The appeal of specialist, venture-style investments is high at the moment, and becomes more so when layered with tax advantages. In the UK Enterprise Investment Schemes and Venture Capital Trusts are relatively accessible ways to play the alternative investments game. This article delves into the details.

This article examines a specialist area of the UK-based investment scene: those entities steering money into start-ups and young, fast-growing firms where there are significant tax breaks to magnify the appeal. Enterprise Investment Schemes and Venture Capital Trusts have been around now for over a quarter of a century, surviving Conservative, Labour and coalition administrations. In some ways these funds give investors a seat at the “private equity table” for a lot less than would be required to get into a conventional PE or venture capital fund. The sector for VCTs and EIS funds is still relatively small versus overall investment, and they carry certain risks that clients must be aware about. With more attention being driven towards PE as a sector – contrasting with the low yields on conventional listed equities – these structures are worth attention. 

In this article Susie Harris, head of business development at Parkwalk, a UK-based investment firm, talks about the pros and cons of these structures. The editors of this news service are pleased to share these views with readers and invite responses. The usual editorial disclaimers apply. To respond, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

Why EIS has so much to offer
Recent fund-raising figures have proven that VCTs continues to enjoy a solid place in a diversified client portfolio, with figures released by HM Revene & Customs in December showing a 33 per cent increase in income tax relief claimed via VCTs between the 2016/17 and 2017/18 tax years and VCT fundraising at its highest levels in over a decade.

HMRC and other industry commentators link this increase largely to the continuing impact of pension changes and investors’ need to find alternative means of saving tax-efficiently for retirement. But we seem to be ignoring the fact that an alternative solution to the VCT exists - and it’s one that comes with a much broader range of tax benefits and greater potential for real returns on investment: EIS.

The persistent perception that an EIS is riskier and therefore suitable for fewer investors thana  VCT ignores the wide-ranging benefits afforded by the structure and its natural position as a complementary planning mechanism.

Greater potential for upside returns; downside underwritten 
Whilst VCTs offer diversification across a greater number of underlying companies, this spread can limit upside potential for investors given the large portfolio. 

On the other hand EIS investors will typically be diversified across 5-15 companies, meaning that there is a greater proportion of their funds invested in each investee company and therefore greater potential for participation in successes. 

And whilst diversification within a VCT means it is often championed as the lower risk investment option, this ignores the fact that EIS investors are able to claim loss relief. 

For an additional rate taxpayer, this reduces potential exposure to loss to just 38.5 per cent of the original capital invested. The government is effectively underwriting a large chunk of the risk. 

A multi-purpose planning tool
Income tax, capital gains tax, inheritance tax: few investment structures tick as many planning boxes as an EIS and enjoy such flexibility around the application of these reliefs:

-- Income tax relief can be used in the year of investment or carried back to a prior year; 
-- Existing capital gains can be deferred indefinitely;
-- Gains within the EIS portfolio are free of CGT; 
-- Loss relief can be offset against income as well as capital gains; 
-- Once held for two years, EIS investments are free of IHT. 

All this is combined with much higher maximum investment limits over VCTs (particularly for Knowledge Intensive Companies).

Impact of combined EIS reliefs
Let’s take the example of a client selling a buy-to-let property with a £100,000 ($130,250) gain. If invested into an EIS, this gain not only results in £30,000 initial income tax relief but a deferral of the £28,000 CGT liability. This liability can be deferred indefinitely by reinvesting future proceeds back into EIS investments – gaining 30 per cent initial tax relief on each reinvestment. 

On the death of the client, the CGT dies with them. Given that EIS investments are IHT-free, this investment has therefore potentially benefited from: 30 per cent initial tax relief, 28 per cent CGT and 40 per cent IHT – a combined tax benefit of 98 per cent! 

Clearly the returns must justify the risk - and there is a risk that the EIS investment could fail leaving the investor with a crystallised CGT liability (albeit with loss relief available in the year of exit). But there are few instances where an advisor is able to deliver quite such a comprehensive list of benefits.

Timing EIS right
While there is a collection of EIS managers with good, relevant track records, delivering attractive growth returns, like everything in life, timing is important. The most credible EIS managers, by third party research scores, will be deploying capital over a 12 to 18-month period. 

That means, if you are considering using an EIS for CGT deferral purposes, this deployment lag needs to be factored into the three-year window to invest in an EIS after realisation of the gain. 

As an example, Parkwalk, set to be the largest EIS fund again in 2019/20, takes an average of 12 months fully to invest subscriptions. Despite this being one of the shortest deployment timeframes in the market, it means that any gains made before early 2018 are unlikely to be invested in EIS investments in time. 

Likewise, the earlier in the year that EIS subscriptions are made, the more will be available for carry-back to the prior year, which simplifies tax planning. So, if you can, don’t wait to have EIS conversations with clients. 

Given the continuing increase in IHT receipts since 2009, the record £9.2 billion in CGT receipts in 2018/19 and the fact that pension limits continue to bite, it is no wonder the EIS, as the only solution which addresses all of these issues, continues to play an increasingly important part in the tax planning process.