As markets continue to deteriorate, investors should consider the tax relief offered from VCTs and EIS portfolios, argues Martin Sherwood
Venture Capital Trusts (VCTs) have been one of the major success stories of recent years. But like many investment products, they have taken several years to become fully established. Introduced in 1995, they were viewed with suspicion and dismissed as too risky for a long time.
But people have slowly come to feel more comfortable with them, encouraged no doubt by the superb returns from some of the leading funds as we approach the end of the initial five-year period. Values of more than £2 for each £1 invested are not unusual, a net return of 150% on a net cost of 80p. The VCT market is likely to take around £450m this tax year, a sharp increase on the £270m of last year, itself the best so far.
Analysts and advisers have consistently overplayed the risk profile of VCTs. With a high-quality manager and a wide spread of investment, the risk profile is definitely at the lower end of the scale. In fact, a portfolio of blue chip equities could be considered a lot riskier, certainly in the short term. The vital thing about a small company portfolio is spread ' you can never have too much. Not surprisingly, the bigger the fund, the greater the spread and the lower the risk.
Many people fail to understand how the share prices of VCTs work. Investors receiving the full tax breaks have no incentive to sell their shares before the expiry of the initial three-year tax term.
While buyers of second-hand VCT shares receive two of the four VCT tax breaks (tax-free dividends and exemption from tax on any profits made), there are few that want to invest without the advantage of the initial tax reliefs.
This is therefore not a liquid market and almost all VCT shares drift to a discount to their issue price. Since selling VCT shares re-triggers the original CGT, we believe many people will opt never to sell their VCT shares. If you can strip all the value out by way of tax-free dividends, why bother with selling them and re-crystallising the original tax liability?
Since their inception in 1994, Enterprise Investment Schemes (EIS) have had a fairly poor press. People have generally dismissed them as too risky to warrant serious consideration. Many people have associated them with the worst excesses of the 1980s and likened them to the early Business Expansion Schemes (BESs), many of which went bust. They almost invariably regard them as an investment of last resort, as if you would have to be fairly mad or desperate to invest in one.
These attitudes are out of date. In recent years, the choice, variety and quality of available EIS investments has risen steadily, to the extent that it is now entirely possible to put together a balanced portfolio of high-quality smaller company investments, all of which qualify for EIS relief.
People are becoming more and more comfortable with VCTs but still largely dismiss EISs because they are single companies rather than a spread fund. They don't realise that you can replicate the structure of a VCT by investing in a portfolio of EISs, as opposed to just investing in a single scheme.
So what are the advantages of EISs over VCTs? Unlike VCTs, when you invest in an EIS you get unlimited CGT deferral and a higher limit of £150,000 per year for income tax relief (both are limited to only £100,000 per year with VCTs). With the EIS, CGT deferral can be claimed on gains going back for up to three years, instead of only one year with VCTs.
What is more, if CGT has already been paid on a gain made within the last three years, it can be reclaimed from the Inland Revenue (plus interest). And provided you survive for two years, an EIS investment is inheritance tax exempt.
How do you go about establishing an EIS portfolio? This is not easy to do on your own, as you need not only access to information, but also to the deals themselves. All too often the first you will hear about an issue is a short report in your weekend newspaper.
A quick phone call on Monday confirms your worst suspicions ' that the issue is fully subscribed already, or worse still, restricted to the clients of a particular firm. This is why two or three of the smaller company brokers have recently launched EIS portfolio schemes. No-one's deal flow is perfect but theirs is likely to be a lot better than yours is.
A good portfolio will contain a spread of stage and sector. In general, the earlier you invest in the life of a company, the cheaper your investment will be. If you're only investing at the flotation stage, you will be paying considerably more than at an early stage. Spread of sector protects you against a sharp downturn in any individual sector. The last year has seen a fairly savage mark down in the value of smaller IT and internet companies but many old economy holdings have been relatively unscathed.
There are even safe asset-backed activities that are still allowable for tax relief. Just occasionally, you get one that is not only asset-backed but also where the asset will appreciate substantially in value ' children's nurseries is a current example.
All portfolios rely on the star investments to achieve an outstanding performance record. And what are the star investments of today? Here are just four: a recently floated IT consultancy business of the highest calibre, whose shares have already doubled in value since flotation; an electronic messaging company due to come to the market shortly, which is already worth three times cost; a hi-fi speaker business due to float in the next year, already worth five times cost; and an electronic employee benefits company due to float soon, already worth three times cost.
People become liberated by the knowledge that all CGT liabilities can be sheltered. All they have to do is sell the asset, give rise to CGT on the gain, and defer the tax liability by re-investing the value of the gain into a spread of VCTs and EISs. We have a client who saved over £1m CGT in this way when he sold his business and retired. Another client felt she was trapped or locked into shares because she could never sell them without giving rise to a tax bill. She found out about an EIS portfolio just in time to sell out at the top of the market.
We also have a steady trickle of middle-aged clients with elderly parents, who have just woken up the fact that they can avoid inheritance tax by disposing of their elderly parents' share portfolios and transferring into an unquoted portfolio.
Aim portfolios are particularly popular for this purpose, as they rank as unquoted for tax purposes but are relatively liquid to provide an easy disposal when the elderly parent dies.
Most people assume that you have to have a tax problem to invest in an EIS. To date, this has been the spur.
As the main markets continue to deteriorate however, serious consideration should be given to investing in VCTs and EIS portfolios even if you don't have a capital gain to shelter. After all, they provide 20% income tax relief, so the net cost of investment is only 80p in the pound.
All profits made on the investment are free of tax on disposal. And just look at the returns of the top VCTs that are currently in the process of maturing ' several times your money back after just five years, and once again, it is free of tax.
VCTs were dismissed as too risky when introduced in 1995.
VCT market is likely to take around £450m this tax year, a sharp increase on last year's £270m.
Bigger funds have a greater spread and consequently are lower risk.
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