Advantages and disadvantages of EIS and VCTs

EIS came first - launched in 1993 to 1994 - as a way for sophisticated investors to help fund small UK companies.

Many years later, in 2012, chancellor George Osborne announced the creation of the Seed EIS. In his Budget at the time, he said this would help entrepreneurs receive funding to do start-ups, which would come with tax breaks to encourage investors who might otherwise perceive such entry-level investment as too risky.

Have these investments proved popular? According to the EIS Association, since the launch of EIS in 1993 to 1994, more than 24,500 individual companies have received investment through the scheme.

VCTs started life in 1995, when the then Conservative government offered tax breaks to encourage people to invest in early-stage UK companies.

According to the Association of Investment Companies (AIC), which covers VCTs, there are three main types of VCT, although the management styles of each can vary. The three types are:

■ Generalist (which covers private equity including development capital).

■ Alternative Investment Market.

■ Specialist sectors, for example technology or healthcare.

But what initially started out as high-net worth, sophisticated investment schemes have now become more attractive to the mass affluent investor seeking different, tax-incentivised ways to save.

Advantages of VCTs

Before looking at the tax advantages, the AIC points out that VCTs employ a professional fund manager to make the day-to-day investment decisions, which means the individual does not have to do the legwork.

VCTs are provided with significant tax features to incentivise investors and this is really what attracts people to them Jason Hollands

On VCTs, according to HM Revenue & Customs, the tax reliefs available to investors are:

■ Income tax relief – individual shareholders aged 18 plus can claim income tax relief at the rate of 30 per cent of up to £200,000 annual investment, provided their shares are held for at least five years.

■ Dividends - no income tax is payable on dividends from ordinary shares in VCTs.

■ Capital gains tax (CGT) - No CGT is payable on disposals by individuals of ordinary shares in VCTs.

As Ben Thompson, group marketing director for the Foresight Group, explains: “VCTs provide access to tax-free income in the form of dividends, with no tax to pay regardless of the marginal rate of tax for the investor.

“Given the recent changes in dividend taxation [from April 2016, headline rates changed and there was a new dividend allowance] this area will become more attractive for a broader range of investors.”

“VCTs are diversified, managed portfolios, with clear similarities to investment trusts”, says Jason Hollands, managing director of business development and communications for Tilney Bestinvest.

“Given the higher risk of the qualifying investments in VCTs, these are provided with significant tax features to incentivise investors and this is really what attracts people to them.

“For example, there is a 30 per cent income tax credit when investing in a VCT new share issue.

“In other words, a £10,000 investment attracts a £3,000 rebate off your income tax bill, so even if you only got your original £10,000 back at the end, with the tax relief you’d have effectively made a 43 per cent tax-free return.”

Add to this many VCTs have a focus on returning cash to shareholders through the mechanism of tax-free dividends, and it is clear these can help to provide income for investors.

Mr Thompson adds the administration of VCTs is quite simple, as it generates one tax certificate with which tax can be claimed.

Disadvantages of VCTs

Although the tax relief and the ability to invest in the next generation of UK business giants, there are some disadvantages to EIS and VCT investment.

For example, according to a spokesman for the AIC, VCTs “invest mainly in a specific type of company – small companies with high potential for growth that need some financial support”.

Because of this, they are not investing in well-established public companies with a long track record and therefore, according to the AIC, “may be higher risk than conventional investment companies given the companies they invest in.

“The value of the underlying investments of a VCT can be uncertain, as they are often unquoted investments that do not have a readily available market price.

“Also, it can be difficult to sell VCT shares on the secondary market, although some VCTs offer a ‘buy-back’ facility”.

However, as Paul Sheehan, investment manager for WH Ireland explains, the fact the investments are packaged within a VCT structure does allow some flexibility for investors.

He says: “VCTs are listed on the London Stock Exchange so therefore potentially provide an investor with the ability to sell their shares if required, although they forefeit the tax benefits.”

Contributors to this guide agree VCTs should be viewed as long-term investments, and investors should not opt for one simply for the tax benefits. And, as always, professional advice is a must.

Advantages of EIS

EIS tax benefits, according to HMRC, are:

Foresight’s Mr Thompson says: “EIS, in addition to reducing income tax from a range of sources, also offer the ability to defer CGT and benefit from an IHT exemption after two years.

“Where CGT is deferred, the taxable gain can be reduced through the withdrawal of the annual CGT allowance, year on year.

“Where an investor dies holding a deferred gain in EIS, the capital gain and tax liability dies with them, meaning in many cases the investment can be passed to beneficiaries free of all taxes.”

But apart from the generous tax reliefs, there are other advantages to EIS. John Glencross, chief executive of Calculus Capital, says: “A major incentive and benefit is it allows investors to access a unique asset class - small, unquoted companies - to which it can be otherwise difficult to gain exposure.

“Unlisted companies tend to have low correlation to mainstream equity markets, so can be a good source of portfolio diversification.”

Considerable expertise, experience, research, capability and specialist skills are required to successfully undertake investing in EIS John Glencross

HMRC’s involvement is another advantage, as Mark Brownridge, head of Mazars’ research and development team, explains: “EIS has the added advantage that all providers must submit their business plans to HMRC before they can start to raise money from investors.”

According to Mr Brownridge, who is to become the EIS Association’s director-general in August, this means: “The system, called Advance Assurance, should give investors comfort the EIS they are investing in will receive tax relief. This is a unique feature of EIS.”

Disadvantages of EIS

The risks and rewards of EIS are similar to those of VCTs, but could expose the investor to higher potential losses due to the young nature of such companies.

Investors need to be aware although the growth potential of such companies can be great, “such companies do come with more risk”, says Mr Glencross.

This is why he says: “Considerable expertise, experience, research, capability and specialist skills are required to successfully undertake investing in these enterprises.”

Because these companies are so small, the possibility of losses is greater than with large, mature blue-chips, but as Mr Glencross says, this is where the loss relief comes into play.

He explains: “This allows losses on any individual investment to be offset against an investor’s marginal rate of income tax, or against a CGT liability.

“For a 45 per cent income taxpayer, loss relief means that, should any single EIS investment lose all of its value, the loss could be capped at 38.5p for every £1 invested.

“It’s important to remember loss relief is available on each individual investment, so if there is a single loss-making investment in an EIS portfolio, this can still be offset against an income tax or CGT liability.”

Administratively, adds Mr Thompson, EIS can be more onerous than VCTs, as EIS investment will generate several certificates over several months, and tax relief cannot be reclaimed until certificates are submitted to the investor’s local tax office or as part of their self-assessment.