by Mark Bower-Easton, Business Development Manager, Oxford Capital
The Enterprise Investment Schemes (EIS) is a government initiative, created by John Major’s government in 1994, and has continued to receive the full backing of parliament, regardless of which side of the political spectrum is in power. EIS is designed to boost the economy and jobs market by offering tax incentives to those looking to create new businesses, and people looking to invest into those businesses. To download Oxford Capital’s Guide to EIS, click here.
In the early days of EIS, if you wanted to take advantage of the tax reliefs you would need to find your own investment opportunities and deal with all of the administrative requirements that came with it. In 1999, Oxford Capital was founded, and a new way to utilise EIS tax reliefs was pioneered – the EIS portfolio. Oxford Capital removed the burden of private investors needing to source and undertake due diligence on the companies, and provided a portfolio of pre-sourced, vetted companies that private investors could invest in to. This model has since been adopted by every other venture capital house in the UK, in one form or another.
Before we talk about the multitude of tax reliefs available to private investors, and how these can be utilised by high-net worth investors in the real world, it is important that we talk about risk. The underlying assets within an EIS portfolio are high risk. They are early-stage, unquoted companies, that might succeed, but may also suffer total failure. Due to the shares being unquoted, there is no market to trade them, so liquidity will be non-existent until the point that the shares held can be sold, typically via trade sale, IPO or management buyout. Recently we have made some partial sales in our businesses, aimed at crystalising some of the growth we have achieved, and returning some funds to our investors, but this isn’t something that will happen on a regular basis.
In order to invest in EIS you need to be comfortable with the risk levels present. You also need capacity for loss –if your investment was to lose a significant amount of value, that it wouldn’t materially affect your standard of living. You also need to be comfortable with the lack of liquidity, or access to your money for at least 5-7 years. If you are not comfortable with one or more of the three areas of risk just mentioned, then you should not be considering EIS as a viable investment option.
However, for those who are comfortable with the risk, the capacity for loss, and lack of liquidity, an EIS can be a compelling investment option. Investors will gain access to an asset class that is otherwise unavailable and will be investing into some of the most exciting companies the UK has to offer. On top of that, investors will be able to take advantage of a multitude of tax reliefs, which are summarised below, which can help to make effective tax planning choices.
Income Tax Relief
For every £1 that is invested in to an EIS, 30p income tax relief will be given. This can be offset against your income tax bill either in the current tax year, or if not previously utilised, the previous tax year. When I previously worked as an adviser, I had a lot of clients who would place their annual bonuses in to EIS in order to reduce the burden of income tax on it as much as possible.
EIS can also be a great option for business owners – particularly those who are looking to extract profits but have already maxed out their annual pension contributions or hit their lifetime allowance. Typically, business owners will pay themselves a small salary, usually the same figure as the income tax nil-rate-band, and pay themselves the rest as dividends, as dividend rates are lower than earned income rates. Regardless of whether their income is earned income or dividend income, the income tax relief generated by an EIS can be used to offset most of the liability.
It is important to note that Income Tax Relief is given at the point EIS3 certificates are provided to HMRC via an annual tax return – not at the point the initial investment is made. Each company in an investor’s portfolio will receive an EIS3 certificate. It should also be noted that the minimum holding period to maintain income tax relief is three years. If the shares are sold before this time has elapsed, HMRC will claw back the income tax relief already given.
Capital Tax Free Gains
When the time comes to sell EIS shares, any growth generated will be totally free from Capital Gains Tax. Early stage companies have the potential for significant growth, so the tax saving of an EIS share compared to a share listed on a quoted stock exchange (and not held within a tax-free wrapper, such as an ISA) will be very significant.
Again, this tax relief is subject to the minimum three-year holding period, and income tax relief must have already been claimed.
Capital Gains Tax Deferral Relief
Perhaps you have a holiday home, a buy to let property, or a portfolio of shares that you are looking to sell but are reticent to do so due to having to pay a large CGT bill upon sale. With an EIS it is possible to defer a capital gain indefinitely, by investing the realised gain in to an EIS. All the while the EIS shares are held, CGT will not be payable. This can be a very effective solution for estate planning, as CGT is the only tax in the UK where your liability dies with you.
An example of how this might work in practice would be an investor with a large portfolio of shares, and also a large IHT liability. If the investor did nothing, at the point he or she passed away, their beneficiaries would not have to pay the CGT bill. However, the total value of the shares would be added to their estate for IHT purposes, and tax would be payable at 40%. By crystallising the gain and investing it in to EIS, you are deferring the capital gain, but also eliminating IHT, assuming he or she lives a further two years from the point of purchase of the EIS shares (more on IHT benefits below).
To qualify for CGT deferral relief, the reinvestment in to EIS needs to be made no earlier than 12 months prior to, or three years after the original gain was made.
In this scenario, if you sell your EIS shares, the CGT liability will become payable again. However, you can simply reinvest in to a new EIS qualifying investment and continue to defer. If at some point you decide to pay the CGT liability, it is worth noting that the liability will be taxed at the relevant rate at that time, not at the point at which the CGT liability originally arose.
All EIS shares qualify for Business Relief. Put simply, this means that after a holding period of two years, the value of the EIS shares are not liable for IHT, assuming they are still held upon death.
Business Investment Relief
EIS shares are an allowable asset under BIR rules. This enables UK resident, non-domiciled investors to invest using offshore funds. BIR allows this money to be utilised without them incurring the remittance tax charge, which typically puts off these investors from using offshore funds. When a company exits, the investor can choose to take the money back offshore, or alternatively can bring the capital gain element into the UK without any liability to tax.
As mentioned earlier, EIS investing is high risk. However, there is a safety net in place. The UK Government is effectively underwriting a significant proportion of the downside risk by giving every investor loss relief.
If the share value drops to zero (i.e. the company fails), or the shares are sold for less than the original amount invested, then an investor can claim loss relief, which will enable them to offset a loss made on an EIS company against either their CGT bill or income tax bill, depending on which best suits their situation. The amount of loss relief provided depends on your income tax rate, so if you are an additional rate taxpayer, the maximum loss you could incur by investing in to EIS is 38.5% of your capital. Click here for our guide to loss relief.
To qualify, the share needs to fall below what is known as the “effective cost”. Simply put, the amount invested minus the amount claimed in initial income tax relief on that share, so usually 70% of the gross cost, as the initial income tax relief figure is 30%.
Loss relief is based on each company in a portfolio, not on the portfolio overall. So, even if your EIS portfolio is showing a 3x return, if there are one of two failed companies in there, it is perfectly acceptable to claim loss relief on these.
In summary, an EIS, can be a great way to diversify an existing investment portfolio by adding a new asset class, and providing access to companies unavailable elsewhere. The multitude of tax benefits can also play a significant part in creating an efficient tax strategy if you are looking to reduce your income tax bill, defer a CGT bill, or reduce your IHT liability – as long as you are comfortable with the risks associated with early-stage investing.