As we approach tax year-end and with pension tax allowances continuing to shrink, I have noticed an increased interest in alternative income tax relief investments such as enterprise investment schemes/seed enterprise investment schemes and venture capital trusts.
But while these products can be the right recommendation, they should not be seen as the next-in-line investment for anyone who has maximised their Isa and pension allowances. Here is a reminder of some of the reasons why.
EISs and VCTs are high risk. And they are supposed to be. The generous income tax relief is designed to encourage wealthy people to inject money they can afford to lose into young and risky businesses.
We have already seen tax relief eligibility removed from industries such as renewables, where investment is deemed not to be risky enough to deserve the relief. So it is safe to assume all these investments are particularly risky.
While the underlying investment needs to be considered, it is not part of a standard approach to long-term portfolio construction and, especially if you are passive, will not necessarily fit in with your investment philosophy.
Specific risks include:
- Illiquidity: long-term investment in small, unlisted companies with limited or no opportunity to trade. Providers might provide a buyback option but this is on their terms. Investors often have no other option when it comes to exiting
- Legislation: there is no guarantee the investments will remain eligible for the reliefs
- Performance: the tax relief could well be the only return the investor sees
- Concentration risk: investment is in niche sectors, leaving this part of the client’s portfolio exposed to the risks of a single market
- Compensation: investors are not usually eligible for compensation
- Fees: charges are often higher than other mainstream investments and will eat into the already uncertain returns.
Appropriate knowledge and experience
Continuing professional develop-ment records should demonstrate you have the appropriate level of knowledge to advise on these investments. Depending on the structure of the investment, you may need an additional securities qualification, such as CII J10, along with an amended Statement of Professional Standing.
Some training and competence schemes require an adviser to be “licensed” by the firm to advise on such products or for such advice to be pre-approved before presenting to a client. Pre-approval as a minimum is the norm.
You need to be very careful if promoting a VCT or EIS, as it needs to be aimed at the right audience and highlight all the relevant risks. This means you will probably only promote it to clients who already have these investments, if at all. Some providers also restrict the sale of their investments by asking applicants to self-certify as a high-net-worth/sophisticated investor.
I often see a fair bit of “localism” in VCT selection, where a lot of business goes to the same provider and a relationship is struck up. This implies a fair analysis of the whole of the market is not always taking place in every recommendation. There are good reasons why you might be consistently using the same providers but you need to be able to evidence this for each case.
A number of firms review the likes of VCTs and EISs within their investment committee and create a panel using research from suppliers such as Martin Churchill, Allenbridge and Micap. Certainly, using specialists to pin down the right solutions can be far more efficient than leaving it to individual research from scratch. Telling an adviser to research from the whole of the market without offering any guidance or tools often leads to confusion.
No suitability short-cuts
There is no avoiding the full disclosure and suitability require-ments for these investments, even if the investor is in a rush to get money in before the tax year-end. A complete assessment, including a full report and demonstration of suitability on the client file, is needed. You need to demonstrate the client has the relevant knowledge and experience to be investing in these products, and why they are doing so now.
It should be clear why the amount selected to invest is appropriate and what the specific objectives are.
Given the unusual nature of the investment and the fact it is unlikely to fit in with your usual portfolio management, it makes sense not to report on it as just another part of your client’s long-term investment portfolio, and deal with it separately.
Check your PI cover allows for advising on these investments and the implication on future premiums. Insurers have pulled cover on VCTs in years gone by.
None of this is new but as tax and legislation changes around us, it is useful to remember the risks inherent in more unusual investments remains the same.
Phil Young is managing director at Threesixty