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The 2006 Budget signalled major changes to the EIS and VCT regime. Now that the market has had time to digest these changes, we consider the merits and pitfalls.
VCTs
The changes announced in April 2006 seem likely to herald the end of a boom period for the Venture Capital Trust (VCT) market. VCTs raised over £1.2bn from private investors in 2004/05 and 2005/06, the primary attraction being the 40% income tax relief on investments up to £200,000.
Relief has been reduced to 30% as of 2006/07. In addition, the size of qualifying companies has been reduced, presumably in order to focus investment on the smaller end of small companies. Investors are now required to hold VCT shares for a minimum of five years as opposed to three.
We will have to wait and see what effect these changes will have on the VCT market, but it is bound to dampen demand, which is clearly what is intended. Commentators suggest that the size of the market will reduce to £200m in 2006/07, roughly a quarter of last year.
EIS
Enterprise Investment Schemes (EIS), long considered the poor relation of VCTs, deserve a better press. The income tax relief on investments of up to £400,000 in 2006/07 may only be 20%, but EISs offer three things which VCTs don’t: capital gains deferral, inheritance tax exemption (after two years of ownership) and loss relief. The only thing they don’t provide is tax free dividends. The mere mention of loss relief can send shivers down the spines of investors, but if approached on a portfolio basis, which is the logical method, losses can be set against gains.
There were comparatively few gains in the period 2001 to 2004, although there has been a strong revival in the last two years. Capital gains are often made on unquoted securities or family business holdings and are now subject to accelerated taper relief, the effect of which is a 10% tax liability rather than 40% (assuming a minimum period of ownership of two years). Having said this, following the recent upturn in the stockmarket and substantial increases in the property market, there are now increasing numbers of people with good gains on personal assets which are subject to tax at 40% – and these are sometimes substantial.
Remember, to defer a CGT liability, you need only to invest the value of the gain or the profit itself and not all of your disposal proceeds. So, if your gain is £10,000, you need to invest £10,000 in the EIS, and in the process you defer or freeze the £4,000 CGT liability you would otherwise have to pay if it was subject to tax at 40%. It should be noted that this is a deferral, not an outright relief. When the EIS shares are disposed of, the original CGT liability is re-triggered, but can be re-deferred by reinvesting the value of the original gain.
It should also be remembered that the EIS provides unlimited CGT deferral (the raised £400,000 annual limit is only in respect of income tax relief) and this can be in respect of gains realised in the previous three years. What’s more, if you have already paid the CGT on those gains, you can reclaim it (plus interest!). Finally, EIS companies (even those on AIM or OFEX) are exempt from inheritance tax on death, assuming the shares have been owned for two years, unlike VCTs which are fully taxable, along with most other classes of asset. So the lesson here is that whilst VCTs may be good for providing tax-free lump sums in later life, try not to die with one!
Building an EIS portfolio
Building up an EIS portfolio can be difficult for a private investor. Investments can only be new share issues and it is difficult to access new share deals, even if you can find out about them The answer is to enlist the help of a manager specialising in EIS with access to deal flow, who can build up a portfolio of investments for you.
EISs are often dismissed for their low quality. However, the standard has risen steadily in recent years and today there is a reasonable choice of good quality investments. There are still some assetbacked trades which are allowable for relief. Children’s nurseries were all the rage as EIS investments a few years back, but more recently the favourite has been pubs, which have a business model most investors can understand!
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