VCT and EIS: Tax efficient ways to invest in start-ups
What are Enterprise Investment Schemes (EISs) and Venture Capital Trusts (VCTs)?
EISs and VCTs were introduced by the government in 1994 and 1995 respectively to encourage investment into early stage and new companies.
The thought behind them was to raise private capital for smaller companies in order to stimulate the economy, as the smallest 2% of companies generated about 30% of the growth.
Essentially, they’re tax efficient ways to invest in small and dynamic UK companies but they’re not tax avoidance or loophole schemes.
While they look and feel very similar to each other, there are important differences.
VCTs are run by a fund manager who invests in small companies, which are either unquoted or listed on the Alternative Investment Market (AIM).
In contrast, EIS investments are held directly by the individual who is investing so it’s fair to say that they’re a bit more complicated than a VCT.
The investments may be subject to initial and ongoing fees, including administration fees and an annual management charge.
What are the benefits of each?
With both EISs and VCTs, there are a number of ways investors can benefit from tax-relief:
- Income tax relief of 30% on investments of up to £200k in any tax year, although investors must hold the VCTs for a minimum of five years. The minimum investment is usually £5,000.
- The dividends earned from VCTs are tax-free and do not need to be declared on a tax return.
- Growth in value of VCT shares is capital gains tax free.
- Income tax relief of 30% on investments of up to £1m in any tax year, including up to £1m backdated to the previous tax year.
- 100% capital gains tax deferral for the life of the investment.
- 100% inheritance tax relief after two years (provided their still held at time of death).
- Growth in value of EIS is capital gains tax free.
- Investor can claim back ‘loss relief’ if it falls to below the effective cost of the investment.
Who are they aimed at?
Paul Latham, managing director of Octopus Investments, the largest provider of VCTs in the UK according to the Association of Investment Companies (Oct 2014) and the largest provider of EISs in the UK according to Tax Efficient Review 2014, says they can prove to be a valuable planning tool and are often considered by those looking for investments capable of generating additional income, or to complement existing retirement plans.
“High earners, business owners, landlords and those in pension drawdown could also benefit from VCTs. Many VCT investors use a financial adviser, because VCTs are not for everyone, and should be considered in the context of a whole portfolio. They should be considered high risk investments,” he says.
And of EISs he says they’re only appropriate for investors with the appropriate risk appetite.
“Investors with capital gains are among those who could benefit, as an EIS can be used to defer or eliminate paying tax following the sale of shares or property that has triggered a capital gains liability. Investors meanwhile can use an EIS to offset the income tax liability created by surrendering their investment bonds.”
He adds that those approaching their lifetime allowance could consider EIS as an alternative, while income tax relief can also be used to offset the tax paid on pension incomes for those already in pension drawdown.
He also notes that landlords can benefit because EIS income tax relief can be offset against earnings from property, while for business owners, it offers a way of extracting profit from a business tax-efficiently, by using income tax relief to offset the liability created.
They are high risk investments so what should investors look for in new start-ups?
Latham gives the following five tips:
- Take financial advice: A financial adviser can provide an assessment of your current financial situation and what it’s likely to look like in the future, and advise on what steps to take to meet your long-term financial goals. If you do use an adviser, you may want to select a VCT that can facilitate paying your fee to them as this is easier and more tax-efficient for you.
- Consider the risks: VCTs and EISs should be regarded as high risk as they invest in early-stage companies so you may not get back the full amount put in. For this reason, the government offers tax reliefs as an incentive. For those products that do well, they have the potential for significant returns. Shares of smaller companies and VCT shares may be more volatile than those listed on the main London Stock Exchange market, and may also be harder to sell.
- Check performance tables: Check performance tables from reputable sources in order to select those managers who have proven, over the long-term, they have a good track record of managing VCT and EIS investments. However, past performance is no indication of future success. You may also wish to consider the size of the VCT fund – larger VCTs can mean you are buying into a well-established, diversified portfolio of investments.
- Check liquidity: At some point you’ll want to sell your shares. Does the manager have a stated policy of buying back VCT shares? Some will reduce your proceeds by 10%, or perhaps more. With EIS, does the manager have a good previous track record of providing an exit route in a timely way?
- Ask around and act quickly: Ask people about the service they receive, whether they are provided with regular and clear communications and whether they would recommend them to you. Also, there may be more demand for VCT and EIS funds this year than there will be supply. The best products are already raising significant amounts so don’t wait too long.
Key stats for investors
- £435m raised in 2014/15 – this is the fourth highest total ever (source HMRC, September 2015)
- VCTs paid out £240m in dividends during 2014-15 – a record (source AIC, April 2015)
- Since VCTs launched in 1995, £3.46bn has been invested (source AIC, April 2015)
- Since VCTs launched, they’ve raised nearly £6bn of funds (source HMRC, September 2015)
- Since EISs launched in 1994, £12.3bn has been invested (source HMRC, October 2015)
- 2,795 companies raised a total of £1,56bn of funds in 2013/14 (source, HMRC, January 2016)