The launch of new HMRC-approved EIS Knowledge Intensive Funds adds carry-back to 2019/20 to the broad range of benefits of EIS over VCT.  Susie Harris from Parkwalk looks at the differences between EIS and VCT, and the introduction of EIS Knowledge Intensive Funds.

EIS: a growing need

VCT continues to enjoy a solid place in a diversified client portfolio, raising over £619m in the 2019/20 tax year; the third-highest raise since the tax relief was established in 2006.

Despite uncertainty over Brexit, the general election and then COVID-19, it seems that the continuing impact of pension changes and investors’ need to find alternative means of saving tax-efficiently for retirement is continuing to drive this demand. This is a growing problem for investors, and one which is arguably much more effectively serviced by an alternative solution to VCT – 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. The COVID-19 pandemic has emphasised this limitation, with investors into VCT effectively buying into historical valuations.

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 unlike VCTs, EISs are forward-looking in terms of valuations and must invest in equity – so they are ideally positioned to take advantage of valuation adjustments swiftly.

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). And the recent launch of HMRC-approved EIS Knowledge Intensive Funds now allows for 100% income tax relief carry-back to 2019/20, claimed via just one EIS5 certificate, reducing administration and simplifying the tax claim process – a key reason VCT has been favoured by many investors in the past.

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.

Choosing the right EIS

While there are a huge number of EISs out there, including a few offering income tax relief in this tax year and carry-back to 2019/20, choosing which to invest with is more important than ever. In an environment where there have been multiple rule changes and some high profile (for all the wrong reasons) exits from the market, there are three key areas in which a potential investor should be looking for consistency:

  • Deal flow: where is the EIS sourcing its deals from and what has been its long-term deployment record?
  • Investment strategy: how long has the EIS been operating – and importantly, has it had to change how it invests over this period, and if so, how long has it been operating under its current investment strategy?
  • Track record: does the EIS have a proven history of successful exits under its current investment strategy?

A new option for tax year end

In previous years, the need to carry-back income tax relief to the prior tax year has frequently driven investor behaviour at tax year end, rather than the quality of an EIS’s deal flow, investment strategy and track record. With the advent of the new EIS Knowledge Approved Funds, investors can have the best of both worlds: access to quality deal flow via quality EIS managers, whilst linking all of their initial income tax relief to the current tax year, with the entirety therefore available for carry-back to 2019/20.

Within these new fund structures, HMRC allows 100% of the initial income tax relief to be linked to the close date of the fund, whilst requiring subscriptions to be deployed over the following 12-24 months, with at least 80% into Knowledge Intensive Companies. All other EIS reliefs are linked as usual to the dates of the underlying investments, and just one EIS5 is issued once the fund is 90% invested in order to claim tax relief.  

As an example, the Parkwalk EIS Knowledge Intensive Fund has a close date of 1st April 2021, meaning that the entirety of an investor’s initial income tax relief will be linked to that date, and may be utilised in the current tax year or carried back to 2019/20. With Parkwalk’s strong existing deal flow of Knowledge Intensive businesses driving our average deployment timeframe of 12 months, the EIS5 certificate is therefore likely to be issued around April 2022.

With yet another compelling additional reason to invest in EIS, we expect EIS to play an increasingly important part in the tax planning process and drive real returns for investors.

To learn more about EIS investing, see here. Please see our risk warnings around investing in EIS.