If you pick up a newspaper this month, you are almost guaranteed to read about the taxes the new chancellor is planning to hike, or the tax reliefs she is looking to axe. But one set of tax reliefs we know is here to stay are those supporting venture capital trusts.

The Treasury has just confirmed the VCT scheme will now run until at least 2035 in order to support small British businesses. Many investors will have heard of VCTs but might not know too much about them, so here’s a lowdown on the key features to help you decide if they’re worth considering.

What are VCTs?

VCTs are investment funds, run by a professional fund manager, which come with attractive tax breaks attached. They invest in very small companies, which either aren’t listed on a stock exchange at all or are listed on London’s junior market (AIM), so they come with high risks attached. They are most often used by experienced, adventurous investors, especially those with large tax bills who have perhaps used up their pension and ISA allowances.

What are the tax benefits of VCTs?

VCTs come with a very generous tax treatment. Investors who buy VCTs on the primary market can claim a 30% tax rebate on investments of up to £200,000 in each tax year. So potentially an investor could reduce their annual income tax bill by up to £60,000. You can’t reclaim more tax than you are liable for though, so if you’ve paid or are liable for £20,000 of income tax in a given tax year, that’s the maximum relief you can claim by investing in VCTs. It’s important to factor into your calculations any other reductions to your income tax liability, for instance pension contributions and charitable donations, which may reduce the amount you can reclaim via VCTs.

Once you’ve invested in a VCT at issue, you also need to hold the VCT for more than five years to stop the tax relief being claimed back. As well as the 30% upfront income tax relief, growth is free from capital gains tax, and dividends are free from income tax too. In order to qualify for the tax breaks, you must also buy newly issued VCT shares, which means buying from the VCT manager or a broker when the VCT is fund-raising. VCTs are structured as investment trusts, and so they can be bought and sold on the secondary market, but any such purchases do not attract the same tax benefits.

VCT shares form part of your estate on death, so they are potentially liable to inheritance tax. This is in contrast to investing directly in qualifying private companies or AIM shares, which are normally free from inheritance tax if held for at least two years before death. However, it’s practically very difficult to invest directly in private companies, unless you set up and run a business yourself. It is possible to invest directly in AIM companies, but then of course, investors don’t get the 30% up front tax relief offered by VCT investment.

How do I get returns from VCTs?

Returns from VCTs can come from capital growth in the value of the underlying portfolio, stemming from portfolio revaluations as the businesses grow, or share price rises for companies listed on AIM, or from exits where the VCT manager is able to sell on holdings at a profit. Of course, within any portfolio there can be expected to be holdings which are loss-making as well as profit-making. VCT managers often use cash raised from exits to pay dividends to shareholders, which can be a welcome source of returns without having to encash shares in the VCT.

What are the risks of VCTs?

VCTs invest in small, often private companies, usually with unproven business models. Small companies which prosper can deliver exceptional returns, but that can take a long time. Some won’t make it to profitability and could ultimately end up being worthless. The companies in question aren’t usually very liquid, so buying and selling can’t be done at the drop of a hat, or perhaps at the price investors would like. It’s also fair to say that the valuation placed on private companies, which in the end determines the price of some VCT shares, is more subjective than tradeable stocks, where an active market tells you what price other investors are willing to pay for the shares.

The VCTs themselves may also not be easy to sell on the secondary market, because not surprisingly most investors choose to buy newly issued shares, to benefit from the tax relief. This may mean if and when you sell, you might do so at a discount to the net asset value of the VCT. Some VCT providers offer share buyback schemes, where the VCT manager will buy back shares from investors, and these might offer shareholders a way to exit their VCT holding at closer to the net asset value of the underlying portfolio.

What about charges?

The charges for VCTs can be high relative to other actively managed funds. Typically, annual charges are around 2%, whereas most actively managed funds will charge 1% or less. Performance fees are also commonplace for VCTs, whereby the manager takes a slice of the profits if they do well. VCTs often come with initial charges too, though these may be discounted if you buy through a broker. Investors need to assess the charges of any VCTs they are thinking about buying, and evaluate whether the extra costs are worth it, considering the tax relief and the risks and potential rewards of investing in the underlying companies.

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