Madeleine Ingram, Head of Investor Relations at Calculus Capital looks at the pros and the cons of both venture capital trusts (VCTs) and enterprise investment schemes (EISs) for What Investment magazine.
In the past 10 years the VCT and EIS markets have doubled in size as awareness of them has grown and the amount investors can save into pensions has been squeezed.
Both schemes were designed with the intention of directing private risk capital into small UK businesses and helping the British economy grow, so might be considered patriotic investments.
Benefits of both
Both offer attractive tax benefits and low correlation to mainstream, large-cap markets (like the FTSE 100), so can be attractive to investors who are looking to reduce tax bills, build diversification into their portfolios and are comfortable with the risks involved.
VCTs and EISs are particularly useful for higher-rate taxpayers looking to reduce their income tax bill. They can help investors who want to save for retirement tax efficiently but have used all their pension contribution allowances or who may be close to breaching their pensions lifetime allowance.
Despite these similarities, they each have some distinct features that may make one more suited than the other for individual investors.
VCT – ‘income, income and more income’
When you buy a VCT you are essentially buying shares in an LSE-listed company that invests in a range of qualifying investments. You can invest £200,000 each year into VCTs and claim back 30% income tax relief on that investment, though you must hold the investment for five years. Any profits on disposal are free of capital gains tax (CGT). What makes VCTs special is that any dividends they pay are completely tax free. This makes them particularly useful for those looking to generate extra income without increasing their tax bill. VCT benefits in short:
– Up-front income tax relief of 30% on up to £200,000 worth of VCT investment as long as held for at least five years.
– No CGT payable on disposal of shares.
– No income tax payable on dividends.
EIS – ‘a capital growth investment, or something to pass on’
You can invest up to £1m a tax year in an EIS (compared to £200,000 for VCTs) and still enjoy 30% income tax relief on your investment as long as the shares are held for at least three years. Some, or all, of that tax relief can also be carried back a year to apply to earnings in the previous tax year (which it cannot with VCTs). If you invest in ‘knowledge-intensive’ companies that fulfil a set of government-approved guidelines the limits double to £2m.
As with VCTs, EIS gains are free of CGT but you also have the ability to defer a capital gains liability.
This means EISs can be especially helpful if you have just sold a business or received a generous bonus (or are about to) and are facing a big capital gains or income tax bill.
Though you only have to be invested for three years to qualify for these benefits, you will probably find you are invested longer. Many investors prefer to invest in a professionally managed EIS fund that itself will invest in a portfolio of perhaps six to eight qualifying companies.
You then have to wait for suitable exits for these companies – for instance, when the business has grown sufficiently and an appropriate buyer has been identified, or the company has listed on the AIM.
EISs are not tradeable, so investors should be comfortable with a long-term investment horizon.
Unlike VCTs, EISs do not offer tax-free dividends, so the investments are focused on generating long-term growth rather than offering a regular yield. EISs can be a little more cumbersome administratively — requiring certification for each company investment and more paperwork than VCTs but they do offer special extra benefits.
A key one is loss relief, where if any one of the companies in an EIS portfolio experiences a loss it is possible to offset that loss against taxable income in the year the loss occurs or even carry back to address income tax liabilities from the previous tax year. This is available even when the rest of the portfolio is in profit. The loss can also be taken as a normal capital loss if preferred.
This helps reduce the risk of the underlying investment. Another distinct benefit is that EIS investments are free of Inheritance Tax (IHT) liabilities after they have been held for more than two years, so while they may not be suitable for those looking for income in retirement, they can be valuable for those investors with IHT challenges and the appropriate risk appetite.
EIS benefits in short:
– Income tax relief of 30% on up to £1m worth of EIS investments as long as held for at least three years (£2m for “knowledge intensive” EIS investments)
– No CGT payable on exit.
– Loss relief available.
– IHT free after two years.
– CGT deferral.
The choice is yours
Now in their third decade of existence, VCTs and EISs have something to offer a diverse range of investors. Each carries risk, but each also comes with generous tax benefits. For investors who have exhausted their more traditional savings routes, these can be valuable. Tax planning can be complicated and we believe it is always worth taking professional financial advice before investing.