Tax? No thanks. I'm investing in VCTs...

Most investors in VCTs buy them new. They subscribe to new issues in the VCT season just before the end of the tax year, so that they can offset this year's income tax against the amount of the subscription.

But in fact, VCTs also offer long term tax advantages since no tax is payable on either the income from dividends or any capital gains made on a VCT - whether you bought it new or 'second hand' through a broker. 

I'm going to be relying on my investment income to fund my lifestyle for the next couple of years and quite a number of VCTs showed up as possible yield machines. They are also, most of them, available at quite significant discounts to net assets, though of course it has to be said these assets are mainly shares in privately held companies, so not as easy to value or as reliably valued as the more liquid quoted shares in which plain vanilla investment trusts tend to invest.

Not all VCTs are created equal - some investment houses have better records than others. Northern seems to be regarded by many as one of the better investment managers and has a good record, so I started by looking at shares in three of their VCTs; Northern Venture Trust (LON:NVT), Northern 3 Vct (LON:NTN) and Northern 2 Vct (LON:NTV) .

All three are quoted on discounts of 15% or so - quite some way above the average for investment trusts - while offering yields of between 5 and 11 percent. That looks very tempting, so I ran an eye over the annual reports. The spread of investments looks reasonable, offering good diversification, and maturing investments have enabled the funds to free up funds (which can then be paid out as dividends). The only fly in the ointment is that the portfolios of all three trusts look fairly similar, so you won't get much diversification by buying all three of them.

I also checked out the dividend history; all three funds appear to be regular payers and keeping their payouts reasonably level (though Northern Venture Trust (LON:NVT) missed the final payment last year, it had two interim payments). That's quite important, since some VCTs that appear to have high yields are affected by major one-off asset sales.

To explain this we need to look at the history of the VCT. These trusts were for some years used as a device for deferring Capital Gains Tax liabilities, and therefore many of them put a high priority on returning funds to shareholders, rather than growing the net asset value. If a VCT sells one of its best performing investments, quite often the majority of the gain will be paid out to shareholders as a dividend, so that the dividend history can be quite uneven, compared to the more regular progression of dividends from a trading company or a regular investment fund. 

This can make the numbers misleading. For instance, a fund might pay out 10.6% this year and nothing next year. Equally, if it is coming towards the end of its expected life, the company may be selling most of its assets and paying them out as dividends, so that the apparent high yield is actually a running down of the fund.

I also checked out VCTs from two other well regarded houses, Foresight and Baronsmead. None of the Foresight funds is currently producing a better yield than 5.9% - that's Foresight 3 Vct (LON:FTD), which trades on a 14% discount to net assets, and is the cheapest of the stable. (Bear in mind though that's 5.9% with no tax, so it equates to 9.8% for a 40% taxpayer.)

The Baronsmead bunch are all producing yields around 8%, with discounts to net assets of about 8% as well. So the discount is pretty tight, but the yield is good, and as with Northern, the stream of dividends in the past has been pretty reliable. 

Now for the caveats. Secondhand VCTs can be quite tricky to buy and the spread can be quite large (so you might have to take a yield a few points lower than what I've indicated here). And since most investors are only interested in the up-front tax breaks, there's a limited market for secondhand VCTs if you want to sell. (Some houses are now providing a buy-back service in order to help protect the share price.)

However, as long term dividend income machines, I think mature VCTs offer a lot of attractions, not least the fact that just like ISAs, you don't need to put anything about them on your tax form. My one major concern would be that as capital return vehicles, eventually they will run down and be wound up - many VCTs are now being offered on a 'protected exit' basis with a view to liquidation in six years. Time to get digging among the annual reports again, I think!