How the taxman can help your investments

If you're one of the growing number of people who are dismayed at the poor rates of interest being offered by savings accounts at the moment, the bad news is that there are few ways of chalking up a better return which don't involve taking on a much greater degree of risk.

Both the stock markets and the credit markets remain volatile – and for every person who says that there is a once in a generation buying opportunity, you'll find another who believes that asset values could continue to fall for years to come.

One increasingly popular way of providing some protection against risky markets, however, is by making use of tax-efficient investment products – such as venture capital trusts (VCTs) and enterprise investment schemes (EISs) – which offer income and capital gains tax breaks for investors. While these are certainly not low-risk products, the tax breaks mean that these investments will need to lose 20 or 30 per cent of their value before you, the investor, have lost a penny.

You'll need at least £5,000 or £10,000 to invest – and most advisers would recommend that you put no more than 10 per cent of your portfolio into these kinds of products.

But if you have the money, and can afford to take on a degree of risk, many of these products promise to produce returns of 10 per cent or more each year.

Venture Capital Trusts (VCTs)

VCTs are a type of mutual fund which invest in unquoted companies, or businesses listed on the AIM or Plus markets. Because they are investing in relatively small and young companies, they can be quite risky for investors.

However, over the past few years, a new breed of VCTs – known as "limited life VCTs" – have begun to offer slightly lower risk propositions for investors, by focusing on companies with established revenue streams, or with substantial assets on their balance sheets.

The great attraction of VCTs for private investors is that they come with a 30 per cent income tax break, on the condition that you hold the investment for five years.

This means that if you invest £100,000, you'll get £30,000 off your income tax bill for the year. Or, to look at it another way, you're only paying 70p for every £1 that you invest. All capital growth and dividends are also tax-free within VCTs.

Martin Churchill from taxefficientreview.com – a website which publishes a wealth of information on VCTs and EISs – says that investors who are looking to preserve as much capital as possible, and possibly generate a return by making full use of the tax breaks, should look at the Limited Life VCTs.

These are designed to be held for five or six years and aim to return around 8 to 12 per cent a year to investors.

For those who are willing to take on a greater degree of risk – in search of better returns – the "generalist VCTs" are the products to consider. But investors should be taking a seven to 10-year view with these kind of products.

Over the period of a decade, the majority of VCTs have generated a positive return for investors, although some – particularly those that were launched during the tech boom of the late 1990s – have lost investors a considerable amount, even after the tax breaks have been taken into consideration.

The very best fund – the Foresight Technology fund – has returned investors almost 25 per cent a year over the last decade, when the tax breaks have been accounted for. In contrast, the Pennine Downing AIM VCT 2 has lost investors more than 11 per cent a year since it's launch in 2000.

Anyone over 18 can invest up to £200,000 each tax-year into VCTs. So if you're considering making a big investment this year, bear in mind that there's only 15 days until the end of the current tax year.

Enterprise Investment Schemes (EISs)

Today, much of the EIS market is not so different to the VCT arena. Whereas EISs used to typically allow people to invest in one small company, investors now tend to look for a portfolio of EISs – much like a mutual fund.

The big difference for investors, however, is that EISs have different tax breaks. Instead of a 30 per cent income tax kickback, you get just 20 per cent in an EIS – and you only have to hold the investment for three years to qualify. However, you can also use EISs to defer capital gains tax (CGT) liabilities. So, for example, if you had a second home which you rented out, and sold two years ago at a profit of £100,000, you would have been liable to pay capital gains tax at 40 per cent on your profit. But EISs allow you to defer payment of this CGT bill – and you can use it to defer CGT on gains that were realised up to three years before or after the date when you invest in an EIS.

This is particularly handy at the moment as, last April, the Chancellor of the Exchequer cut the rate of CGT from 40 to 18 per cent.

So, if you sold your second home two or three years ago, you would have had to pay tax at 40 per cent tax on the profit. However, if you invest in an EIS now, you can claim back this tax, and defer the bill for a few years – into a world where you only have to pay 18 per cent tax.

Another advantage of investing in an EIS is that you can shelter your money from inheritance tax (IHT). Once you've held your investment for more than two years, it can be passed on free of IHT when you die.

You can invest up to £500,000 each tax-year in EISs.

As with VCTs, there are a growing number of Limited Life EISs, which look to preserve your capital by investing in stable businesses. Churchill says that Downing Corporate Finance's Protected EIS fund looks to invest in businesses that have asset protection – such as pubs, which have their property.

Alternatively, they look for businesses where there is a steady stream of revenue coming from a reliable counterparty –such as a government agency.

You can also invest in the film industry via EISs. Goldcrest, which last year was involved in films such as Tropic Thunder and Twilight is one of the current production companies raising money for new films.

Beware that investing in EISs and VCTs can be quite an expensive business. Most will take a fee of at least 5 per cent upfront, and will have annual management fees of between 2 and 5 per cent.

Where to invest

Martin Churchill from taxefficientreview.com says that there are many less VCTs to choose from this year, as investors' appetite for risk has dried up. However, there are still a handful of new launches and existing funds asking for new money.

If you're looking for a lower risk VCT, Ben Yearsley, an investment manager at the Bristol-based advisers Hargreaves Lansdown, says Downing Protected is definitely worth a look.

Or if you're interested in more risky generalist VCTs, he recommends Proven's new fund, or the Matrix Income & Growth fund. The Matrix fund is topping up, but already has around 50 per cent of its portfolio in cash – ready to invest. Yearsley believes that this presents a real opportunity in the current market.

"Smaller companies looking for finance can't get the funds elsewhere," he says. "So VCTs can get in there are get more bang for their buck this year."

Churchill recommends that investors find a financial adviser who is familiar with VCTs and EISs before getting involved. Not all financial advisers will know this market, so it's worth looking for those who have higher investment qualifications.

In order to find an adviser in your immediate area, go to www.unbiased.co.uk and tick the boxes for higher investment qualifications before carrying out your search.

For more information on VCT past performance, it's best to visit www.taxefficientreview.com.