Take a tax break

Secret Escapes, the company offering those handpicked luxury holidays, is just one example of the type of investments you can make while you collect a generous tax break. There's nothing dubious about these schemes, either. They're government-approved tax breaks given to those who help to boost new and growing companies and British jobs.

To encourage investors to back smaller companies, the government offers a number of attractive reliefs in compensation for the risk you are taking on.

You can take a tax break in several different ways, including via venture capital trusts (VCTs), Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS). All of these invest in early-stage companies, such as Secret Escapes, which was backed by VCT manager Octopus Investments, and/or Alternative Investment Market (Aim) shares.

Given how other tax breaks have already been snipped away - for example the annual pension contribution allowance has been cut from £50,000 to £40,000, along with the lifetime allowance from April 2014 - placing yet another squeeze on higher earners trying to save and grow their money - VCTs and EISs are worth exploring.

VCTs and EISs offer tax relief at 30 per cent, so for every pound you invest you get 30p back, as long as you hold the VCT shares for at least five years and EIS shares for three years. With VCTs the tax relief certificate comes with the share certificate (probably a few weeks later) but with EISs you have to wait until the money goes into a company and starts trading.

VCTs pay out tax-free dividends, which can provide an attractive income stream - for example if you are in retirement or want to supplement pension contributions. The Association of Investment Companies (AIC) reports that 59 per cent of its member VCTs are yielding over 5 per cent.

"Take a fairly typical VCT dividend of 5 per cent a year and an investment of £50,000," says Dan Tubb, head of VCTs at wealth manager Bestinvest. "To get the effective equivalent yield you need to add back the tax rebate and ask yourself what a certain dividend is actually worth to someone who would otherwise be paying 40 per cent or 45 per cent on any income. You can see why so many higher and additional rate taxpayers use VCTs as a way for securing a good yield in an investment environment that is so often devoid of good yields."

The effect of tax breaks on VCT yields

"Pre-retirement investors regard VCTs as a long-term savings plan and mostly reinvest their dividends to get a further 30 per cent income tax relief on the value of their dividend," adds Patrick Reeve, managing partner of VCT provider Albion Ventures. "After retirement investors can start taking the cash instead."

Reinvesting dividends, as some generalist and Aim VCTs allow you to, can massively boost returns. EISs and SEISs, however, typically do not pay dividends as they are focused on capital growth. But if you hold EIS shares for at least two years they do not form part of your estate for inheritance tax purposes and, if you die while invested in an EIS, you can pass them to your heirs in full.

When you dispose of your VCT shares you do not incur capital gains, either, while EISs allow you to defer capital gains if you reinvest them in an EIS. You only pay once you realise gains on the EIS and, if you die before it happens the CGT liability dies with you.

EISs also benefit from loss relief. The maximum loss a 50 per cent taxpayer will suffer in a single investment is 35p in the pound and is not offset against other gains in the portfolio. You invest only 70p in the pound because of your 30 per cent EIS income tax relief. If this is all lost due to the investment failing, then you qualify for loss relief at your marginal income tax rate: for 50 per cent taxpayers this equals 35p.

For a 45 per cent taxpayer (the new highest rate as of April) the same applies, but loss relief comes in at 45 per cent instead of 50 per cent, meaning your loss is capped at 38.5p in the pound.

While VCTs, EISs and SEISs do not have an annual lifetime allowance, the amount you can put into them on a yearly basis is capped. You can only invest up to £200,000 a year in VCTs, and £1m into an EIS. However with an EIS if you did not lose your allowance last year you may be able to carry it forward.

Minimum investment into these funds is typically higher than on a unit trust or investment trust, usually at least £3,000 - and in the case of some EISs as high as £50,000.

Open VCT offers

Investment climate

As with any investments you should not just look at the tax breaks but also the investment proposition, as this is a major determinant of your returns. Despite the economic climate in the UK, managers of these funds are fairly upbeat because lack of bank financing over recent years has created a squeeze on smaller company funding, meaning they have a wide choice to invest in. It has also been difficult for smaller companies to raise finances on Aim.

Established VCT and EIS managers are also sometimes approached by companies and they may have contacts who can bring them opportunities.

"I have never seen such a large and attractive pipeline of high-quality companies seeking funding," says Susan McDonald, chairman of EIS manager Calculus Capital. "Traditional lenders and investors, such as banks, are unwilling to commit capital to smaller UK companies at the moment so the terms we are being offered have never been more attractive."

VCTS

While VCTs and EISs share some tax reliefs there are differences between the funds, and sub categories of each. VCTs are listed on the stock exchange like investment trusts while EISs are unlisted.

Although there is a secondary market, 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 your dividends are still tax-free when you buy secondary VCT shares, and they mostly trade at a discount to net asset value (NAV), in some cases very wide ones. However, VCTs such as Baronsmead, Mobeus and Northern have tightened recently so Mr Tubb argues that it is better to get into their primary issues.

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. "Enhanced buy-backs are well worth looking at if you are already in a VCT and want to stay in for another five years," says Martin Churchill, editor of the Tax Efficient Review.

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 doing enhanced buy-backs include Amati VCT and VCT2, Chrysalis VCT, Downing Income VCT and VCT 4, Edge Performance VCT C shares, The Income & Growth VCT, Mobeus Income & Growth VCT and Mobeus Income & Growth VCT 4, Foresight 4, and ProVen VCT and ProVen Growth & Income VCT.

VCTs are subject to the same rules as other listed companies, and have to report regularly on their progress and have a board. It is easier to get historical performance data on VCTs than EISs, for example on the AIC website at www.theaic.co.uk or www.bestinvest.co.uk.

VCTs fall into three main types:

■ Generalist VCTs mainly invest in unquoted companies and tend to allocate across a variety of sectors, so are arguably lower risk than specialist VCTs focused on one area. If you are keen to get a strong dividend stream then you should look at a more mature fund that is doing a top-up issue and has a good record of paying dividends.

Over the years the Baronsmead and Northern VCTs have been among the best-performing generalists and have strong dividend streams. However, due to their success they usually sell out fast as has been the case again this year: only Baronsmead V is still open at time of writing. 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. You can check to see which are still open at www.taxefficientreview.com.

■ Aim VCTs mostly invest in Aim shares. Their performance has been held back in recent years due to rules that did not allow them to invest their qualifying money (70 per cent of their assets) in companies with gross assets of more than £7m and more than 50 employees, putting many companies beyond their reach. However, now that these limits have been raised Aim VCTs have a broader universe to choose from and some Aim VCTs, such as the Amati and Hargreave Hale vehicles, have already been accessing larger companies with money raised before April 2006, before the £7m and 50 employee restrictions came in.

Buying Aim shares via VCTs is beneficial in that you get a generous tax break, helping to compensate for the riskier nature of these companies. However, Mr Tubb prefers VCTs that invest in unquoted companies because the VCT managers often sit on the board of the companies they invest in, giving them more control. But Douglas Lawson, manager of the Amati Aim VCTs, argues that they have liquid underlying investments relative to unlisted companies, and that because they buy stock-market-listed investments they have higher standards of corporate governance and greater transparency.

■ Planned-exit VCTs aim to wind up as soon as possible after five years and protect rather than grow capital, although there is no guarantee as to how soon these will wind up, and it is unlikely to be the moment they hit their five-year anniversary. These are better for tax planning over a shorter period.

EISs

EISs are unlisted, so if you want to get out 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. EISs are arguably less transparent than VCTs and the extent to which they report is down to the discretion of the manager. But EIS managers say the lower regulatory burden means lower costs, which benefits investors.

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 EISs get their income tax relief on the date of each investment, providing it qualifies.

Some EISs invest in a single company, which makes them higher risk, while others hold around 10 investments.

Some EIS providers will ask you to fill in a form that declares that you are a high-net-worth or sophisticated investor.

PICKING A FUND

VCTs have had mixed results over the years, meaning that the class as a whole has attracted criticism, although as with every other kind of fund there are ones that make good returns. The average VCT is up 4 per cent over one year, 21 per cent over three years, 2 per cent over five years and 61 per cent over 10 years, according to the AIC.

The funds' profits rely on the managers being able to exit the investments at a good price. "It is very important to get a good-quality management team that has already done deals in this area and that has a bank of experienced contacts," says Mr Tubb.

A management's track record is very important, especially with EISs and SEISs where you cannot necessarily assess them otherwise. It is difficult to gauge how they have been performing other than to look at how their manager’s past investments have done, according to Philip Rhoden, director at discount broker Clubfinance, so it is important to choose managers who have invested in that sector before. Research and ratings on VCTs and EISs such as on the www.taxefficientreview.com and www.bestinvest.co.uk websites are helpful.

You should also think about how the managers will get out of the investments and understand what you are investing in, the strategy and stage of development of the companies, according to Mr Churchill.

Mr Tubb says that of the VCTs still open, Mobeus Income & Growth VCT, 4 VCT and The Income & Growth VCT linked offer have good yields, respectively offering 7.9 per cent, 4.2 per cent and 12.3 per cent. Baronsmead VCT 5, meanwhile, offers a 6.4 per cent yield. British Smaller Companies & British Smaller Companies 2 linked fund raising is still open and these have strong long-term performance records as well as attractive yields of 13 and 9.1 per cent. The ProVen and Albion VCTs also offer attractive yields.

Among limited-life VCTs Bestinvest rates Puma 9 VCT and Downing Planned Exit 2 G Shares five stars, its highest ranking. The Puma VCTs have a successful track record, with past issues having returned more than 100p in the pound.

"The Downing Planned Exit VCTs offer is suitable for investors seeking a relatively higher degree of security because it focuses on investments with exposure to a tangible asset, which is usually a freehold property or in receipt of government-backed subsidies such as renewable energy," says Bestinvest. "The offer will look to deliver solid but not spectacular returns and is specifically designed with mitigating downside risk in mind."

Among Aim VCTs, Mr Churchill suggests Hargreave Hale VCT 1 & VCT 2 as they have made good returns so far in a difficult market. Bestinvest rates Amati 1 & 2 VCT four star on the grounds that they are run by capable fund managers who know their market well and understand their chosen investments. "This, combined with strong performance, makes the Amati VCT our preferred Aim VCT," says Bestinvest.

For multi-sector EIS funds targeting growth with a track record Matthew Woodbridge, vice president at Barclays Wealth & Investment Management, suggests Calculus EIS Fund 14 and the MMC EIS Fund, both of which are run by experienced teams with a history of profitable exits. Mr Churchill also suggests Octopus Eureka EIS Portfolio Service, Downing Growth EIS Fund and Oxford Gateway EIS Portfolio.

For EISs focused on a specialist area, Mr Woodbridge suggests Downing Renewables EIS and Ingenious Renewable Energy EIS Fund.

Other EIS funds targeting lower-risk renewable investments with a track record, according to Mr Churchill, include Foresight Solar EIS, Oxford Capital Infrastructure EIS, Guinness EIS Fund 4, STIL EIS Fund and Merepark Solar EIS Fund 2.

Top 20 performing VCTs over five years

THE RISKS

Last year the Financial Services Authority (FSA) proposed restricting private investor access to VCTs and EISs, meaning they could only be promoted to investors classified as sophisticated or high-net-worth. Since then, the FSA has said that it is unlikely to ban promotions of VCTs, but it is still considering this with regard to EISs and SEISs.

With some EISs you already have to be classified as high-net-worth or sophisticated to invest in them, but there are also a number for which this is not the case. But none of the offers this tax year will be affected as the FSA is not confirming what it will do until April 2013.

Unquoted companies can be difficult to sell and you need to hold VCTs, EISs and SEISs for a number of years to benefit from the tax breaks as well as give the underlying investments time to mature.

Because VCTs, EISs and SEISs focus on early-stage companies they should only account for a small part of your portfolio. Jason Hollands, managing director at wealth adviser Bestinvest, suggests only a modest overall exposure to smaller companies of which VCTs, EISs and SEISs could form a part. He says, for example, an aggressive portfolio could have an overall allocation of 15 per cent to smaller companies related investments with these funds forming a part of this.

Bear in mind...

■ Advisers generally say you should not invest more than around 10 per cent of your portfolio into EIS, VCTs and SEIS.

■ These funds are only suitable for higher-rate tax payers with a long-term time horizon.

■ Returns from both VCTs and EISs can be lumpy, with many of the gains coming later on as the investments start to mature. Newer VCTs may pay little or no dividends - another reason why you may want to buy an established one.

■ VCTs, EISs and SEISs make their profits from selling on their underlying investments and if this is not possible for economic or other reasons this will hit the funds' returns.

■ These are unregulated investments so do not qualify for compensation under the Financial Services Compensation Scheme (FSCS) in the event of failure.

■ Just because EISs and SEISs qualify for income tax relief after three years doesn't mean the companies they invested in are ready to return your money. Realisations could take some time.

■ Both VCTs and EISs can take on debt which can increase risk.

Open EISs and SEISs