It is common knowledge that investors benefit from a 30 per cent upfront income tax relief on investments that qualify for the Enterprise Investment Scheme and Venture Capital Trust rules. While these government-sponsored schemes may appear similar at first glance, in detail and application they typically have very different structures.
The EIS was established in 1994 as a way of supporting smaller companies by offering attractive tax relief on investment into these businesses. This was followed in 1996 by the launch of the VCT scheme.
HM Revenue & Customs operates an advanced assurance regime for both schemes, reassuring clients as to the qualifying status of their investment – application can be made to HMRC to determine whether the intended business plan and corporate structure of the relevant EIS/VCT investee company will meet the “qualifying company” requirements.
If HMRC approves the submission, then assurance is given that shares will qualify for their respective reliefs providing the business plan is followed and the corporate structure remains consistent with the original assurance obtained.
Comparing EIS and VCTs
1.Structure:
EIS shares qualify by company, and relief is usually given on a company-by-company basis. As such, clients will often be invested into a portfolio service which allows the manager to select what they consider to be the investee companies that most closely match their stated strategy. Each company is distinct, and capital is likely to be returned on a company-by-company basis. EIS companies are typically wound up by shareholder vote and are therefore extremely illiquid. Unlike VCTs there is no secondary market for EIS shares.
VCTs are London Stock Exchange-listed vehicles which pool investors’ capital and are reported on as an individual company, although they invest in a number of different underlying investments. Seventy per cent of a VCT’s total assets have to be allotted into qualifying investments, leaving up to 30 per cent which may be invested at the manager’s discretion; “non-qualifying” holdings might include listed equities, bonds or bespoke loans/investments. Care should be taken to understand the strategy for the “non-qualifying” portfolio as it can represent a relatively large portion of the VCT’s assets. VCTs have a maximum allocation of 15 per cent to any one company, which can offer better diversification than EIS portfolio services.
2. Contribution Levels
Income tax relief is available on investments of up to £1m each tax year for EIS-qualifying shares and up to £200,000 for VCTs. An investor can put more money in, but they will not benefit from income tax relief on the excess. While VCTs are listed entities that pool investors’ capital and might be considered more diversified, more transparent and lower-risk than their EIS single company counterparts, it is perhaps surprising that the EIS allowance is significantly higher.
Importantly, while EIS investors can carry-back their allowance to the previous tax year, the same carry-back is not available for VCT investors.
3.Tax Treatment:
In addition to the 30 per cent income tax relief up to the limits set out above, both VCT and EIS investors will also benefit from capital gains tax relief on any capital gain. However, that is as far as the similarities go regarding tax.
As well as income tax relief and an exemption on capital gains, VCTs benefit from tax-free dividends, which is valuable for clients seeking an income from their investment. It also enhances internal rates of return, as dividends can be reinvested into another investment sooner, rather than having to wait for a full realisation. According to LSE data, more than 60 VCTs are currently yielding more than 5 per cent a year. An investment that was subject to income tax would have to earn 8.33 per cent a year to equal a net-of-tax return of 5 per cent.
In contrast, EIS-qualifying investments do not benefit from tax-free dividends, but have the advantage of allowing tax payable on capital gains to be deferred. Another key consideration is that the overwhelming majority of EIS qualifying businesses also qualify for business property relief, and are therefore inheritance tax-efficient after a two-year holding period so long as the shares are also held at death.
A capital gain that was crystallised three calendar years before EIS share allotment, or one calendar year after share allotment can be deferred for as long as the EIS shares are held; this is not an exemption from tax but a deferral. However, if a rolling EIS strategy can be employed, then a capital gain can potentially be deferred until death. This, combined with the inheritance tax benefits of EIS, can make for very efficient estate planning.
4.Holding Period
The holding period in order to retain tax benefits for EIS shares is three years, and five years for VCT shares.
EIS shares have to be held for three years after being issued or three years after the date the EIS company started trading, whichever is later. In reality, this means it is likely to be at least four years before an EIS can return the investment to clients maintaining the tax benefits. Moreover, as shares in EIS-qualifying companies are likely to be illiquid and exits often rely on trade sales, it can take longer to secure a return of capital to investors. It may therefore be that the holding period for EIS shareholders is likely to be similar to that for VCT shareholders.
5.Tax Certificates
Another key differentiator is the turnaround time on certificates from HMRC required to claim tax reliefs. VCTs are given tax relief on the listed vehicle, not the underlying companies, allowing VCTs to issue tax certificates within weeks of share allotment. Certificates are required to claim income tax relief and, as such, the timing will have an impact on time-adjusted returns.
EIS companies must have been trading for at least four months before certificates can be applied for. With HMRC turnaround times increasing, receipt of certificates can be anywhere between six to 18 months after the EIS company begins trading.
6.Qualifying Investment Criteria
The criteria pertaining to both EIS and VCT-qualifying investments is very similar. Investee companies must not exceed 250 employees and gross assets of £15m. There is a £5m aggregate annual limit for funds raised which can benefit from state aid money, that is, EIS, VCT and seed enterprise investment schemes. Both schemes have qualifying criteria that exclude certain trades such as holding land, financial services, farming, forestry, shipbuilding and companies that benefit from government subsidies, such as feed-in tariffs on the more established renewable energy sources such as solar and wind.
EIS and VCTs differ considerably, and have different applications for advisers looking at clients’ tax-planning requirements, their desire to receive a running income versus capital, time horizon for investment, and attitude to risk and diversification. It is therefore very much a case of choosing the right horse for the right course.
Once all these factors have been carefully considered, the fundamental question remains as to the right underlying investment strategy for the chosen vehicle and whether the manager has a proven track record. There are a large number of different strategies available, ranging from investing in start-up, high-growth potential internet companies to investing in more established, cash-generating asset-backed investments which may not offer the potential for such high growth but might provide some level of downside protection should a business fail.
One thing is for certain: with the liberalisation of pension rules and the increasing and well-publicised focus of HMRC on aggressive tax-avoidance schemes, we can expect clients will be increasingly asking their advisers about which EIS and VCTs horses to back.
David Kaye is chief executive of Puma Investments
Key Points
Investors benefit from a 30 per cent up-front income tax relief on investments that qualify for the Enterprise Investment Scheme and Venture Capital Trust rules.
VCTs benefit from tax-free dividends, which is valuable for clients seeking an income from their investment.
A capital gain that was crystallised three calendar years before EIS share allotment or one calendar year after share allotment can be deferred.
