The EIS offers the compelling combination of a tax-efficient investment and an opportunity for capital growth, especially when used in the context of the increasingly popular and well diversified EIS funds.
Not only does the EIS allow investors to take advantage of income tax, capital gains tax and inheritance tax benefits but it also provides an opportunity to capture value from emerging businesses.
Greater Government commitment to EIS schemes coupled with increased investment flows and risk diversification show that the tide has begun to turn and EIS funds are becoming the tax-efficient vehicle of choice for investors and their advisers.
The EIS was introduced as a Government initiative to encourage private individuals to invest in emerging innovative bus- inesses in the UK economy.
Under the scheme, over £500m was raised during the last tax year for investment in smaller companies which might otherwise have had no access to growth capital.
The benefits of other tax-efficient investment programmes such as VCTs have been eroded in recent years, in particular, the curtailment of the tax advantages associated with film schemes, but the Government has expressed its continued support for EIS and further enhancements were made in the pre-Budget Report 2008.
EIS v VCTs
Over the past few years, the tax benefits associated with the EIS have been steadily enhanced by successive Budgets. Most recently, the period for income tax carryback relief was extended from six months to the previous 12 months and the Government has published its findings from the consultation process to review and streamline the scheme for investors and companies alike.
This consultation is, we believe, an indication of the Government’s commitment to the scheme when several other tax-efficient investment opportunities have been removed or greatly restricted.
One case where the Government has withdrawn tax relief for investors is VCTs. When fund-raising for VCTs reached its peak in 2005/06, income tax relief was available at 40 per cent. This has since been reduced to 30 per cent on a maximum investment of £200,000 while the minimum required holding period has been extended from three to five years.
As a consequence, industry consensus suggests that in 2007/08, the amount of money raised into VCTs was overtaken for the first time by the amount of money raised into discretionary managed EIS fund and portfolio services. The tide has turned.
A direct comparison of the advantages available under EIS funds and VCTs is shown in the table published above.
EIS funds attract significant tax advantages. For EIS investments, 20 per cent income tax relief is available up to a maximum investment of £500,000 per tax year, subject to a holding period of only three years.
For EIS fund investments, a CGT liability which arose in the previous three years or arising in the next 12 months can be deferred and such deferral is unlimited.
Other tax benefits include:
EIS arbitrage opportunity
In the 2008 Budget, the Chancellor confirmed the change to the headline rate of CGT to 18 per cent. A consequence was to make the tax benefits of EIS funds even greater.
Investors who have crystallised capital gains chargeable at 40 per cent can defer the gain via an EIS and recrystallise the gain on exit at the new capital gains tax rate of 18 per cent, thus creating a 22 per cent saving on the amount of capital gains tax to be paid.
Types of EIS funds
EIS funds reduce risk by investing in a diversified portfolio of companies and by providing a spread of opportunities both in terms of company sector, stage and expected maturity.
There are two main types of EIS funds – approved and unapproved. Approved funds receive pre-approval from HMRC, subject to certain conditions, whereas unapproved funds receive approval on each investment made into a portfolio company, without such restrictions.
Although the terminology somewhat unhelpfully suggests that approved funds are preferable to unapproved funds, there is no such implication. Both funds have their relative advantages, particularly with regard to the timing of tax relief and the deployment of capital, so investors will need guidance from their advisers in selecting which funds are most appropriate for their tax planning needs.
A key factor in choosing an EIS fund should be whether the fund manager undertakes to build a sufficiently diversified portfolio so that risk can be reduced wherever possible.
The investment strategy of these funds is wide and varied. Some managers take a generalist approach; some invest in asset-backed companies such as public house or restaurant chains while others invest in high-growth sectors such as sustainability, healthcare and communications which offer broadly diversified portfolios.
With such an extensive range of tax benefits on offer, EIS funds appeal to a broad range of investors. However, the importance of the investment opportunity and the potential for capital growth should not be overlooked.
The best EIS funds will not let the tax incentives overshadow their investment strategy and will ensure that each investment decision is made on the merit of a rigorous assessment of how that company will perform and whether it is likely to produce significant returns for investors.
It is the compelling combination of a diversified investment programme coupled with generous tax advantages that makes EIS funds so appealing to many investors.
Lucy Foster is head of investor services at Oxford Capital