On the face of it, EIS (Enterprise Investment Scheme) and VCTs (Venture Capital Trusts) look to be similar opportunities. Both are high risk investments, investing in early-stage unquoted businesses, while providing investors with some attractive tax benefits that offer a tax efficient alternative to annual ISA and pension contributions.
However, look beyond these top-level similarities, and you will see some significant differences. Below is a summary table of the key features and benefits of both:
Feature / Benefit
|Annual Contribution Limit||£200,000||£1,000,000|
|Tax Year Carry Back Option||No||Yes|
|Minimum Holding Period for Income Tax Relief||5 years||3 years|
|Income Tax Relief||30%||30%|
|Tax-Free Capital Gains||Yes||Yes|
|CGT Deferral Relief||No||Yes|
|IHT||No||Yes, after a 2-year holding period|
At present, VCTs are by far the more popular option to invest in venture capital. It is understandable why this is the case – the VCT is a fund-based approach, which will be familiar to anyone who invests in more traditional assets such as unit trusts or pension funds.
Also, a VCT has a reputation for being slightly more liquid. Although the minimum holding period to maintain income tax relief is five years, compared to three years, the fact that a VCT must be listed on a recognised stock exchange means that there is a market to buy and sell holdings in VCT stocks. The reality, however, is that the market still relies on there being a willing buyer of the shares, and these markets usually operate at a significant discount to NAV (Net Asset Value). Whilst the minimum holding period for EIS is three years, the likelihood of a successful exit after three years is slim. Realistically, an EIS will need to be held for 5-7 years. The reason for this is simple – VCs invest in business at their earliest stages, and it takes effort and time to build a successful business to a point where it is big enough to IPO, or attractive enough to be purchased.
If an investor simply has a requirement to gain income tax relief and generate a tax-free income, then VCTs are certainly the way to go, as unlike EIS, dividends generated from VCTs are tax-free. The way VCTs and EIS generate their returns are different. VCTs generate their returns by providing investors with tax free dividends, which are paid out from the revenues generated by the underlying companies, and upon exit, VCT investors will ordinarily receive their initial investment amount back. With EIS, the focus is on increasing the value of the businesses, so they become as attractive as possible for a successful exit, so it makes no sense to pay out dividends, especially as dividends are taxable.
Going back to the table above, advisers and investors may be missing a trick by not looking more closely at EIS for those who aren’t looking for a tax-free income.
Let’s focus on the core differences:
- Capital Gains Tax Deferral Relief
Unlike VCTs, EIS provides investors with the ability to defer a capital gain, by investing the profit generated from another asset into an EIS, which will defer the necessity to pay the CGT bill all while the gain amount is held within their EIS. Many investors we speak to are sitting on share or property portfolios with big capital gains, and using an EIS to help crystallise those gains, but avoid having to pay a hefty CGT bill. CGT is the only tax liability that dies with you, and if you can also reduce IHT liability at the same time, this is a real benefit.
- Inheritance Tax Relief, via Business Relief
Unlike VCTs, the underlying shares in EIS qualify for Business Relief (BR). This means that, subject to a 2-year minimum holding period, and the shares still being held at point of death, those shares will fall outside of the investor’s estate for IHT purposes. This can be of huge benefit when conducting estate planning, as by making use of CGT deferral relief and Inheritance tax relief, an EIS moves from simply being a high-risk investment with some attractive income tax reliefs, to a holistic tax planning tool. Providing that as an investor you have a suitable attitude for risk, capacity for loss, and do not require short-term liquidity.
- Loss Relief
Unlike VCTs, EIS provides a safety net. The UK Government is effectively underwriting a significant proportion of the downside risk by giving every investor the opportunity to apply for loss relief for those occasions where a company struggles or fails.
If the share value drops to zero (i.e., the company fails), or the shares are sold for less than the original amount invested, then an investor can claim loss relief, which will enable them to offset a loss made on an EIS company against either their CGT bill or income tax bill, depending on which best suits their situation. The amount of loss relief provided depends on your income tax rate, so if you are an additional rate taxpayer, the maximum loss you could incur by investing into EIS is 38.5% of your capital.
Loss relief is based on each company in a portfolio, not on the portfolio overall. So, even if your EIS portfolio shows a 3x return, if there are one of two failed companies in there, it is perfectly acceptable to claim loss relief on these.
To summarise, the choice is quite simple – if as an investor you are looking for income tax relief and a tax-free income, then VCTs are certainly a good option. However, if you are looking for tax-free capital growth, to help defer CGT, or if you are interested in investing in to early-stage companies but want the comfort of a downside safety net, then an EIS is a consideration.