As awareness of the Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS) has grown in the past decade, these markets have doubled in size. We are currently mid-way through the ‘tax season’ of November to January for these types of investments.
In an environment where more and more clients are finding access to pensions restricted by both the Lifetime and Tapered Annual Allowances, VCTs offer an excellent alternative whilst EIS offer some attractive tax reliefs. Both VCT and EIS offer low correlation to mainstream, large-capitalisation markets and can add diversification to your portfolio but are investments that are high risk by nature.
EIS and VCTs are designed to encourage investment in small to medium size firms and their tax benefits compensate for the increased risk associated with investing in smaller, less liquid companies. So, a good investment manager needs lots of experience and expertise to spot real potential for success in a small business.
With a range of ‘time-limited’ VCT/EIS having just been launched, and capacity being in short supply, now could be the perfect time to invest for those able to absorb the high level of risk typically associated with this type of investment.
Each VCT and EIS has its individual investment approach, risk and return profile, so will suit different clients according to their needs and their risk appetite.
It is our job to consider your requirements and to match your investment objective to the type of product selected. The manager’s strategy and the structure of their product must fit your requirements, so they certainly aren’t for everyone.
For example, VCTs are sometimes mistakenly considered as being solely focused on achieving returns through capital growth, but in reality, many VCTs deliver regular income via tax-free dividend payments. Finding a VCT with an income profile matched to your requirements is crucial.
For example, clients considering a VCT as a supplementary pension planning tool may be better suited to a VCT with a track record of consistent dividend payments, especially the older investor. Whereas, younger clients who are less reliant on regular income might prefer something that offers the opportunity of some special, but less consistent, dividends.
One thing that is certain, is that experience and due diligence is critical when looking to invest in either the VCT or EIS sectors, something that HFMC Wealth is more than able to provide.
The background – More than £25 billion raised through these schemes
Both VCT and EIS are well established financial planning tools. EIS was launched in 1994. Over the last 25 years, 27,905 companies have received investment through the scheme, totalling more than £18 billion. The VCT story is similar. VCT began a year later, in 1995, and since then almost £7 billion has been raised.
It is estimated that in the last ten years alone investors have been able to secure more than £3 billion in tax relief.
The reliefs for VCT and EIS are similar in many respects, but there are some significant differences. The table below highlights the main reliefs for clients.
*there is no limit on CGT deferral
How might a VCT work for me?
When you buy a VCT, you are essentially buying shares in a company listed on the London Stock Exchange that invests in a range of qualifying investments.
You can invest up to £200,000 a year, and 30% income tax relief can be claimed back so long as an investment is held for five years. Any profits on disposal are free of Capital Gains Tax (‘CGT’).
A VCT is complementary to a pension, particularly if you are close to or in retirement.
What distinguishes VCT from EIS is that any dividends paid are completely tax-free. So, a VCT is often used in retirement planning when investors are seeking a regular tax-free yield.
As a listed vehicle they can also be held on a reporting platform for reporting purposes. This gives you the comfort of seeing a market quoted price.
One factor to remember is that VCT investments come with increased risk, which means they are typically held as a “satellite” holding alongside a “core” diversified portfolio for our clients.
The benefits of EIS
Enterprise Investment Schemes (EIS) are typically aimed at the knowledgeable investor with large capital gains on which they wish to defer tax and/or an income tax liability that they wish to reduce or eliminate and who wish to include some high-risk companies within their overall portfolio.
The limit for investments in EIS is five times more than VCT, at £1 million. If you invest in ‘knowledge-intensive’ companies that fulfil a set of government-approved guidelines, then the allowance doubles to £2 million.
You enjoy the same 30% income tax relief on your investments as a VCT and, some (or all) of that relief can be carried back to apply to earnings in the previous tax year. As with VCTs, all EIS gains are tax-free.
The benefits of EIS mean therefore that it can be useful if you have just sold a business or received a generous bonus and you’re facing a big capital gains or income tax bill. Alternatively, you may be disposing of some long-held assets and face a CGT bill. Gains on the disposal of EIS shares are generally exempt.
EIS money must be invested for only three years to qualify for these benefits (compared with five years for VCT), but you should expect to be invested longer as these investments are less liquid. EIS also offer two special additional benefits – loss relief and Inheritance Tax (‘IHT’) relief.
If any one of the companies in an EIS portfolio experiences a loss, then it is possible to offset this against taxable income in the year the loss occurs. It is also possible to carry it back to address income tax liabilities from the previous tax year. This is available even when the rest of the portfolio is in profit – so losses are not offset against gains. The loss can also be taken as a normal capital loss if preferred.
For additional-rate taxpayers, the combination of loss relief and income tax relief reduces the maximum risk of the underlying investment to just 38.5%, as there are potential total tax reliefs of 61.5% of the original investment.
EIS investments are also IHT-free after the shares have been held for two years. This makes them a valuable additional tool in IHT planning as they qualify as relevant business property. An EIS can also be useful in advance of gifting and setting up a Trust once held for 2 years as it qualifies as relevant Business property, which is exempt from IHT. This means that if a qualifying EIS is used to settle a discretionary trust then there is no immediate charge to IHT which is relevant for large amounts being settled into Trusts. The asset may subsequently be sold and reinvested within the Trust.
You should remember that you will have to wait for suitable exits for these companies – most likely when the business has grown sufficiently, and an appropriate buyer is identified (or when the company has a liquidity event.) As such EIS investments are not tradeable, so you should be comfortable with investing for the long term.
Who are these investments suitable for?
These types of investments are higher risk than the core portfolios that we offer. There are several scenarios in which tax mitigation investment planning solutions are helpful. We typically vie
w these as short to medium term planning tools until your personal tax situation has improved and funds can be re-deployed as part of more standard financial planning.
Some of these scenarios include but are not limited to:
- If you are subject to a 45% income tax charge, you may benefit from using VCTs and EIS to reduce your income tax liability.
- When execution of your financial planning advice requires disposal of assets which are subject to significant capital gains, you may benefit from a portfolio of EIS qualifying investments to defer some of these gains while also benefiting from income tax relief and potential Business Relief (‘BR’). (Whilst this is definitely a positive reason historically used for EIS we would not generally recommend the use of CGT deferral for EIS unless there is an immediate cash flow issue. This is because we consider CGT rates to be at a historically low level and because of the possibility of increases to CGT rates in future that could lead to an increased liability.)
- When execution of your financial planning advice requires disposal of offshore and/or onshore bonds or extracting value from SIPPS which are subject to income tax charges, you may benefit from a portfolio of VCT and/or EIS qualifying investments to mitigate some of these charges.
- Entrepreneurs who have sold their company may benefit from using a portfolio of BR and/or EIS qualifying investments to defer capital gains over and above their entrepreneur’s relief allowance. If the company previously qualified for Business Relief, you may benefit from rollover relief without having to restart to minimum two-year holding period.
- Entrepreneurs who wish to extract value from their business but are no longer capable of funding their pension may wish to consider using EIS investments to mitigate some of the reclaimable income tax charge on their dividends.
Why mention them now?
While we do recommend some ‘evergreen’ VCT and EIS investments which accept funds all year round, many of these types of investment have a limited investment window, with most fund raises taking place between November and January.
It is possible to invest in VCT and EIS in the same year, and so now could be a great time to consider this type of investment as opportunities are currently available.
To find out more information about VCT or EIS investments, please get in touch with your adviser, send us a message via hfmcwealth.com or call us on 020 7400 4700.