Strategic options to aid tax planning

Starting in 1994, the EIS market has now reached a level of investment subscriptions of more than £600m a year, with more than £7.7bn has been invested since 1994.

While the scheme was established as a way of providing support and funding for smaller companies, it is the generous tax breaks that accompany an investment that make them attractive for investors and advisers alike.

It is important to note, however, that EIS investments represent a significantly higher level of risk as they involve taking long-term equity stakes in smaller companies. Investors also have to be able to commit to investing into an EIS for a minimum of three years, and preferably need to look at an EIS with a minimum five-year horizon.

Anyone considering whether an investment into an EIS is suitable for them should seek advice from their independent financial adviser.

That said, the tax benefits that come with an EIS do make them an attractive tool for sophisticated investors seeking ways of increasing their tax efficiency. With the 30 per cent income tax relief available to UK taxpayers on EIS investments of up to £1m per year, the most common usage for a client is likely to be as a tool for reducing an income tax bill.

They can also be used to defer capital gains tax liabilities, but this is only a deferral and not an exemption.

With the recent rises in UK house prices (up on average by 30 per cent during the past five years), coupled with the freezing of the inheritance tax (IHT) nil-rate band at £325,000 until April 2019, it is the eligibility for EIS investments to qualify for business property relief (BPR) after two years that is becoming increasingly attractive to investors.

The advantages of holding BPR-qualifying investments for IHT planning are twofold. First, after two years the investment should qualify for BPR and should therefore be exempt from IHT, as opposed to seven years if a gift is made.

Second, the individual retains control of their investment from day one. The investment still needs to be held for at least two years at the point of death, but the client is free to sell their investments, or they can move them from one BPR scheme to another without the two-year clock restarting.

EIS investments will become even more salient when the ability for investors to make large withdrawals from their pension pots comes into effect in April 2015. Many investors welcome the newfound freedom that comes with flexible drawdown, but any withdrawals from a pension could trigger a significant income tax bill. So the 30 per cent income tax relief available on an EIS investment would help to soften this blow.

Then after two years, the EIS investment should qualify for IHT relief under BPR, which would not have been the case if the money had remained within the pension. But again, it is important to seek advice, particularly when it comes to pension withdrawals.

EIS investments are not the only method of investment to take advantage of BPR. Another option to consider is investing in the Alternative Investment Market (Aim).

Investors should be aware of higher levels of volatility within Aim and its capacity for large falls in value in times of stress in equity markets. The fact that there is a listed price for Aim stocks does provide a higher degree of liquidity, particularly when the market is rising. It can also be argued that the Aim market has reached a greater level of maturity given the companies trading on it and many product providers offer collective portfolios of Aim stocks, with initial investments from £15,000.

Some investment managers operate investments in unquoted companies carrying out a BPR-qualifying trade. These can offer a lower level of volatility and potentially more predictable returns.

Product providers offer many options in this space but there are some considerations financial planners should bear in mind – principally, what the underlying businesses are, the transparency of the structure and how much the underlying costs to the investor might be.

Tax planning is a complex and sometimes emotive subject. These strategies are just some of the avenues open to investors and they each have their pros and cons. If a client’s portfolio is of a size that allows it, diversifying across two or more such strategies is always a recommended course of action.

Hugh Rogers is business development director at Puma Investments

EIS market: key figures

£7.7bn

Amount invested in EIS since 1994

30%

The income tax relief available to UK tax payers on EIS investments up to £1m a year

£325,000

The amount at which the inheritance tax nil-rate band is frozen until April 2019

ADVISER VIEWS

Jonothan McColgan, Combined Financial Strategies

Enterprise investment schemes (EIS) are fantastic vehicles for a very niche market of clients who want to achieve 30 per cent income tax relief, defer capital gains tax and benefit from business asset taper relief to save potential inheritance tax (IHT).

However, a number of changes to legislation through the years have reduced these benefits. So demand for EIS has really fallen over the last five years.

I would now only consider using EIS where clients are basic-rate taxpayers with high-risk profiles, as they will get better tax relief at 30 per cent in the EIS, rather than 20 per cent in a pension; where clients need to save income tax from the previous tax year and pension input periods cannot be used to do so; where clients want to have an investment that is exempt from IHT after two years.

AJ Somal, Aurora Financial Planning

I would only consider EIS investments for the sophisticated high net worth investor who has used up all available pension and ISA allowances for the tax year.

An EIS could be used as part of a wider, diversified portfolio for the sophisticated investor with a suitable capacity for loss, but it would only represent a small proportion of a suitable client’s portfolio.