Over the years, governments have introduced, and then replaced, a variety of schemes to stimulate investment in new and small businesses. A key feature of all these schemes has been some type of tax incentive. The Treasury views these tax sweeteners as a necessary cost to attract ‘patient capital’ from private investors. The net result is that today the rules governing the three current schemes – venture capital trusts (VCT), enterprise investment schemes (EIS) and seed investment schemes (SEIS) – are highly complex. Before embarking on investment in any of this trio, it is crucial to understand the constraints that surround them, the inherent risks, as well as the potential rewards.
Relief on investment
All three schemes – VCT, EIS and SEIS – offer income tax relief on the initial investment into new shares, with VCT and EIS providing 30% relief, and SEIS offering 50% relief. These reliefs are subject to a number of conditions, primarily being the minimum holding periods. VCTs need to be held for at least five years and EIS and SEIS for at least three years, to avoid the relief given on investment being clawed back on disposal. In addition, it is important to note that income tax relief can only be obtained on income tax actually paid.
Over recent years, this income tax relief offered has become a key attraction for many high-income investors who find their scope for pension contributions has been constrained or eliminated completely by the reductions in the pension lifetime and annual allowances.
HM Treasury does not give tax relief without good reason. In the case of VCT, EIS and SEIS, that reason is the risk that the investor is expected to accept. This was underlined by a change to the legislation for all three schemes introduced by the Finance Act 2018. Broadly speaking, any underlying company in which investment is made must now satisfy a “risk to capital” requirement. For investments in companies that qualify for relief, the investment needs to demonstrate that the company has objectives to grow and develop over the long-term, and there needs to be a risk that there could be a loss of capital to the investor of an amount greater than the tax relief provided.
The aim of this test is to prevent low risk, growth-averse companies from being established solely for the purpose of accessing the tax reliefs available. It has had the desired effect, with VCT and EIS providers regularly reminding investors that the returns are likely to be more volatile than before the 2018 change.
Other tax incentives
In addition to the income tax relief on a qualifying investment, VCT dividends are tax-free and many VCTs focus on returning capital to shareholders through the payment of regular and special dividends. EIS and SEIS investments qualify for business relief after being held for 2 years’ ownership. This grants the shares in EIS and SEIS exemption from inheritance tax, as long as the shares are held until death. EIS also offers investors the ability to defer capital gains tax charges for gains made between 3 years before to 1 year after investment.
Risk to capital
It is important to acknowledge that investment in any of these schemes involves holding shares in very small and fledgling companies. These companies are seeking capital to help them grow, and whilst there are substantial success stories where exceptional returns have been achieved, the risk that these companies fail to deliver is also considerable. By way of example, companies that qualify for VCT funding need to hold assets of less than £15m at the time of investment and have fewer than 250 full-time employees (or 500 for so-called “knowledge-intensive” companies). SEIS qualifying companies are much smaller still, with the company needing to hold gross assets of less than £200,000 and have fewer than 25 full-time employees.
An additional risk is the fact that these investments can be hard to sell once the minimum holding period has elapsed. VCTs are listed on the London Stock Exchange (LSE), but trading in smaller issues can be thin, partly because of the tax relief clawback rules. That being said, VCTs normally offer a buyback route, where the shares are re-purchased by the company at regular intervals, at a discount to the underlying asset value. EIS and SEIS investments are not quoted on the LSE, and disposing of these unquoted investments relies on finding a buyer for the shares, which can take some time.
The importance of advice
It’s necessary to point out that VCT, EIS, and in particular SEIS investments involve a higher level of investment risk when compared to the likes of other equities, bonds and cash. The potential returns, of course, can be higher than those provided by more traditional asset classes, and the various tax incentives are attractive.
Selection of the appropriate investment is vitally important, as there can be vast differences in performance between individual VCT and EIS funds. Different investment approaches are also taken, with some focused on a specific area or field, and others being more generalist in nature. For this reason, you should always discuss this with one of our experienced financial planners first to ensure that any VCT or EIS investment sit appropriately within your investment risk profile, time horizon, and your other assets and investments.
If you are interested in discussing your VCT, EIS or SEIS investments with one of our experienced financial planners at FAS, please do get in touch here.
This content is for information purposes only. It does not constitute investment advice or financial advice.