VCTs (venture capital trusts) and EISs (enterprise investment schemes) are becoming an increasingly important part of a high-net worth (HNW) individual’s investment portfolio. This is mainly due to the following reasons: the attractive tax advantages, the investment diversity on offer and the changes in pension legislation.
The changes in pension legislation have been designed to reduce the maximum amount that can be saved in a pension, before significant taxes are applied, otherwise known as the lifetime allowance. An increasing number of HNW individuals expect to surpass the new lifetime allowance in their pension pots, which means that to lower their tax liabilities, alternative investment vehicles such as a VCT and EIS can be used.
VCTs are often thought of as high-risk investments, although this is not always the case nowadays. For a long time, the VCT market has offered many types of risk and return, ranging from high-risk types such as those that operate as specialist venture capitalists, sometimes specialising in one particular sector, to more generalist offerings including asset-backed and a wider range of companies in different sectors and stages of development.
These include top-up offers, whereby investors have access to existing investments and are offered regular dividend payments almost immediately. Companies listed, or about to become listed, on the Alternative Investment Market can be invested in via AIM VCTs. On the whole, EIS offerings are more risky. Historically, there is less diversification in institutional offerings in an EIS. However, there are EIS providers that now offer asset-backed as well as venture capital and private equity opportunities too.
State aid
VCTs and EISs offer income tax relief to investors, which means the state is effectively funding partial investments. Following pressure from Brussels and the European directives on state aid, new rules and guidelines were introduced last year to cut back on this de facto subsidy. The biggest change concerns the age of the company receiving the investment. The company cannot now be more than seven years old. This has ruled out investment in management buyouts of older companies, where in most cases the founding family shareholders sell their business to existing management and VCT schemes help finance the buyouts.
There is a perception of lower risk around this style of investing because there is an existing business, with revenues and often a long trading history and stable management. Some would argue that the changes are very healthy because the point of these investments is to stimulate growth in small companies with an accompanying creation of jobs. This has not always materialised with management buyouts.
The net result is that there are far less VCT offerings this year. At present, there are about £325m, whereas in previous years the figure was closer to £450m. There are no available figures for EIS because the market is so diverse. It ranges from large retail offerings from venture capital houses to the thousands of EIS companies being created by entrepreneurs every day up and down the UK whose business ideas are best suited to EIS rules with the accompanying tax reliefs. Since VCTs were first introduced in 1995 there have been many rule changes, mostly concerning the allowable underlying investments. To date, they have been fair and there have been no retrospective rule changes, which is something to be applauded.
High demand
Most large retail offerings for this tax year were launched before Christmas and those offerings are already filling up fast. Our research suggests that more than 50 per cent of VCT offerings have now been filled. Availability is likely to dry up by mid-February, much earlier than in previous years, so early planning is recommended.
Track record
Venture capital houses can now boast five to 10 years' worth of track record, with returns that include initial tax relief averaging about 8 per cent for the asset-backed marketplace and about 10 per cent for the pure venture capital providers. Over this period, we have seen new household names prosper from VCT and EIS beginnings. Zoopla and Graze are two that spring to mind in the business-to-consumer space.
Rising risks
These returns were generated at a time when the British economy was undergoing a multi-year recovery after the global financial crisis. Asset prices were supported by the Bank of England interest rate policy and quantitative easing. Any successful venture capital investment needs a stable economy in the same way as listed securities. It might not have always felt like it, but that is what the UK has undergone since the crisis. Looking ahead, I wonder whether we are likely to see further increases in asset prices in the same way as we have seen since 2009. At some stage, the economy is likely to be affected again by Brexit concerns.
There is huge interest in the disruptive technology space this year, from entrepreneurs and investors alike. It feels as though a bubble, not unlike the tech bubble of 1999, is growing. Not all of the potential disruptive technology companies seeking funding will succeed and it is very difficult for professional and amateur investors alike to know which ones will go on to be a success.
VCT and EIS
The venture capital trust (VCT) scheme was introduced on 6 April 1995 and was designed to encourage individuals to invest in smaller companies. VCTs are themselves listed on the London Stock Exchange and provide capital finance for small, expanding companies with the aim of making capital returns for investors. Money raised from individual investors is pooled by the VCT to acquire a number of different investments, with the aim of spreading the risk across the VCT’s portfolio. Investors must hold these investments for at least five years.
The enterprise investment scheme is the latest in a series of UK tax reliefs launched in 1994 in succession to the business expansion scheme. It is also designed to encourage investments in small unquoted companies carrying on a qualifying trade in the United Kingdom. For investors, they are a tax efficient way to invest into smaller companies. Investors must hold these investments for at least three years.
Tax advantages of VCTs and EISs
• Income tax relief at the rate of 30 per cent on the amount subscribed, available on investments of up to £200,000 per tax year for VCT and £1m per tax year for EIS.
• Exemption from income tax on dividends paid by the VCT, not available on EIS.
• Exemption from CGT on disposal of the shares for both schemes.
• Additional advantages of EIS schemes include loss relief carry forward. What is more, an investment can use the previous year’s income tax situation as well as the current year's.
• An EIS can also be used to defer paying capital gains made on any other type of asset. If the capital gains made in any other asset are invested into a company using an EIS, the capital gains tax owed can be deferred until the sale of the shares invested in.
• EIS schemes qualify for business property relief after they have been held for two years and so are not included in the investor's estate on death.
How is tax relief claimed?
When a new issue VCT or EIS is bought, the purchaser receives a share certificate and a tax certificate. The tax certificate is sent to HM Revenue & Customs to claim the income tax relief.
Those investors paying tax under PAYE can choose to have their tax code adjusted immediately to pay less tax, or can apply for an immediate tax repayment if they are investing at the end of the tax year.
Table of cash flows based on targeted returns
A worked example of a VCT
If someone contributed a total of £100,000 into a VCT in this tax year, the situation would look as follows:
• £100,000 gross investment
• £30,000 tax relief * (direct or through tax code)
• £70,000 net investment (assuming held for five years minimum)
• Targeted payments of £6,000 every year (tax free), 8.6 per cent annual yield on net investment.
• Targeted total returns, dividends and final capital repayment, dividends, £30,000 (tax free), £30,000 tax relief receivable in year one, capital returned, £100,000, total £160,000.
In summary, an investment of £100,000 creates a return of £160,000 in five years, after costs.
*assuming sufficient tax paid already
A worked example of an EIS investment
If someone contributes a total of £100,000 into an EIS in this tax year, the situation would look as follows.
• £100,000 investment.
• £30,000 tax relief * (direct or through tax code).
• £70,000 net investment (assuming held for three years minimum).
• No targeted payments during the life because these payments are not tax free.
• Total returns vary depending on the strategy. Asset-backed strategies target similar returns to VCTs. Venture capital and private equity target a return of two to three times the value of the initial investment, similar to the returns achieved by the same businesses in their institutional private equity offerings (non retail).
*assuming sufficient tax paid already
Suitability
A VCT is by nature a higher-risk investment and should form part of an overall balanced portfolio. As a rule, they are only suitable for investors that meet the following criteria:
• High-net worth and sophisticated investors who are UK residents.
• Investors who have a sufficient income tax liability to reclaim income tax relief at 30 per cent of the amount subscribed.
• Investors who have realised a capital gain that would attract capital gains tax.
• Investors who will not need access to their capital for at least five years and are comfortable with higher-risk investments.
Timescale
Now is the time to plan for these investments. There are early-bird fee discounts for new investors, although the discount is greater for existing holders and most early bird offerings have now run their course and expired.
The number of offerings is less because the traditional management buyout funds are only serving up small offerings this year and they are to existing holders only.
In the VCT space, there are no more than 20 potential offerings across all categories of specialist, generalist, top-ups and AIM. In the EIS space, the figure is also less than 20.
Independent research
A quick search of the internet will give an investor the full list of offerings still available. From there, it is highly recommended that the investor looks in more detail at the individual websites for those offerings.
Most websites contain plenty of extra information. A VCT must have a prospectus that meets London Stock Exchange rules. There is also normally information on past performance numbers and future potential risks.
Most offerings also include reports written by an independent financial expert called Martin Churchill. This section of the literature is always called the Tax Efficient Review. The reviews give each investment a score out of 100 and this allows investors to look at the relative strength of each offering. They are well put together, independent and offer in-depth reading and analysis.
These independent overviews consider all areas of an offering, including a review of the institution and the main decision-makers of potential investments and the process followed. They are a good read and are unafraid of offering praise or criticism.
If these reviews are not included on the website of the institution seeking investors’ money, people need to ask themselves questions as to why not. They are an established part of the suite of literature usually provided with this type of investment.
Alistair Candlish is director of Carrington Investments
Key points
• Venture capital trusts (VCTs) are often thought of as high-risk investments, but this is not always the case nowadays
• The enterprise investment scheme is the latest in a series of UK tax reliefs launched in 1994 in succession to the business expansion scheme
• A VCT is by nature a higher-risk investment and should form part of an overall balanced portfolio
