The EIS

If one was to create a rallying cry for the Enterprise Investment Scheme it would be: «Investors! Back Britain’s small business!»

It sounds rather Empire but the EIS and its simpler cousin the Venture Capital Trust (VCT are devised as heavily tax-incentivised products to encourage the advanced investor to back Britain’s small business – and in doing so boost the economy from the inside.

Adventurous investors looking for longer-term investments offering attractive tax breaks are currently very much on the government’s radar. They’re seen as a valuable source of funding for the small and embryonic UK businesses that – if they can source financial support – could help drive economic growth in the difficult years ahead.

To that end, the coming months will see the relaxation of rules restricting investment into small, high-risk firms by venture capital trusts and enterprise investment schemes. We’ll also see the introduction of a new type of EIS with generous tax breaks, geared to funding very small ‘seed’ businesses. More of which later.

EIS schemes are intrinsically high-risk because they invest in small companies. The tax relief on initial investment into an EIS is 30%, but investors can put in between £500 and £1,000,000 – potentially getting rid of their entire income tax liability for a year.

EISs are not listed, and are therefore less liquid than VCTs, as there’s no established secondary market where investors can sell if they need to – so the tax breaks for investors are rather more generous. From April, the maximum annual investment will be doubled to £1 million from £500,000.

Any capital gains when you exit the EIS will be tax exempt, while capital losses can be offset against your income tax bill. It’s also possible to defer gains from the sale of other investments by rolling them into an EIS. There are inheritance tax planning attractions too: because EISs are generally invested in assets eligible for business property relief, the shares fall out of your estate after only two years.

However, timing can be an issue on the tax planning front. While you can specify which tax year VCT shares are issued in, for most EISs, the relevant dates are when shares in each underlying investee company are issued, which may be some time after the original investment.

Also, unlike VCTs, EISs do not pay tax-free dividends – though because they are invested in smaller businesses than VCTs, there’s less likely to be much in the way of dividend payments forthcoming anyway.

EISs, and VCTs, can invest in businesses with gross assets of up to £15 million with up to 250 employees – these have been raised substantially from old limits. And both collectively are able to invest £10 million in an individual company each year, up from £2 million.

There is also the potential to defer capital gains made on a separate investment, by reinvesting them into an EIS. The reinvestment has to meet certain criteria – disposal of the original asset has to be less than 12 months before the EIS investment or less than 36 months after it.

In this way, gains can be deferred until a tax year in which an investor is not using their capital gains tax allowance, or has retired and is paying lower tax rates anyway.

For the EIS investment itself, no capital gains is payable if you sell the shares after three years, provided the EIS initial income tax relief was given and not withdrawn on those shares. Any losses on EIS shares can be set against the investor’s capital gains income tax liability in the year of disposal.

Investors can find out about investment opportunities through the Enterprise Investment Scheme Association, www.eisa.org.uk.http://www.eisa.org.uk/

The companies eligible for EIS schemes have to be worth less than £7 million, and the individual cannot have more than a 30% stake in the business, so these schemes are not for widows and orphans investors. However, the tax breaks mitigate some of the risks.

The so-called Seed EIS (SEIS, a ‘junior’ version of the EIS, will be introduced from April 2012. It will be similar to its big brother in terms of tax reliefs. However, it will differ in certain important respects:

• It will have only a £100,000 maximum annual investment limit per individual.
• It will offer 50% income tax relief on investments.
• As a one-off incentive for investors, it will offer complete capital gains tax exemption (rather than deferral on gains from other investments realised in 2012/13 and re-invested in the same tax year under the SEIS scheme.
• SEISs can only invest in unquoted UK firms less than two years old with less than 25 employees and gross assets of up to £200,000. They must not have received previous EIS or VCT funding and can accept no more than £150,000 in total.

The government’s changes should boost funding prospects for this sector of the market. A broader spectrum of companies should become eligible for investment, there is likely to be greater support for smaller, higher-risk firms, and more money should be available for individual businesses.

Quite apart from the potential for improved returns that the rule changes may foster over the medium term, EISs already boast a number of tax attractions to compensate investors for the considerable risks involved in investing in smaller, unlisted firms and start-ups.

VCTs – listed companies investing in a portfolio of eligible firms – are the simpler option. Provided they hold the VCT shares for the minimum holding period of five years, investors in new issues receive 30% income tax relief on the amount invested, up to a maximum subscription of £200,000 a year. In addition, dividends paid out by the VCT are tax-free, and there’s no capital gains tax to pay on gains from the sale of shares (you can’t claim tax relief on capital losses.

What then should you consider if you’re thinking of investing? Be clear, first, about what you’re thinking of taking on. EISs and VCTs are complex, high-risk investments designed for wealthier investors, so it’s sensible to use your ISA allowance and make contributions to your pension first. You need to have a stomach for risk and the wherewithal to tie up your money for several years. And you should seriously consider taking expert advice.

The second step is to decide which type of investment will best suit your needs.

EISs come in various forms and are generally more complex investments that VCTs. They also tend to be longer-term because they invest in earlier-stage businesses.

Historically, say experts, they have tended to be tax-driven investments used by people with a capital gains tax liability to roll over, or for inheritance tax planning.

Additionally, for those with Empire-sized ambitions, EISs may offer access to quite esoteric opportunities – racehorses, wine or films, for example – so they can be good for diversifying your portfolio. But, be warned. It’s vitally important with an EIS in particular to understand exactly what you’re buying.

There is wide variation in the way EIS investments are structured, ranging from single-company EIS offers to EIS funds, so, as ever, do your research to ensure the investment meets your needs and desires.

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