend in 2008 and 86 per cent in 2009, and these tended to be in line with previous years. "Many VCT managers have been going out of their way in recent years to try to smooth dividends, that is, to try to provide a relatively stable dividend record," says Jemma Jackson, PR manager at the Association of Investment Companies (AIC).

Dividend paying VCTs, typically generalist or Alternative Investment Market (Aim) ones, can provide a tax-free income stream in retirement, or if you are younger you could use the income to supplement pension contributions.

Income tax relief

Following changes in last year's Budget, both VCT and EIS now offer tax relief at 30 per cent. To qualify, you have to hold VCT shares for a minimum of five years, compared with only three years for an EIS. But when you buy VCT shares the tax relief certificate comes with the share certificate (probably a few weeks later), whereas with an EIS you only get the relief when the fund has put money into a company and this company starts trading – and obviously, you have no control over that.

Investment levels

You can only invest up to £200,000 into a VCT each year, whereas you can invest £500,000 a year into an EIS, and this rises to £1m on 6 April this year. Also, EIS allowances can be carried forward, whereas VCT is 'use it or lose it'. If you didn't use your 2010-11 EIS allowance, this tax year you could invest £1m, and if you don't use this tax year's allowance, in 2012-13 you could invest £1.5m.

Minimum investments into VCT new issues are typically between £2,000 and £5,000, but with EIS they range between £5,000 and £50,000, a notable exception this year being Ingenious Shelley Media Fund 5, which stipulates £3,000.

Subsequent taxation

As well as tax relief upon investment, EIS offer loss relief on the underlying investments. If they make a loss, you can offset that against your income tax in the same or preceding tax year. You can also offset it against capital gains tax (CGT) in the same year, or carry it forward to offset against future gains. The net effect is to limit the investment exposure to 48p in £1 for a 40 per cent tax payer and 40p in £1 for a 50 per cent tax payer, even if the shares become totally worthless.

Provided you've held them for at least two years, EIS don't form part of your estate for inheritance tax (IHT) purposes. So if you die while holding your EIS, it will pass to your heirs in full. You can also defer tax on other capital gains by rolling them into EIS; by doing so, you will not have to pay CGT on the gain until you realise gains on the EIS. If you die before that happens, the CGT liability dies with you.

You can't defer capital gains using VCT, but like EIS, gains on them are not subject to CGT.

Top-performing VCTs over past 10 years and their dividend records

The secondary market

EIS are unlisted vehicles. If you want to get out of an EIS, you have to wait until the underlying investments are sold via a trade sale or flotation, although there are some instances where the EIS manager will buy back your shares.

VCT are listed on the stock market, so there is a secondary market. But it’s illiquid, partly because VCT shares bought on the secondary market do not qualify for the 30 per cent income tax relief available on a new issue. But you still get tax-free dividends and the lack of income-tax relief means you will almost certainly be able to buy the VCT shares at a discount to net asset value (NAV).

Sometimes managers offer an enhanced buy-back facility where you can sell back your VCT shares at close to NAV and get new shares in the same VCT with a further 30 per cent income tax relief. Open or forthcoming VCTs offering this include Amati VCT 2, Hargreave Hale AIM VCT 1, Hargreave Hale AIM VCT 2, ProVen Health VCT and Ventus VCT and Ventus 2 VCT.

However, if the VCT is underperforming some advisers say it could be better to sell your shares at a discount and move your money into a better investment.

VCTs are subject to the same rules as other listed companies; they have to report regularly on their progress and have a board. It is easier to get historical performance data on VCTs – for example, on the Association of Investment Trusts (AIC) website at www.theaic.co.uk.

EIS do not have to do this: the extent to which they report is down to the discretion of the manager. EIS managers say the lower regulatory burden means they have lower costs, which benefits investors.

Investee companies

Although both vehicles typically invest in small companies needing venture capital, EIS may invest in earlier stage and therefore riskier companies, and some also target more unusual investments such as vineyards or theatre productions. Single company EIS are even more concentrated.

A number of EIS have a portfolio rather than a single company though the number of holdings in these still tends to be much smaller than those in a VCT. Portfolio EIS such as those offered by Oxford Capital may hold between six and 20 investments, whereas a VCT is likely to have in excess of 40.

The government has proposed changing the investment rules for VCT and EIS to enable them to invest in a wider range of companies. The changes include an increase in the employee limit from 50 to 250; raising the gross assets threshold from £7m to £15m before investment and £16m after; and lifting the maximum annual amount that can be invested in an individual company from £2m to £10m. Individual VCTs will also be able to invest more than £1m a year into a company.

"This will allow VCTs to participate in larger deals without the need to run multiple VCTs in parallel," says Martin Churchill, editor of the Tax Efficient Review. "This could encourage VCT managers running multiple VCTs to merge them and reduce running costs."

However, they will also be restricted from investing in buy-out deals or ones where their investment replaces existing shareholders. "This is potentially a very serious restriction in the kinds of deals done by generalist VCTs in the management buyout (MBO) and growth capital areas and the future impact is not clear," says Mr Churchill. However, this restriction will not affect investments made into VCT funds raised during this tax year.

Because VCTs and EIS invest in alternative and unquoted companies, sometimes in esoteric sectors, their performance is not necessarily correlated with mainstream investments like equities.

Early-bird VCT offers

The investment case

VCTs and EIS are clearly very tax-efficient. But are they any good? VCTs in particular have had mixed results over the years, attracting criticism for poor performance and wide discounts to net asset value (NAV). But some have done very well so, as with every other kind of fund, it's rather a waste looking at averages. You need to do your research and pick out the funds and asset managers with good records.

Over the long term, generalist VCTs have delivered the most average consistent returns with an average share price total return of 51 per cent over 10 years, according to the AIC, while last year, five of the 10 best-performing investment companies were VCT. Although the VCT sector as a whole was down 3 per cent at the end of last year, it outperformed the average investment company, which was down 11 per cent over the same period.

If you have an allocation to smaller companies in your portfolio you could get your exposure to this via an Aim VCT rather than buying shares or a fund directly. By using a VCT, your 30 per cent income tax relief may mitigate future losses. If you are happy for your smaller companies allocation to be to unquoted companies, then you could look at other types of VCT and EIS.

Market environment

A climate of tight lending to small and start-up businesses makes for plenty of opportunity for VCT and EIS managers. "VCTs invest for the medium term, five to seven years, a period over which we have seen consistent returns," says David Hall, manager of the British Smaller Companies VCT. "The current environment sees good value with asset prices at the lower end and great medium-term growth prospects – that is quite a compelling combination."

However, market uncertainty is a problem at the other end of the process – realisations. Selling out of investee companies is how VCT and EIS make their profits. Initial public offerings (IPOs) are difficult at present but trade sales are still possible. "Research and development budgets were cut at the beginning of the financial crisis at technology companies so these need to buy smaller ones to do this," adds Ian Wainwright, fund manager at EIS provider Parkwalk Advisers. "There has already been a good deal of merger and acquisition activity among technology companies."

Open EIS offers

Picking a VCT

Generalist VCTs invest in mainly unquoted companies and tend to allocate across a variety of sectors, so are arguably lower risk than specialist VCTs focused on one area.

Over the years the Baronsmead and Northern vehicles have been among the best-performing generalist VCTs and have strong dividend streams. However, due to their success they usually sell out fast, which is already the case this year. It is a good idea to do your research and invest early, especially as some VCTs do early-bird offers that give you additional shares an as incentive.

Of the generalist VCTs that are still open, Matt Woodbridge, head of investment products at discount broker Chelsea Financial Services, suggests the Matrix VCTs and British Smaller Companies VCT 2. Martin Churchill, editor of the Tax Efficient Review, suggests ProVen VCT, a generalist but with a slight tilt to media companies.

The Albion VCTs also have made some good returns.

Aim VCTs mostly invest in Aim shares. Their performance has been held back in recent years due to the rules that do not allow VCTs to invest in companies with gross assets of more than £7m and more than 50 employees, putting many Aim companies beyond their reach.

However, if these limits are raised Aim VCTs will have a broader universet to choose from, and some Aim VCTs, such as the Amati and Hargreave Hale vehicles, have been able to access larger companies with money raised before April 2006.

If you are more interested in growth, some generalist and Aim VCTs allow investors to reinvest their dividends, which can massively boost returns. Of the VCT offers currently open, Albion, Amati VCT 2, Matrix Income & Growth 4, the Income & Growth VCT and ProVen VCT offer dividend reinvestment.

Planned exit VCTs aim to wind up as soon as possible after five years and protect rather than grow capital. These are better for tax planning over a shorter period.

From 6 April 2012, VCT and EIS investments will have to meet a Disqualifying Purpose Test. Limited-life VCTs typically have lower-risk investments and some of these could fall foul of this legislation. However, some planned exit investments may still qualify and the rules do not apply to underlying company shares issued before 6 April.

Mr Churchill suggests Foresight VCT & Foresight VCT 2 Infrastructure share class and Downing Planned Exit VCT 2 & 3 F share linked offer. Mr Woodbridge suggests Puma 8 VCT.

Open VCTs

Picking an EIS

There are two main types of EIS, approved and unapproved, which are subject to different investment rules. Approved have to invest 90 per cent of their assets in the 12 months following launch, so may not have as many investments as an unapproved fund, but they are guaranteed to qualify for income tax relief for the year in which you invest. Unapproved EIS get their income tax relief on the date of each investment, providing it qualifies.

Some EIS providers will ask you to fill in a form that declares that you are a high-net-worth or sophisticated investor. Discount stockbroker Clubfinance lists the EIS that require this on its website at www.clubfinance.co.uk.

For a portfolio approach across different sectors, Mr Woodbridge suggests the Oxford Capital and Octopus vehicles. Mr Churchill suggests the Calculus EIS Fund 12 and MMC EIS Fund.

If you have a higher-risk tolerance and are prepared to look at one sector, the City Pub Company East & West EIS is run by managers with a good track record.

Sun sets on solar

Government subsidies for solar power have attracted a number of VCTs and EIS to the sector. Subsequent attempts to reduce subsidies (known as ‘feed-in tariffs’ or Fits) have been challenged in court, so the outlook is murky and Mr Woodbridge for one has not been suggesting VCTs and EIS involved with solar power.

However, some managers have succeeded in making some investments in installations that were up and running before 12 December and qualify for the higher Fits. These include EIS offered by Ingenious and Oxford Capital. Jonathan Fry, who runs a solar EIS advice service, says solar EIS are a valuable opportunity, in particular for 40 and 50 per cent rate taxpayers.

After 6 April VCTs and EISs will still be able to invest in hydro and anaerobic digestion schemes that benefit from feed-in tariffs.