Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EIS) have always been a grey area for investors. Warned off by the “at your own peril” signs put up by the FCA, many people have been frightened off by the level of risk they would have to take, despite returns being pretty decent.
In their essence, VCTs and EISs are investments in small companies that attract tax reliefs. And it’s because the investment is in small companies that the risk is significant. Obviously, the general rule of thumb in investing is the bigger the business, the less likely it is to fail.
One of the key things to bear in mind when opting to take the EIS/ VCT route is its manager. Generally, the managers who focus on more mature businesses so as to mitigate risk, target yield for a tax free income, have a clear exit strategy and a proven track record are the managers to opt for. They should also sufficiently diversify your holding, taking your existing portfolio into account.
There are several types of EIS and VCT. Generalist EIS/ VCTs are the managers who have a truly private equity background and look for qualifying investments across the whole market. These managers will often take board positions on AIM. A specialist manager is just that – one that focuses on a specific sector, like media. Some managers look to return total value to investors as close to the minimum holding period as possible (five years for VCTs and three for EISs) by selling the underlying assets and making payments to investors through tax free dividends (VCT) and capital gains, which are tax free (EIS) – these are referred to as ‘Limited Life investments.’ There are also AIM specific VCTs and EISs.
So why are VCT/ EIS such tax efficient investments? Both have different tax treatments, but both are beneficial from a tax perspective for canny investors who want to reduce their tax liability. With VCTs, investors can enjoy 30% income tax relief on investments up to £200,000 in a tax year, subject to the five-year retention of shares. When selling an investment in the UK, any capital gains generated are tax-free and dividends are paid without further tax liability. Additionally, VCTs themselves are not subject to corporation tax on gains or distributions from UK companies. Regarding EIS tax features, investors can see 30% income tax relief on investments up to £1million, subject to a three year retention and can carry back to the previous year if unused. A particularly good feature is that EIS can defer capital gains tax if the investment has been cashed in in the last three years, or the subsequent 12 months. Finally, with EIS investments, investors can enjoy 100% IHT relief after a two-year holding period.
It all looks pretty rosy doesn’t it? What’s not to love? Well, the price you pay for investing in VCTs/ EISs is swallowing that significant spoonful of risk. As we said earlier, smaller often means riskier in investing terms, particularly where start ups are concerned. Liquidity is another risk factor – you might have difficulty selling these investments at a reasonable price and sometimes it might be difficult to sell them at any price. The lack of visibility is another issue, where it may be tricky to obtain reliable information about the value of the companies or the extent of any risks they may be exposed to. There is also a risk with the manager – if they don’t stick to the rules, they forfeit tax relief. VCT/ EIS are also often criticised as some are not regulated by the FCA and therefore don’t guarantee the protection to investors that other investments might.
There are other risks. And investors considering an EIS or VCT investment really have to be aware of the risks of this asset class. If you’re thinking about it, it’s highly likely you’ll need professional help to understand the nature of the investment and whether that level of risk suits your profile. But for those investors who are prepared to contemplate riskier investments, the tax relief and the returns investors have realised in the past definitely warrant a second look. But the “at your own peril” signs, might mean that you need your armbands.
Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested.
Tax benefits depend upon the investor’s individual circumstances and clients should discuss their financial arrangements with their own tax adviser before investing. The levels and bases of taxation may be subject to change in the future.
The investments discussed in this document may not be suitable for all investors. Investors should make their own investment decisions based upon their own financial objectives and financial resources and, if in any doubt, should seek advice from an investment adviser.