Mark Bower-Easton, Business Development Manager, Oxford Capital
The government has been promoting private investment in to early-stage businesses via the Enterprise Investment Scheme (EIS) since 1994, and it shouldn’t be underestimated just how important entrepreneurial businesses are to the UK economy. EIS are high risk, but also offer the potential of strong returns, along with some attractive tax reliefs, which can address some major pain points of the UK taxation system for investors.
Following on from our recent blogs focusing on income tax relief and Capital Gains Tax Deferral Relief, I will now focus on how investing into an Enterprise Investment Scheme can help to reduce an individual’s Inheritance Tax Liability. Again, I will be examining the rules around this relief and our case study subject, Mrs Smith will be making another appearance. The case studies illustrate how an EIS investment can be used to help mitigate a number of tax issues that UK resident investors may face, including today’s main topic, Inheritance Tax Relief.
Each individual UK resident is given an Inheritance Tax nil-rate-band of £325,000. If the individual is married, their nil-rate transfers to their surviving spouse, effectively providing a £650,000 nil-rate-band, as there is no IHT to pay between spouses.
A portfolio of shares or funds would be liable to Inheritance Tax upon death, as would cash. If they had been gifted prior to death, the survival period required for the portfolio to become fully IHT-free would be seven years. The rate at which IHT would be payable tapers down over that seven-year period, from the full 40% in years one and two, down to 8% in year 6.
EIS shares benefit from being eligible for Business Relief (BR). As a result, the shares held within an EIS can be passed on to beneficiaries without any liability to IHT so long as they have been held for a minimum of two years, and are still held, at the point of death. The two-year ticking clock commences from the date stated on the EIS3 certificate from the company you have invested in to.
Now let’s introduce Mrs Smith, to illustrate how EIS can be used to help alleviate IHT concerns:
Mrs Smith and her husband are now reaching an age where IHT planning is becoming an issue. They have two non-dependent children and want to leave as much of their estate to them as possible. They have resided in the UK for the past 25 years, and are deemed UK domiciled for IHT purposes, and therefore liable to IHT on worldwide assets. Mrs Smith and her husband have an estate valued at £5,900,000, which is broken down as follows:
- Main residence and possessions: £1,500,000 (liable to IHT at 40%)
- Combined pensions: £2,000,000 (exempt from IHT)
- ISAs: £750,000 (liable to IHT at 40%)
- Shares: £750,000 (liable to IHT at 40%)
- Cash: £650,000 (liable to IHT at 40%)
- EIS: £250,000 (exempt from IHT, as have been held in excess of 2 years)
From this breakdown, £3,650,000 of their estate would be liable to IHT (Total estate value, minus exempt assets). They both have their £325,000 nil rate band available, and as there is no IHT to pay between spouses this will in effect reduce their estate liability down to £3,000,000 upon 2nd death. 40% tax would be payable on this amount, giving rise to an inheritance tax charge of £1,200,000.
They have asked their adviser about ways to reduce their IHT liability further. The adviser has mentioned gifting, although the £3,000 annual limits won’t solve the problem anytime soon. Also, any gift in excess of the gift limits could find their way back into the estate for IHT purposes due to the 7-year rule, should they not survive.
Mr & Mrs Smith are pleased with the performance of their EIS, and they still have the risk appetite to invest further amounts. They realise that there is very little that can be done with the liability caused by their main residence and possessions. However, they could look at reducing their IHT liability from their ISAs, shares and cash holdings.
ISAs are very tax-efficient investment vehicles, but not for IHT purposes. Mr and Mrs Smith could look to sell down some of their portfolio without any liability to tax, and could invest the proceeds in to an EIS, taking advantage of the initial income tax relief, and BR, making the holding exempt from IHT after a two year holding period.
Mr & Mrs Smith’s share portfolio would be liable to CGT on encashment, but not on death. However, the entire amount would be liable to IHT upon death. They could sell down some of their shares and invest in to an EIS. They would again receive income tax relief and IHT exemption after two years, but could also take advantage of CGT deferral relief which we covered in our previous blog, here.
Mr & Mrs Smith have a large cash holding, spread across numerous current, savings accounts and providers. Again, this amount would be liable to IHT. They could look to divert a proportion of their deposit holdings to EIS, again giving them the benefit of income tax relief and relief from IHT after holding their EIS shares for two years.
The adviser suggests Mr & Mrs Smith sell down £250,000 from their ISAs, £250,000 from their shares, and £250,000 from their cash holding, and invest it in to EIS. The result of this action would be to reduce the taxable estate value from £3,650,000 down to £2,900,000 (not including their respective nil rate bands), and after a holding period of two years there would be a reduction in IHT payable from £1,200,000 down to £900,000, a tax saving of £300,000. In addition, they would benefit from Income tax relief at 30% of the invested amount and could indefinitely defer any CGT liability resulting from the disposal of their shares.