Tax break deals for the nervous investor

Small or, as they are optimistically termed, growing companies, can offer huge potential rewards to those who invest in them. But the risks are often so high ordinary retail investors would not touch them with a bargepole.

Small or, as they are optimistically termed, growing companies, can offer huge potential rewards to those who invest in them. But the risks are often so high ordinary retail investors would not touch them with a bargepole.

But there are two Government investment schemes offering tax breaks generous enough to calm the nerves of would-be investors - Enterprise Investment Schemes and Venture Capital Trusts.

Enterprise Investment Schemes, which replaced Business Expansion Schemes in 1994, offer 20 per cent tax relief to people making venture capital investments.This means that for every £100 you invest, £20 more is added by the Inland Revenue. And all the gains you make from the investment are free of capital gains tax, if the shares are held for at least five years.

If you make a loss on EIS shares, these losses are allowable for tax purposes, except for the part which relates to tax relief.

EISs are particularly good for anyone who has made a large capital gain, say, from selling a business. That gain can be deferred by re-investing the taxable element of it in an EIS company up to three years after the gain was made.

A company can qualify for EIS tax relief if it is unquoted and carries on a trade for at least three years from the time you invest. Firms specialising in EISs include Matrix and Close Brothers. EISs tend to be one-off investment opportunities which are typically open for two weeks to two months.

The minimum EIS investment is £500 and to get the full tax breaks, you must not invest more than £100,000 in any one tax year.

"Enterprise Investment Schemes are higher risk than VCTs," says Michael Aaron of independent financial advisers the David Aaron Partnership. "You need to accept that if things go wrong you could lose it all. If you're looking at it for the tax benefits, look at VCTs first."

VCTs are quoted investment trusts - collective investments run by managers who invest in the shares of smaller companies. This means they are less risky than EISs which depend on the fortunes of just one company.

The tax perks for Venture Capital Trusts are similar to those for EISs. Investments in VCTs attract tax relief at 20 per cent, as long as they are held for at least five years. Dividends are tax free, and the proceeds from the sale of shares is free of capital gains tax.

They, too, can be used to defer tax. If you buy shares in a VCT using the profit from another investment within a year of making it, you can defer the tax on it until you sell the VCT shares. But this deferral is available only if you are investing at the initial subscription of a VCT.

VCTs cannot invest in companies listed on the stock market, but they can hold shares quoted on the junior exchange - the Alternative Investment Market. At least 70 per cent of the investments they hold must be qualifying investments, generally meaning shares in unquoted companies or those on AIM.

Investors can buy shares in VCTs directly from the manager of the trust, or through a stockbroker. There are usually several VCTs on offer at any time, but investment groups tend to open VCTs for new subscriptions around the end of one tax year.

David Thorp of the British Venture Capital Association says VCTs have performed well as investments, partly because they tend to hold relatively high proportions of technology stocks. "In their first four years, VCTs have seen people being attracted by the tax relief, which is substantial. What is now becoming clear is that VCTs can perform as well as any investment trust."

So, he says, anyone prepared to invest in an investment trust should go into a VCT. "Not only do you make the same return, but you get these tax reliefs," he says.

But this does not mean VCTs are tame investments, says Tim Cockerill. "The risk is lower. But you can't get away from the fact that this type of trust is still at the higher-risk end of the market."

Though the tax breaks are good, advisers do not recommend anyone invests in a VCT for tax reasons alone. You should buy only if you consider the underlying investment is a good one, they say.

But unlike other collective investments, with a VCT it is hard to tell how your investment is performing during the first five years. This is because there is little demand for shares in VCTs past the initial subscription because the best tax breaks are at the start.

So how do you choose your new VCT? Mr Thorp says you should look at the investment policy of the particular trust, which will dictate the level of risk the manager is taking, and learn about the reputation of the manager.

Tim Cockerill, of Bristol-based IFAs CCK, says the ability of the fund manager is even more important than it is for the type of investment funds that stick to blue chips. "Fund managers need to be pretty switched on," he says. "It is a much more skilled job to find an unquoted company worth investing in."

The Allenbridge Group, independent performance analysts, rates VCTs in their Tax Shelter Report.

The British Venture Capital Association can provide information on particular VCTs: 0171 240 2846

CCK: 0117 9625679

David Aaron Partnership publishes a guide to VCTs: write to Shelton House, Woburn Sands, Milton Keynes, MK17 8SD

Allenbridge Group: 0171 409 1111, or see web site www.taxshelter-report.co.uk

Best Investment publishes guide to VCTs: 0171 321 0600