Robert Pemberton examines how advisers can utilise VCTs and EISs in retirement planning portfolios
Few people would argue that they pay too little tax while current financial market conditions are proving challenging with most asset classes delivering minimal or negative returns over the last year. As a result it is paramount that individuals take advantage of the opportunities on offer to enhance or create returns from a carefully constructed tax mitigation strategy.
The tax mitigation benefits of pensions are well known and appreciated but other opportunities are available. Among the most tax efficient options are venture capital trusts (VCTs) and enterprise investment schemes (EIS) which are traditionally at the high risk end of the investment spectrum but offer generous tax incentives.
Venture capital trusts
VCTs were introduced by the UK Government in 1995 to encourage direct investment in small trading companies. VCTs are companies themselves, listed on the London Stock Exchange, and approved by HMRC. They are in effect a tax efficient investment trust. To qualify as a VCT, the trust must invest 70% of its capital in 'qualifying companies' within three years and not have more than 15% in any one company. Companies in which the VCT invests must have less than £7m of gross assets at the time of investment and £8m immediately afterwards. They must also employ less than 50 people. The balance of the VCT's funds, up to 30%, may be held in 'non-qualifying' investments such as cash, gilts, structured products or unit trusts. The investment limit on which income tax relief will be available is currently £200,000 per year and the minimum holding period to qualify for this is five years.
The tax advantages
- Income tax relief is currently 30% regardless of an investor's marginal rate of income tax. Thus, the effective cost of £100,000 invested is only £70,000; the tax rebate easy to reclaim through completion of the special VCT section of your tax return;
- Income from both income yielding investments and capital realisations are distributed as tax-free dividends and gains made on the sale of VCT shares are free of capital gains tax (CGT). In addition, capital gains and distributions from underlying UK companies within the VCT are free of corporation tax.
Tax benefits are all well and good but of no use if the VCT proves to be a poor investment losing most of the investors' initial capital. VCTs have a somewhat chequered past; tough lessons have been learnt and today's products are by and large more robust investment propositions.
The early VCTs were generalist in nature investing in small companies in a wide range of businesses, 1999 and 2000 saw a plethora of specialist tech VCTs with all too predictable results. The savage bear market from 2000 until 2003 highlighted the poor quality of many of these trusts and subsequent years have seen less issuance but of a far higher quality. Nowadays VCTs tend to be available in four categories:
- AIM - companies that are listed or seeking listing on the alternative investment market;
- specialist - narrowly defined sectors such as healthcare;
- limited life - aim to protect capital and return it at the earliest opportunity.
Significant changes in tax legislation over the years which both reduced income tax relief and increased the holding period had the effect of reducing inflows into VCTs while also improving their risk profile. VCTs nowadays tend to avoid start-up companies favouring development capital for established businesses or management buyouts (MBOs). The introduction of limited life VCTs is part of an increasingly innovative trend towards capital protection and mitigating the risks traditionally associated with VCTs. These trusts invest in businesses with substantial property assets or predictable revenues such as nurseries, pubs and health clubs, or cashflow backed by contracts such as live events.
- VCTs have traditionally invested in small, higher risk companies though the recent trend to asset and cash flow backed VCTs can mitigate this effect;
- though they are listed companies there is no secondary trading in VCTs as the tax relief is only available to the initial investor. VCT prices are invariably quoted at a discount to net asset value (NAV);
- the investor needs to understand the trust's exit strategy for returning capital after the five year qualifying period. Again, the limited life VCTs bring transparency to this issue.
Enterprise investment schemes
EIS funds are broadly similar to VCTs in that they offer substantial tax advantages to encourage investment in small companies. When EIS were first introduced they were often in single companies with a high commensurate level of risk but there has been an increasing issuance of EIS portfolio with broadly similar characteristics to VCTs including asset or revenue backed companies.
The maximum annual investment is £500,000, minimum holding period is three years and the schemes offer different and complementary tax breaks to VCTs. Income tax relief is 20% rather than 30% but the real benefit of an EIS is that investors can defer CGT on realised gains sold up to three years previously through investment in an EIS. The 2008 Budget changed the headline rate of CGT from 40% to 18% such that an investor with crystallised capital gains charged at 40% can now effectively defer the gain via an EIS fund and benefit from the new lower CGT rate of 18%. Gains on an EIS fund (other than those for which deferral relief is claimed) are tax free and after two years of ownership an EIS investment is treated as business property and becomes exempt from inheritance tax which can be particularly attractive for older investors.
Both VCTs and EIS can offer an attractive investment proposition together with substantial and complementary tax mitigation benefits which offer considerable value in protecting and enhancing personal wealth. They are typically of most benefit to those individuals seeking capital growth with large incomes as well as those clients with existing capital gains and/or substantial estates. The key issue must always be that the investment proposition on offer is attractive enough in its own right and that the tax mitigation benefits are not the sole raison d'etre for investment. 'Don't let the tax tail wag the investment dog' is a well known phrase which neatly encapsulates the issues with these schemes, but the right investment within a tax efficient environment can provide substantial rewards for those prepared to take the additional risk.
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