Tax lure for investors sparks VCT and EIS demand

INVESTORS are set to plough millions of pounds into tax-efficient vehicles that were given a massive shot in the arm in last week's Budget.

Enterprise investment schemes (EIS) and venture capital trusts (VCTs) are poised to be among the biggest beneficiaries of the measures set out by Chancellor George Osborne.

Both enjoyed a popularity boost when the 50 per cent rate of tax was introduced last year, as high earners sought to maximise their tax-efficient investment opportunities.

Now Osborne has revealed that the tax reliefs available on EIS and VCTs, which invest in fledgling companies, are to be extended in a bid to encourage more investment in small firms.

EIS already offer capital gains tax (CGT) deferral, with exemption from CGT for any gains made on EIS qualifying shares held for three years or more. But dividends are not tax-free.

However, dividends are CGT-free in VCTs, which offer 30 per cent income tax relief on investments up to 200,000 each tax year, provided the investment is held for five years.

There will also be 30 per cent tax relief on EIS from next week, after the government raised it from 20 per cent in the Budget.

There are several other changes that will interest potential investors.

From April 2012, the maximum that both EIS and VCTs can invest in individual companies will jump from 2 million to 10m and they will be allowed to invest in firms with up to 250 employees, up from the present 50 staff limit.

The amount that individuals can invest in EIS every year will double to 1m next April, at which point the qualifying company limits for both VCTs and EIS will rise from 7m to 15m.

Tom Munro, director of IFA Tom Munro Financial Solutions, said: "These changes will massively expand the level of investment available to small companies, ensuring that both EIS and VCTs can do more to help them grow their businesses."

Some experts predict that the changes will trigger a surge of interest that could see investment volumes rise at least threefold.

Jonathan Gain, chief executive of tax-efficient investment specialist Stellar Asset Management, said EIS in particular now "look fantastic" to investors.

He said: "Identical income tax relief to VCTs and a shortened holding period, with the additional benefits of deferring capital gains, utilising loss relief and inheritance tax relief, all of which VCTs do not offer. So they are now much more attractive to investors."

And Matthew Woodbridge, head of investment products, Chelsea Financial Services, said: "Increasing the income tax relief on EIS to 30 per cent and aligning it with VCTs is a step in the right direction in reducing the complexity of these investments and should precipitate a surge in interest among investors."

But there are some reservations about the prospect of more investors piling into EIS and VCTs, because while both offer significant tax benefits for higher rate taxpayers, investors also risk losses. Patrick Connolly, head of communications at AWD Chase de Vere, said: "There is a risk that increasing initial tax relief on EIS will attract those for whom they are not suitable investments, as we have seen with VCTs, which are even sold 'off the page' as effectively mass-market products.

"EIS and VCTs are both designed to support small enterprises and investors are given attractive tax benefits because these investments should carry high levels of risk."

Some VCTs are riskier than others, depending on their structure and focus. Investors wanting to limit their exposure to risk are often advised to focus on "planned exit" or "limited life" VCTs, which are typically wound up after five or six years, with the proceeds distributed to investors.

But they are still suitable only for those happy to keep their money invested for at least five years and who are comfortable with a high level of risk.

Munro said: "Investing into this sector is not without its problems and as we have seen in the past risks can be high, as numerous fledgling companies fail to break even over the medium- or longer-term, leaving some investments significantly down over the three- or five-year period for EIS and VCTs."

The risk of the schemes also stems from their low liquidity, with potential for investors to have problems selling their shares at a price reflecting their underlying value.

And VCTs can be expensive, with annual charges of around 3 per cent and initial charges of 5 per cent, although these are usually lower if bought through a discount broker.

The risk, costs and the complexity of the schemes makes it highly advisable to get specialist advice before buying in.

While tax is the real driver of the popularity of the vehicles, the type of different products within the sectors, and the levels of risk and return on offer, vary widely.

Munro likes the VCTs and EIS provided by Octopus Investments, which has several options based on an investor's appetite for risk.They include a capital protected product for risk-averse investors, which aims to return the original investment with a nominal rate of interest, usually around 4 or 5 per cent.

He said: "Although this sounds well below average, if you consider the 30 per cent relief on VCTs (and on EIS from 6 April), an investment of 50,000 would net down to 35,000 after tax relief of 15,000 has been claimed.

"A higher rate taxpayer subsequently investing the same 15,000 into a pension arrangement would have the contribution grossed up by 20 per cent tax relief to 18,750, and a further 20 per cent relief can be claimed via self-assessment, taking the total investment to about 71,750 on an initial outlay of only 35,000 before any investment return," said Munro.