For sophisticated investors contemplating the wide range of investment options, EIS qualifying investments provide an appealing alternative due to the many tax reliefs available. Investing in Enterprise Investment Schemes is encouraged by the government to raise funds for a greater number of small businesses, and this is reflected in the high rates of tax relief on offer.
Not an investment expert? No need – tax relief through EIS investments can be broken down into five easy-to-understand incentives:
Let’s imagine a prospective investor, Mr Evans, has sold one of his assets, in this case a property he owns with a value over £325k. His net capital gain from the sale is £100,000. Under usual circumstances, Mr Evans would be liable to CGT at a rate of 28%. However, by reinvesting the £100,000 in EIS shares, he would be eligible to defer this CGT to a later tax year.
This deferral would continue to last until a changeable event occurred. For instance if Mr Evans were to sell his EIS shares after holding them for at least three years, the gain would be ‘revived’, and he would become liable to pay the CGT at a rate of 28%, as before. However, this revived gain would be applied to the current tax year.
Should he wish to do so Mr Evans could then reinvest the revived gain back into a new EIS investment at which the point the original 28% CGT would again be deferred. He can continue to defer the CGT in this way until it is written-off upon death.
There is no upper limit to the amount invested across all EIS shares. There is only a maximum amount that can be invested in any one year: £1 million.
Assuming Mr Evans’ income is sufficient to pay the equivalent in income tax, 30% income relief would be available for the current tax year, saving £30,000 of his £100,000 net capital gain invested in EIS shares.
It is possible for this Income Tax saving to be carried back to the previous tax year. Investors such as Mr Evans will want to take advantage of this if they haven’t paid a total of £30,000 in income tax this year (using the previous year’s income tax to fill the remainder).
In addition to Income Tax Relief and CGT deferral, Mr Evans would also have access to Capital Gains Tax relief on any profit made on the investment, with some caveats. The shares must be held for no fewer than three years and Mr Evans would not be able to claim CGT relief from any business in which he holds more than a 30% stake. On sale of his EIS shares no Capital gains tax will be due on the profit. It is also worth noting that most private companies won’t pay dividends to shareholders, but for those that do, tax is still paid at the usual rate.
For investors seeking to mitigate Inheritance Tax, alternative investments through EIS provide further benefits. By investing in a business that qualifies for Business Relief (BR formerly BPR), up to 100% of IHT can be eliminated. Shares in companies that qualify for EIS can be eligible for Business Property Relief for Inheritance Tax purposes at rates of up to 100% after holding the EIS shares for two years. This reduces or eliminates any liability for Inheritance Tax connected to these shares.
The business must also not:
- Be a company dealing predominantly with securities, stocks or shares, land or buildings, or in making or holding investments
- Be a not-for-profit organization
- Be in the process of being sold
- Be in the process of being wound up
- Qualify for Agricultural Relief
Finally, if any capital losses are incurred after the disposal of EIS shares, the loss can be classified as an ‘allowable loss’. This will provide Loss Relief which can set off against other capital gains.
How to claim tax relief
A tax relief claim can be made after receiving an EIS3 form (Enterprise Investment Scheme Certificate and claim to relief) from the company invested in. The company must have been trading for at least four months before they can issue this form.
To make the claim, investors will need the following information:
- The name of the company invested in
- The amount on which you are claiming relief for this year
- The date of issue of the shares
- The name of the HMRC office authorising the issue of the certificate
While the process may seem complicated, this is something that a fund manager should guide you through, and it is the company you invested in who is responsible for submitting an EIS1 form to approve whether or not they have met all of their requirements set by HMRC.
Managing Risk
The very nature of EIS and – more widely – investment in smaller, more dynamic companies mean that such investments are accompanied by larger exposure to risk and uncertainty. CoInvestor founder Charles Owen wrote about the processes involved in managing EIS risk in early 2016, and what was covered in his article remains true today. There are however some recent developments that shift the landscape slightly, requiring greater consideration and a renewed investigation into how best to manage risk when investing in younger, more volatile companies.
EIS considerations
EIS can be risky from a liquidity perspective, due to the fact that such investments are longer term (delivering growth rather than income) and the lack of a secondary market into which to sell shares should an investor want to exit an investment. With no secondary market in place, EIS investments are more suitable for experienced wealth investors comfortable with investing money for significant periods of time. Shares must also be held for a minimum of three years to be eligible for tax relief, meaning capital is tied up. Companies are more likely to fold or deliver negative returns given their size and age. Capital being locked in for a significant period opens up investments to the threat of inflation.
Having said all this, however, there are a number of ways in which savvy investors can manage this risk and look to take advantage of the EIS opportunities.
Due diligence
The original spirit of EIS was to foster creativity and innovation, while also driving job creation, and there is likely to be an increase in Treasury attention paid to any funding raised by companies under an EIS that don’t fit these criteria. Selecting the most suitable investments is crucial to minimising the risk of EIS fundraising potentially being retroactively investigated, which could render tax incentives invalid. Recent technology innovations have provided individual investors access to a wide variety of new and exciting investment channels, but this brings with it uncertainty and opportunity in equal measure. The role and expertise of fund managers and intermediaries can prove invaluable in navigating risk in the EIS sector, with co-investment platforms becoming increasingly popular as a way of benefiting from the experience of seasoned investment professionals.
Diversified portfolios
One must still place great importance in adequate portfolio diversification, especially when looking to alternative investments. The volatile nature of investing in an EIS can mean that individual investments can be more susceptible to failure, given the typical size of companies receiving investment. Diversification across a variety of companies and sectors can help to insulate an alternative investment portfolio against individual losses, decreasing the overall risk of the portfolio. Portfolio diversification should also take into account correlation between sectors, for example commodities and construction which will share some of the same market stimuli. A colourful pie chart showing many different companies does not necessarily mean a properly diversified portfolio protected again individual losses.
How EIS compares with VCT investing
Ultimately there are several differences between EIS and other investment approaches which make it an appealing prospect, providing investors take precautions to manage risk sufficiently. EIS have a shorter required hold time, three years, than a Venture Capital Trust (VCT) at five years. Individuals can invest up to £200k per annum into VCTs, whereas they can invest up to £1M per year into EIS.
EIS is an investment approach with more implied risk, given the age, size, and relative establishment of the companies involved. While this means due diligence and caution are crucial to investors navigating the potential associated risks, when combined with expert advice and support from fund managers and IFAs an EIS investment can be a fantastic opportunity for investors looking to diversify portfolios and target a strong, even aggressive growth investment strategy.
With the correct guidance and suitable considered approach, EIS can and should be a staple constituent of an alternative investment portfolio for the right investor, and savvy investors would do well to make the most of the associated tax efficiencies.