A client does not want to see his photo on the front page of the tabloids, under a headline berating the latest tax avoider. This could therefore be a very good time to consider the benefits of the Enterprise Investment Scheme and Venture Capital Trust regimes.
An investment in an EIS or in a new VCT gives income tax relief of 30 per cent of the amount invested, provided you have that much tax liability in the first place.
For example an investment of £100,000 will give you tax relief of £30,000 if you have an income tax liability of at least £30,000. The maximum you can invest to gain this relief is £1m with an EIS or £200,000 with a VCT.
With an EIS you can also carry back one year, so you could invest up to £2m and gain up to £600,000 income tax relief. Carry back is not available with a VCT, so the maximum tax relief is £60,000.
Investors must hold EIS shares for at least three years and VCT shares for at least five years, otherwise the initial income tax relief will be withdrawn.
An EIS or VCT investment does not reduce taxable income. This is helpful if you are trying to fund a pension to its maximum at the same time, but it also means this type of investment is not suitable if you want to reduce taxable income – for example to avoid the child benefit charge or a reduction in your personal allowance.
An EIS can also be used to defer any amount of capital gain. There is no £1m limit for this purpose. The gain must have arisen between one year before and three years after the EIS investment. Any entrepreneurs’ relief will be withdrawn when the gain is deferred, but where you have no intention of ever disposing of the EIS and triggering the gain it may still be advantageous to defer it.
An investment in an EIS is free from inheritance tax provided it is held for at least two years. Gains in an EIS are not subject to capital gains tax provided the investment qualified for income tax relief. For an investment over £1m (or £2m if using full carry back), gains on the excess will be subject to tax. This rule also means the gain will be taxed if the investment is disposed of within three years.
Losses in an EIS can be offset against taxable capital gains. Alternatively, you can offset the losses against taxable income in the current or previous year.
Income tax is payable on dividends. As most EIS investments are in companies at growth stage there is not usually an intention to declare dividends in those early years anyway.
Additional tax benefits of VCTs
Any gain in the value of a VCT is subject to CGT. VCTs generally try to distribute their gains as dividends, and therefore avoid creating a taxable gain. Dividends from a VCT are tax free.
Tax Risk
EIS and VCT are investments actively encouraged by the government. I know we have all heard that before with a lot of tax avoidance schemes, including film partnership schemes a few years ago. But EIS and VCT really are different. HM Revenue & Customs want more people to invest in them, as the tax benefits they are “giving away” are far less than the additional corporation tax, income tax, national insurance and VAT they gain from the growth of the EIS companies or the companies in which the VCT invests.
As long as you are not tempted by some “clever” scheme that promises to give your clients all the tax benefits without any of the investment risk you will not be recommending anything regarded by HMRC as tax avoidance. This is pure tax mitigation using the tax rules exactly in the way parliament intended.
The only real tax risk is the tax penalties that will apply if your client’s financial circumstances change and they are forced to dispose of their investments too early. As indicated above, the minimum holding period for an EIS is three years and for a VCT five years.
An EIS portfolio spread
The greater risk of an EIS investment can be reduced (but not eliminated) by spreading the investment in an EIS portfolio rather than investing in individual EIS shares.
The principle here is exactly the same as reducing the risk of equity investment by investing in a unit trust or investment trust rather than in individual shares.
There is a reasonable chance that an investment in a single EIS will fail. But it may also do very well. An investor who has a spread of EIS investments would therefore expect some to fail and some to do very well. Because you can offset losses against other taxable income but gains are not taxable, you will make a profit even if in an extreme case you lose half of your investment but the other half doubles in value.
With a normal portfolio of shares, if half fail and the other half double in value your return will be zero. You will not have lost anything but neither will you have gained. Even taking account of the tax position this is so. You will claim tax relief from the half that fails and offset that against the taxable gain of those that double in value.
But a 40 per cent taxpayer will obtain a staggering 54 per cent return in exactly the same scenario with a portfolio of EIS shares.
Example
You invest £100,000 in an EIS portfolio. After tax relief of £30,000 your net investment is £70,000.
Half the companies in the portfolio go into liquidation. You will therefore have a £50,000 tax loss, giving you tax relief of £20,000. There will be a clawback of 50 per cent of the original tax reducer, or £15,000, as 50 per cent of the shares have been disposed within three years. The overall net effect will therefore be a £5,000 reduction in income tax.
The other half of the companies double in value. You now have a £100,000 investment which only cost you £65,000 (£100,000 investment, less £30,000 initial tax reducer, less £5,000 net tax loss claim). This is a £35,000 return on a £65,000 investment, which is nearly 54 per cent growth. For a 45 per cent taxpayer it will be 60 per cent growth.
This assumes the losses all occur within the first three years. If they occur later, your net return will be much higher, as there will be no clawback of the original tax reducer.
A 40 per cent taxpayer will have a £100,000 investment which only cost £50,000 – a 100 per cent return. A 45 per cent taxpayer will have a 110 per cent return.
This £100,000 is IHT free after three years. In this example you could also have deferred £50,000 taxable gain which will never crystallise if you pass the investment on to the next generation. This is an additional CGT and IHT saving of up to £54,000.
Graham Dragon is chief legal officer of Adviser Breakthrough Group
Key Points
* An investment in an EIS or in a new VCT gives income tax relief of 30 per cent of the amount invested.
* HMRC wants more people to invest in EISs, as the tax benefits are far less than the additional corporation and other taxes they gain from the growth of the investee companies.
* The greater risk of an EIS investment can be reduced (but not eliminated) by spreading the investment in an EIS portfolio.
