Financial seedcorn that can reap a good harvest

Each is a quoted company and rather like an investment trust in

concept. At least 70 per cent of the underlying finance must be invested in a spread of unquoted trading firms within three years and the balance kept in cash.

The term 'unquoted' curiously includes businesses quoted on the Alternative Investment Market. The 70 per cent excludes property investment companies, dealing in commodities, banks, insurance companies, hotels and care homes.

To provide seedcorn, a venture capital trust (VCT) can invest no more than 1m in each company each year and no more than 15 per cent of its assets in any one firm.

For a firm to qualify for VCT money, it must employ fewer than 50 full-time equivalent staff and have gross assets of less than 7m before the investment.

For an investor, there are several key benefits:

n immediate income tax relief of 30 per cent on up to 200,000 annually (reduced from 40 per cent available in 2004/05 and 2005/06) for those aged 18 years plus;

n dividends are exempt from income tax;

n shares bought within the annual limit are exempt from capital gains tax although losses on disposal are not allowable as capital losses.

To gain these tax advantages, shares must be held for at least five years although the period used to be just three years.

With a new income tax level of 50 per cent from next month, many investors like the tax appeal of venture capital trusts (or VCTs). To claim income tax relief, instead of waiting until the end of the tax year in which the investment is made, you can send in your certificate to the tax office and gain relief immediately by adjusting your tax code.

Unlike an ordinary investment trust, capital gains on a VCT's underlying investments are free of corporation tax and such gains may be distributed to investors as dividends.

One of the key reasons for holding a VCT is to gain substantially more than the pension alternative. From 2010 complex rules introduced in last year's Budget mean that high earners could receive as little as 20 per cent income tax relief on additional pension contributions and potentially as much as 50 per cent on income at retirement after their initial tax-free lump sum.

However, it's vital to choose your VCT on its merits rather than simply for their tax savings appeal. "It's worth remembering the old adage that the tax tail should not be allowed to wag the investment dog," warns Annabel Brodie-Smith from the Association of Investment Companies.

"There is a resurgence of interest in VCTs this tax year and I expect demand to be around 250m, which would be an increase of about 70 per cent on last tax year," says Martin Churchill, editor of Tax Efficient Review.

Such a rise is for three reasons: the initial tax break has allowed the performance of most VCTs to weather the credit crunch, a realisation that successful ones are producing a respectable annual tax-free income stream and the appeal of tax relief to high earners following the hike in income tax and pension changes.

By saving in a VCT, you will gain investment exposure to an asset class you might not otherwise be able to access. Select your VCT through an independent financial adviser who is familiar with the different categories and who can consult on the differing risk/reward factors.

There are broadly two types of VCT saver:

n long-term investor of seven to 10 years looking for growth potential with dividend income from a private equity portfolio and low risk;

n short-term tax break saver (up to six years) who has no interest in the underlying spread of companies but wants hedge funds or structured products to create the returns and accepts a fair degree of risk.

Taking the risk factor into account, it is probably advisable that VCTs take up no more than 10 per cent of an investor's stock market money and the same percentage in a pension pot. As with any saving, it makes sense to spread it between different providers and look for alternative management strategies, meaning both specialist and generalist VCTs.

Using a VCT for retirement planning makes sense. If this is your primary need, look for one with a history of paying a good level of dividends or one intending to offer a strong dividend.

Most advisers see VCTs as useful complementary vehicles to pensions, rather than as a direct replacement.

For a well-diversified exposure, Baronsmead 3 and 4 VCTs "have relatively strong track records over a long term period, having been established in 2001," tips Martin Payne, director at Leeds-based stockbrokers Brewin Dolphin.

The two trusts have increased by 59 per cent and 37 per cent respectively since launch. Baronsmead have been running VCTs since 1995 and hold over 200m under management in five funds.

Those looking for a yield of five per cent plus should consider Northern 3 VCT, which has some 22m invested in a relatively well-diversified group of around 40 companies. It is trading at around 16 per cent discount to asset value.

A 25 per cent discount to asset value and no gearing or borrowing is the position with Ingenious Entertainment 1 VCT, which is a specialist trust which invests in festivals, concerts, conferences and sporting events.

For one which invests in loans to small firms such as hotels, pubs, gyms and nurseries, look at Downing Absolute Income VCT. It pays around four per cent and trades at a 11 per cent discount.

One of the factors to consider is that VCTs are illiquid investments. Access to money is restricted by the rules. Ask your adviser what arrangements are in place to leave a VCT.

VCTs are listed on the London Stock Exchange and their shares are traded like those of any other company. A stockbroker will be happy to act for you but, in addition, VCT managers may offer an exit route.

Taking a five year view to the end of January, 100 jumped to 189.27 with ProVen Health VCT, 144.10 with Maven Income & Growth VCT – both generalist funds – and 130.76 with Foresight 4VCT and 128.33 with Foresight 3 VCT – both technology specialist funds, according to AIC research.

These are the top performers.

Attracted by the tax relief and dividends

Linda Wilkinson, from North Ferriby, near Hull, has invested in several venture capital trusts. She used to run an IT company and when she sold it in May 2007, she decided to put up to 10 per cent in the VCT sector.

Her original attraction to a VCT was the tax relief offered but then noticed the appealing good dividend stream, which pays 4-5 per cent currently. She was introduced to VCTs by the private client side of HSBC.

Foresight VCT was her first purchase with 50,000, followed by Albion Ventures, where she has invested 100,000. Her aim is to hold the investments for the long term. Albion's strategy is to pay consistent dividends. As a result their shares are traded 10 times more than any other VCT manager.

If Linda decided to sell, there are two exits available: either to sell to the manager as a 'buy back' or on the open market through a stockbroker.