Enterprise investment schemes explained
There’s no doubt that Isas and pensions are tax-efficient homes for your cash, but there are other investments that can keep the taxman at bay.
Step forward enterprise investment schemes (EISs). They have risen to prominence since the government increased the rate of income tax relief from 20 to 30 per cent, and the annual EIS investment limit for individuals from £500,000 to £1 million.
But what are they? EISs are a tax-efficient way to invest in the new shares of small businesses, as well as giving much-needed capital to businesses that cannot get funding from traditional methods like the banks. The schemes offer investors significant benefits: investors who invest for a minimum period of three years benefit from 30 per cent tax relief as well as exemption from capital gains tax (CGT) and inheritance tax (IHT) – more on that later – which means growth within the EIS is tax-free.
In essence, EISs are unquoted companies and not listed on an exchange. There are several ways to invest, either in single companies, or a collective investment such as an EIS fund. Typically, they will be managed by a venture capitalist and will focus on growth and capital preservation for the investor.
‘We’ve been managing EIS funds for 13 years, but now is the real sweet-spot for EIS investment,’ according to Susan McDonald, chairman of EIS specialist Calculus Capital. ‘Companies are investment-driven and they have large amounts of cash. There are lots of EIS companies out there having a very difficult time raising capital, and now banks are unwilling to lend, it leaves few options for qualifying companies.’
McDonald says she is seeing more and more companies with very compelling entry-level valuations. ‘Economic difficulties have created a very good environment for EISs,’ she says.
Adding that schemes now offer ‘phenomenally generous’ tax breaks, McDonald believes that while EISs might have been considered high-risk in the past, they are now ‘very palatable’ for investors.
EIS schemes are also useful for IHT planning, as investments in EISs fall out of your estate after only two years.
Seed enterprise investment schemes
The seed enterprise investment scheme (SEIS) is a smaller version of EISs, offering an even bigger tax break. By committing cash to SEISs for three years, the investor benefits from a 50 per cent income tax break.
Launched in 2012, SEISs give tax breaks to individuals investing up to £100,000 in qualifying companies.
HOW THE SEIS TAX BREAKS WORK IN THE 2013-14 TAX YEAR
Invest £1,000 and HMRC will give you £500 back on your tax return. On top of this, if you sell another investment that would be liable for CGT, you can write off half the CGT you would have otherwise paid. That means a £1,000 investment in a SEIS-eligible start-up attracts 64 per cent tax relief just for making the investment (in the 2012-13 tax year it was 78 per cent).
When investors hold the shares for three years, and the company continues to comply with SEIS rules, reliefs are also available on disposal. If you sell at a profit, you pay no capital gains tax. If you sell at a loss, you can claim loss relief, which means that if you are a 45 per cent rate taxpayer, you would be entitled to a further 22.5 per cent off your tax bill.
Add together the 64 per cent total upfront relief and 22.5 per cent loss relief, and the total tax break comes to 86.5 per cent of your investment – which is quite generous downside protection.
Things to be wary of
As EISs are not traded on an exchange, they can be illiquid. In addition, they must be held for a minimum of three years to benefit from income tax relief, so they can be quite inflexible. Capital is only returned when the underlying investment is sold, so should only be considered by individuals who can afford to lock money away for longer periods of time.
In addition, unlike other asset classes, there is no secondary market for EISs and you will not be able to sell it easily. Dependent on the investments in the EIS, your money could be tied up for a considerable length of time before you start to see a return, especially if you invest in start-up businesses.
As a priority, Dennis Hall, founder of IFA Yellowtail Financial Planning, says investors should look for providers with the expertise and skill to recognise good businesses and those who focus on the quality of investment opportunity.
‘Recent changes to the EIS rules have made them increasingly attractive from a tax perspective, but too many companies are devising opaque and esoteric funds to exploit the tax opportunities without enough understanding of the underlying investments,’ Hall adds.
‘For wealthier clients EISs are very attractive but you have to choose the provider carefully. EIS investing also has to be part of a broader wealth strategy and should really encompass the micro-investment end of asset allocation within a portfolio.’
Patrick Connolly, chartered financial planner at AWD Chase de Vere, warns against looking at the tax incentive alone.
‘The value of somebody’s investment could fall significantly and they might not be able to get their money back when they want it,’ he says.
‘An EIS investment is not appropriate for most people. It is most suitable for wealthier investors who have used their annual Isa and pension allowances and who understand and are willing to accept the high risks involved.
‘A real danger, however, is that other investors will select EISs because of the tax breaks without fully understanding the investment risks. This could be a decision they come to regret.’
‘In reality only investors who can afford to lose all of their invested capital should consider EIS schemes,’ warns Gordon Kearney, director of Fiducia Wealth Management. ‘EISs are most suited to clients searching for complex tax planning solutions, whether they are looking to defer a large capital gains tax liability or reduce inheritance tax liabilities.’
Julie Lord, certified and chartered financial planner at Bluefin, sums it up neatly: ‘Don’t take the risk if the investment doesn’t stack up. If the EIS fails, the tax breaks aren’t worth it.’