Susie Harris, head of business development, sets out the case for EIS over VCTs. A version of this blog appeared in Wealth Briefing
Why EIS has so much to offer
Recent fund-raising figures have proven that VCT continues to enjoy a solid place in a diversified client portfolio, with figures released by HMRC in December showing a 33% increase in income tax relief claimed via VCT between the 2016/17 and 2017/18 tax years and VCT fundraising at its highest levels in over a decade.
HMRC and other industry commentators link this increase largely to the continuing impact of pension changes and investors’ need to find alternative means of saving tax-efficiently for retirement. But we seem to be ignoring the fact that an alternative solution to VCT exists – and it’s one that comes with a much broader range of tax benefits and greater potential for real returns on investment: EIS.
The persistent perception that EIS is riskier and therefore suitable for fewer investors than VCT ignores the wide-ranging benefits afforded by the structure and its natural position as a complementary planning mechanism.
Greater potential for upside returns; downside underwritten
Whilst VCTs offer diversification across a greater number of underlying companies, this spread can limit upside potential for investors given the large portfolio.
On the other hand EIS investors will typically be diversified across 5-15 companies, meaning that there is a greater proportion of their funds invested in each investee company and therefore greater potential for participation in successes.
And whilst diversification within a VCT means it is often championed as the lower risk investment option, this ignores the fact that EIS investors are able to claim loss relief.
For an additional rate taxpayer, this reduces potential exposure to loss to just 38.5% of the original capital invested. The government is effectively underwriting a large chunk of the risk.
A multi-purpose planning tool
Income tax, capital gains tax, inheritance tax: few investment structures tick as many planning boxes as EIS and enjoy such flexibility around the application of these reliefs:
- Income tax relief can be used in the year of investment or carried back to a prior year;
- Existing capital gains can be deferred indefinitely;
- Gains within the EIS portfolio are free of CGT;
- Loss relief can be offset against income as well as capital gains;
- Once held for two years, EIS investments are free of IHT.
All this combined with much higher maximum investment limits over VCT (particularly for Knowledge Intensive Companies).
Impact of combined EIS reliefs
Let’s take the example of a client selling a buy-to-let property with a £100,000 gain. If invested into EIS, this gain not only results in £30,000 initial income tax relief but a deferral of the £28,000 CGT liability. This liability can be deferred indefinitely by reinvesting future proceeds back into EIS investments – gaining 30% initial tax relief on each reinvestment.
On the death of the client, the CGT dies with them. Given EIS investments are IHT-free, this investment has therefore potentially benefited from: 30% initial tax relief, 28% CGT and 40% IHT – a combined tax benefit of 98%!
Clearly the returns must justify the risk – and there is a risk the EIS investment fails and the investor is left with a crystallised CGT liability (albeit with loss relief available in the year of exit). But there are few instances where an adviser is able to deliver quite such a comprehensive list of benefits.
Timing EIS right
While there is a collection of EIS managers with good, relevant track records, delivering attractive growth returns, like everything in life, timing is important. The most credible EIS managers, by third party research scores, will be deploying capital over a 12 to 18-month period.
That means, if you are looking to use EIS for CGT deferral purposes, this deployment lag needs to be factored into the three-year window to invest in EIS after realisation of the gain.
As an example, Parkwalk, set to be the largest EIS fund again in 2019/20, take an average of 12 months fully to invest subscriptions. Despite this being one of the shortest deployment timeframes in the market, that means any gains made before early 2018 are unlikely to be invested in EIS investments in time.
Likewise, the earlier in the year EIS subscriptions are made, the more will be available for carry-back to the prior year, which simplifies tax planning. So, if you can, don’t wait to have EIS conversations with clients.
Given the continuing increase in IHT receipts since 2009, the record £9.2bn in CGT receipts in 2018/19 and the fact that pension limits continue to bite, it is no wonder EIS, as the only solution which addresses all of these issues, continues to play an increasingly important part in the tax planning process.