There is an inherent danger in making predictions. If you are wrong, your professional credibility suffers. If you are right, well, no one likes a smart Alec. But what is life without risk? So here goes…
Enterprise investment schemes and venture capital trusts are both ways in which investors can secure considerable tax breaks by investing money into start-ups, early-stage and specialist companies, thereby playing a vital role in providing finance for the UK’s entrepreneurial spirit.
The EIS structure first appeared in 1994 and is available to investors as individual unlisted companies that meet EIS requirements or “funds” that invest in a portfolio of EIS-qualifying companies. The tax reliefs are generally well understood, so I will not repeat them here. VCTs were launched a year later in 1995 with somewhat less generous tax reliefs.
The Treasury believes it is necessary to encourage investors to accept a high level of risk and the level of relief provided should be commensurate with the risk taken. While this is entirely reasonable it pre-supposes we are operating on a level playing field. The reality is, however, that the immensely creative minds of the financial services industry have gone to great lengths to devise structures that retain the tax benefits while minimising the risk to investors.
Unsurprisingly, given the greater tax reliefs available, the biggest efforts have been reserved for EISs. As a result, VCTs are the poor cousin, with consistently around three to four times as much money being raised through EISs.
You could argue that even without the industry derisking EISs as it has been, the greater tax benefits afforded to investors in such schemes would have produced similar results. But I am not convinced. More controversially, my prediction is the market will change and the pendulum will swing in favour of VCTs.
To many, this will appear counter- intuitive. After all, changes made in 2015 in relation to management buyouts are more likely to restrict the market. Indeed, a number of VCTs chose not to raise further funds in 2015/16 plus there also real practical difficulties for new entrants, both commercially and in respect of dividend distributions.
However, consider the construction of a VCT and the similarity in qualifying rules reflecting the fact they are (in the main) restricted to investing in EIS-type companies. Then there is the fact the new conditions imposed by the Finance Act (2) 2015 restricting VCTs from investing in more established companies also apply
to EIS. I could go on.
If we accept the clear direction of travel of HM Revenue & Customs is that venture capital should be used to fund the businesses of genuine entrepreneurial companies, we must surely question whether the needs of the majority of investors, in the absence of EIS funds being able to derisk their investments, would not be better served within a VCT.
Put simply, a VCT is a much larger collection of EIS companies than an EIS fund. As such, compared with an EIS, it provides greater diversification, should be more liquid, is generally larger and is listed on the main stock exchange. What is more, while it is a requirement for VCT income to be derived wholly or mainly from shares or securities, this condition is regarded as met, provided at least 70 per cent of the VCTs’ income comes from such sources, which provides additional diversification, derisking and liquidity. The comparable tax benefits are:
- While both VCTs and EISs provide a 30 per cent tax deduction, EISs have a maximum limit of £1m, as opposed to £200,000 for VCTs. That being said, the average EIS investment is well below this £200,000 figure. Furthermore, VCT income tax relief is easier and quicker to claim.
- VCTs have a minimum term of five years, whereas EISs are supposedly three years. In practice, of course, given the definition of termination date, most EISs have an investment term much closer to four years, if not longer, and will often require at least this term to develop the true value of the underlying businesses.
- Capital gains tax deferral can be a valuable benefit I will concede. However, it is only deferral and it remains the fact that income tax is the primary motivation for most investors.
- Only EIS provides loss relief. A valuable relief where there is a net loss, after tax relief, which can further derisk the EIS investment, but not, I would contend, the same level of derisking as is inherent within a VCT.
- Finally, a number of studies have shown the average age of an EIS investor is between 50 and 60. Typically, such individuals are unlikely to be motivated by the existence of business property relief.
There are, of course, a myriad of factors that impact the choice between VCTs and EISs. However, I believe the former are undersold and the latter are oversold primarily because of the derisking providers have managed to achieve through so-called (and poorly named) limited life structures and the overselling of tax benefits. In a market where capacity is a real issue, as is undoubtedly the case here, there will be winners and losers.
I know where my money is.
Tony Mudd is divisional director of tax and technical support at St James’s Place