The pros and cons of EISs

This article is part of
VCT and EIS Investing - January 2013

The amount you can effectively invest in a pension each year has been reduced from £255,000 to just £50,000 currently and will fall further to £40,000 in the 2014/15 tax year. The government has also threatened action against sophisticated and aggressive tax planning schemes..

However, three successive governments have improved the enterprise investment scheme (EIS) regime and the latest changes, introduced in April 2012, mean it is now arguably the most generous tax-efficient investment vehicle available to the UK taxpayer.

EIS is a government-backed way for higher-rate taxpayers to reduce their current tax burden, save in a tax efficient way for the long term and supplement traditional pension savings.

Initially created by the Conservative government in 1993 to encourage investment in small companies that needed capital for development or expansion, the scheme was improved by Labour, then further enhanced this year by the coalition government.

Why? The government says it believes investment in well-run, small, growing companies can help kick-start the UK economy. With banks still facing liquidity challenges and lending restrictions, EIS is seen as a useful way to make the necessary capital available to these companies.

Investing in small companies – particularly early-stage companies – has traditionally been seen as a high-risk strategy because they have a greater chance of failing.

Generally, investors can reduce risk by choosing a good fund manager with a strong track record of investing in the right companies.

A capable manager will take an active role in building the value of the investee companies to help reinforce the chances of success and plan for an eventual exit.

A fund can reduce risk through diversification. It is possible to invest in a single company through an EIS structure, but this is far more risky than investing in a fund, where your money is likely to be spread across a number of companies. Most EIS funds spread risk further by building a portfolio of companies in different industry sectors.

Even if one or two companies in a portfolio perform poorly or fail, it is still possible to enjoy good overall investment returns.

The loss relief available means that for a 45 per cent taxpayer the maximum exposure to loss is 38.5p in the pound.

Importantly, loss relief can be claimed against the individual investment but not the aggregate portfolio. So your tax reliefs on winning investments are not offset against those for any losses.

In addition, further improvements to EIS rules introduced this year allow EIS funds to invest into bigger companies.

Eligible investee companies include those with up to 250 staff (previously the limit was just 50) and gross assets of £15m (previously £7m). Companies can now seek up to £5m in EIS funding (previously £2m).

This means the investment universe has widened considerably and it is possible to invest in more mature, less risky companies.

Curtailed bank lending and limited flotations on the Alternative Investment Market have combined to significantly reduce expansion capital available to small UK companies. This has had the effect of reducing company valuations to very attractive levels.