EIS Explained. 3rd Edition LACOMP BRITISH ENTERPRISE EIS FUNDS

EIS Explained 3rd Edition LACOMP BRITISH ENTERPRISE EIS FUNDS

Contents INTRODUCTION... P1 PROMOTING ENTERPRISE... P2 INVESTMENT ADVISORY PANEL... P3-4 STATUS OF FUNDS... P5-6 FUND INVESTMENTS... P7 TYPICAL CLIENT PROFILES... P8-9 EIS CERTIFICATION... P10 VALUATION... P11 TAXATION... Income Tax Relief... P12 Capital Gains Tax Exemption... P13 Capital Gains Deferral Relief... P13 Loss Relief... P14 Inheritance Tax Efficiency... P15-16 BESPOKE EIS PORTFOLIO SERVICE... P17 EIS and VCT COMPARED... P18-19 IMPORTANT NOTICE... P20

Introduction In the Budget speech of November 1993, the Chancellor announced the intention to provide a targeted incentive for investment in unquoted companies. The Enterprise Investment Scheme (EIS) was established on January 1st 1994 as a successor to the Business Expansion Scheme (BES). Although much of the BES legislation (contained in ICTA 1988 and TCGA 1992) was adopted, there were significant differences, and several budgetary changes have been made over the years. Traditionally viewed as a single-company investment (as opposed to the collective structure of VCTs), the original legislation allowed for EIS Funds to be created. The EIS Scheme plays a significant role in the provision of venture capital for small business according to HMRC figures, the scheme has raised 6.1bn and invested in over 14,000 companies. Such small enterprises are a key driver in raising productivity through innovation but often find difficulty accessing relatively modest amounts of capital because of the equity gap. The tax incentives are intended to help bridge that gap by encouraging investment in young and potentially risky enterprises. This is the third edition of this booklet, incorporating scheme changes that were introduced in the Budget of March 2008. Your attention is drawn to the important notice on p20 this booklet is intended as a brief overview rather than a comprehensive analysis of the Enterprise Investment Scheme. For more detail, refer to www.hmrc.gov.uk/eis. 1

Promoting enterprise and entrepreneurship Whilst the tax regime provides a reassuring backdrop to investment in EIS qualifying companies, Lacomp and the Investment Advisory Panel (IAP) are very much of the opinion that it is the growth potential of these early stage enterprises that provides the chief attraction. The risk/reward profile offers the potential for substantial tax-free capital uplift and the IAP take great care in both selection and ongoing monitoring of investee companies in order to realise this potential at exit. The Performance Fee reflects the commitment of the IAP to achieving capital appreciation merely achieving tax relief would be viewed as a failure of the process. Lacomp view the EIS tax benefits as a means to that end rather than an end in itself. Indeed, it could be argued that a concentration on capital preservation at the expense of growth potential is a negation of the spirit of the EIS legislation which is intended to promote improvements in productivity and competitiveness through the support of UK entrepreneurs. 2

Investment Advisory Panel (IAP) Lacomp has assembled a panel of small company finance specialists to assist in sourcing, selecting and monitoring investee companies. Each independent Panel member has over twenty years relevant experience in this field and, between them, will look at about a thousand business proposals per year. This gives Lacomp a steady flow of top quality business propositions to consider for the Funds and, more importantly, provides the luxury of being able to reject proposals that look basically sound in favour of the pick of the crop. Successful investee companies are closely monitored, with a Panel member usually attending each and every board meeting. The monitoring function serves not only as a protection for the interests of our investors but also as a means whereby we can assist the investee companies in their development. Using the extensive business network of the Panel, Lacomp are able to make introductions to potential suppliers, customers or business partners. Needless to say, there is also the possibility of identifying potential trade buyers, thus facilitating exits as the Funds near maturity. Paul Finnigan, Nigel Milton (standing) and Simon Pannett are independent members of the IAP 3

The Investment Advisory Panel members are: Paul Finnigan Nigel Milton Simon Pannett Director of Hoare Worth & Co Ltd, active since 1985 in mergers, acquisitions and fund raising for smaller companies. Paul brings these skills to bear as investment exit strategies are sought. Former Editor of Investing for Growth, Nigel is an acknowledged and successful stock picker and has contributed cover feature articles for financial publications such as Investors Chronicle and Money Week. Having worked for two City stockbrokers, Simon has spent the major part of his career in investment management and corporate finance with particular expertise in the smaller unquoted sector. The IAP is chaired by Lacomp Managing Director Peter Buxtorf (left), assisted by Investment Director Steve Willmot All Panel members are happy to discuss the investment selection process underlying the Lacomp EIS Funds they can be contacted via the Lacomp offices (01276 475123). 4

Status of Funds The Lacomp British Enterprise EIS Funds are Approved Investment Funds, as defined by HM Revenue & Customs. Approval by HMRC is not to be construed as an endorsement of the Fund or a comment on its risk status but is merely intended to highlight the differing taxation treatment. An Approved Investment Fund (AIF) must invest in a minimum of four qualifying companies. No investment can be made before the fund closes and 90% of the subscriptions (net of charges) must be invested within twelve months of this closing date. However, Lacomp will endeavour to complete fund investments within six months (the timescale applicable pre- October 2006) as it is felt that this provides a more helpful timeframe for advisers planning a CGT or IHT strategy for clients. Income Tax Relief for an investment made in an Approved EIS Fund is granted in the tax year in which the Fund closes, not when the investments into qualifying companies are made. Conversely, when it comes to CGT or IHT aspects, it is the date when the investment into qualifying companies is made that is relevant. 5

EIS Funds can be Approved or Unapproved There are crucial differences between the two forms: As the Approved Fund has to be invested within twelve months of the closing date, capital gains deferral calculations can be planned with greater accuracy when compared to the broader timeframe granted to Unapproved Funds. As an Unapproved Fund is allowed up to three years to choose its investments, it can be difficult for an adviser to undertake accurate capital gains and IHT tax planning on behalf of clients. As previously pointed out, Lacomp will endeavour to invest within six months to assist the planning process further. In the case of both Approved and Unapproved Funds, Capital Gains Deferral Relief and Business Property Relief is granted when investments are placed in the underlying investee companies. Such relief is based on the net amount invested. With an Approved Fund, the regulation covering the minimum investment into a qualifying company ( 500 through an Unapproved Fund or single EIS qualifying company) is relaxed this enabled Lacomp to set a minimum entry level of 3,000 per investor, effectively opening the asset class to virtually all investors with an appropriate risk profile. 6

Fund Investments The regulations covering EIS make specific reference to various industries and sectors that will be deemed non-qualifying. Examples of non-qualifying trades include: Dealing in land, commodities, futures or other financial instruments Dealing in goods other than through normal retail or wholesale trade Banking, insurance and other financial activities Oil extraction Legal or accountancy services Controlling another company which substantially operates in the above areas Property backed activities such as farming, forestry, property development, hotels or residential care homes The Lacomp British Enterprise EIS funds will only invest in business propositions that are demonstrably qualifying companies at the time of investment we require evidence of an in principle approval of EIS status from HMRC before making an investment. It should be noted that, on occasion, it might be deemed in the best long-term interests of investors to allow the qualifying criteria to be breached in order to secure an unusually profitable exit route, via a trade sale, for example. Lacomp always insists on vetoing rights (under the Subscription Agreement into which investee companies enter) that enable us to block any move that would void EIS qualification. Thus, for example, a change of business direction that carried no obvious monetary gain for our investors could be vetoed. These vetoing rights are retained by Lacomp for the duration of the Fund investment, typically three to five years. Apart from the above constraints, it is the intention that the Lacomp British Enterprise EIS Funds will be generalist in nature rather than overly concentrated in a specific sector. That said, the overriding criteria for selection are the quality of the business proposition and the potential for capital appreciation that it offers. This might, on occasion, create an apparent sector bias in a particular Fund. 7

Typical EIS Client Profiles Clients faced with capital gains. Capital Gains Deferral is no longer available in a VCT but remains a key aspect of EIS Funds. Clients in ill health who have a need to undertake estate planning but who are unlikely to survive long enough for a programme of gifting to be effective. After the shares have been held for a period of two years, the EIS investment falls outside the estate under the rules covering Business Property. Should the investor die after the shares have been issued, and provided they are left under a Will to the surviving spouse who retains them for the remainder of the two-year period, the investment remains outside the estate. The ability to substantially reduce the chargeable estate in this manner is a valuable estate-planning tool in this situation. Faced with a guaranteed 40% loss of wealth in the form of IHT, the admittedly higher risk profile of the EIS investment takes on an altogether different complexion in this scenario. Clients who wish to set aside assets in an IHT exempt vehicle but who are not prepared to commit to the finality of outright gifting could use a succession of Approved EIS Funds to build up assets outside their estate. After three years, the income tax relief and capital gains exemption is secured. If desirable, clients could choose to receive the proceeds in the normal manner (typically during years four or five) and take any tax-free gains for their personal use. In this manner, it would be possible to gradually build an IHT-exempt portfolio of assets. Given the new restrictions placed on lifetime gifting, this offers the client the ability to plan ahead without loosing control or access to their wealth. Reinvestment of the proceeds from a maturing EIS Fund allows the two year qualification period to be rolled over to subsequent Business Property without any time constraint on the reinvestment. Note that the two year qualification applies to the original invested amount any capital uplift must be held for two years before qualifying as exempt property for IHT purposes. 8

Clients with a well-diversified portfolio of quoted assets. They can gain further diversification through exposure to micro-cap companies with little or no correlation to the main markets whilst taking advantage of the tax treatment and the considerable potential for capital growth. Because few of the companies considered for investment by Lacomp are likely to have any exposure to global trading conditions or the geopolitical climate, there is a reasonable level of immunity to investor sentiment that often disrupts the main markets. The Investment Advisory Panel are of the opinion that a well diversified portfolio should hold up to 5% of assets in micro-cap companies. Speculative investors who are keen to capitalise on investment opportunities ahead of the capital uplift typically associated with a market listing. In this context, an Approved Fund can be seen as complementary to a VCT that is typically invested in companies that have already progressed through an IPO. The risk/reward profile of the two are very different. Clients who hold poorly performing VCT assets, particularly those earlier VCT issues which allowed CGT deferral, could consider selling and reinvesting the proceeds in an Approved EIS Fund. This would attract Income Tax Relief, perhaps offsetting the previous underperformance, whilst preserving the deferral of capital gains. Trustees seeking to comply with the Trustee Act 2000 but who find portfolio management constrained by heavy capital gains on longheld positions. Trustees have a duty to manage trust assets a buy and hold investment strategy is difficult to justify in light of this obligation. By using an Approved EIS Fund to unlock some of the gains, the remainder of the trust portfolio can be more actively managed and the Trustees can demonstrate the fulfillment of their duties. 9

EIS Certification Process Once the investment of a Fund has been completed, individual contract notes are issued to investors but claims for tax relief must await the issue of form EIS5. The process for claiming EIS relief is as follows: Investee companies must complete and submit a form (EIS1) to HMRC seeking approval. Of course, all investee companies have obtained HMRC EIS approval in principle before we make an investment. Whilst HMRC agree to acknowledge the application within 28 days, there is no timescale for the granting of approval. Once approval is granted, HMRC will send the investee company the form EIS2, together with a supply of EIS3 forms which the firm must complete and send to investors. In the case of the Lacomp EIS Funds, the sole nominal investor is Lacomp Nominees Ltd. who hold the documents of title on behalf of investors. Once Lacomp Nominees Ltd. has received an EIS3 from all the underlying Fund investments, Lacomp will issue a summary certificate (EIS5) to all individual investors. Lacomp as Fund Manager is at the end of this chain of paperwork and cannot therefore issue certificates until all the pieces are in place. This can be a potential source of frustration to both Lacomp and individual investors. You may rest assured that we regularly prompt both investee companies and HMRC in order to speed up the process as much as possible but, as with most bureaucratic processes, there can be delay at various points in the procedure. 10

Valuation of Portfolios Putting a value on companies in the early stages of their development essentially is a subjective process. In essence, a company is only worth what a willing buyer is prepared to pay. This, in turn, presupposes that there is a willing seller! In truth, there are no real gains (and no real losses) until an exit has been successfully negotiated. Lacomp deliberately pursue a conservative valuation policy, only uplifting the valuation where this can be substantiated by events that are either in the public domain or known to us as a result of our close ties with the investee companies. Equally, the valuations reflect any dilution arising from new investment rounds even though this may well be for the ultimate benefit of the investee company and, therefore, its investors. Investors will receive half-yearly valuations but Lacomp only place a value on funds which are more than two years old. During the first two years, the valuations will reflect the purchase cost of shares and thereafter will be based on the most recent price paid by incoming investors (or on information gathered during the monitoring of board meetings). Much of the information received at these meetings may be deemed confidential or commercially sensitive so Lacomp will not necessarily reveal the justification for valuation decisions. At all times, the valuation policy is conservative Lacomp prefer to surprise investors with good news rather than disappointment. 11

Taxation Individuals investing in an Approved Investment Fund benefit from advantageous taxation treatment in the following areas: Income Tax Relief Granted at 20% on the first 500,000 invested. Note that an income tax liability can only be reduced to zero using EIS relief it is not possible to reclaim income tax beyond the liability arising in the relevant tax year, as determined by the Fund s closing date. Example 1: Mr J invests 50,000 into an Approved EIS Fund. He will be able to claim 20% income tax relief in the tax year in which the fund closes. The relief is given on the net investment in the underlying assets, not the gross amount. 12

Capital Gains Tax Exemption Granted on the first 500,000 invested Example 2: Mrs S has a chargeable gain of 550,000 from her share of the sale proceeds of the family business. She invests 550,000 into an Approved EIS Fund. Any growth on the first 500,000 of the investment will be free of capital gains when her fund holding is sold. Capital Gains Deferral Relief Granted on gains crystallised in the period beginning 36 months prior to, or ending 12 months after, the date of investment into qualifying companies. Deferral relief is based on the net investment in underlying companies. Continuing with the example of Mrs S, her gains arose from the sale of the family business in May of 2008. Without the EIS investment, her share of the gain would be reported on her 2008-09 tax return and tax would have been payable on 31st January 2010. By investing in the EIS fund, the entire gains liability can be deferred until crystallised again when the fund is sold. At that point, she would be able to set some of the crystallised gain against her annual CGT allowance and defer the remainder through investment in a further EIS fund. Any gain on the original investment would, of course, be free of capital gains tax on the first 500,000 invested. Had the gain been realised in, say, January 2006 then capital gains tax would already have been paid. Provided her investment via the Fund into qualifying EIS companies is made within 36 months of crystallising the gain, then any capital gains tax already paid can be reclaimed. 13

Loss Relief Should one of the underlying investments fail, Loss Relief is granted against either income tax OR capital gains tax. For example, Mr P. invested 20,000 into an Approved Fund that comprised five investee companies. Assume that one of the five has failed completely and gone out of business. Mr P. would be able to offset the loss on the relevant portion of his investment against either his income tax or chargeable gains arising in the Tax Year in which the fund is wound up. Note that the loss relief is calculated net of any income tax relief: Investment in failed company 5,000 Income Tax relief ( 1,000) Loss relief available ( 4,000 x 40%) ( 1,600) Net loss to a higher rate taxpayer = 2,400 Whilst every effort is, of course, made to avoid any such disasters, loss relief does serve to limit the damage. From the above, it can be seen that loss relief provides an effective limit to the downside of 48% for a higher rate taxpayer. Furthermore, an Approved EIS Fund holds a portfolio of discrete and unconnected investments the failure of one has no impact on the performance of the other constituents of the Fund. This contrasts with a listed vehicle such as a VCT or a unit trust where the failure of an underlying investment constituent will simply depress the net asset value (NAV) and, hence, the share or unit price. 14

IHT Efficiency Once the investments have been held for a period of two years, they will qualify for Business Property Relief, thus making them exempt from Inheritance Tax (IHT). Because of the substantial revisions in the IHT regime arising from the changes to the treatment of trust assets announced in March 2006, the provisions for Business Property Relief look increasingly attractive. The ability to remove assets from the estate after only two years is worthy of consideration where clients face a substantial IHT liability. Example 1: Mr J. receives some bad news from his doctor, indicating that his life expectancy is likely to be severely curtailed. He and his wife had been intending to take steps to reduce the IHT liability on their estate through the use of potentially exempt transfers of assets to their children. Now that this avenue has been restricted, the tax treatment of an Approved EIS Fund looks attractive. Mr J. makes an investment into an Approved EIS Fund and adds a codicil to his Will ensuring that the EIS investments pass to his wife on his death. Should he die soon after the fund has invested in the chosen investee companies, the Business Property exemption will hold provided his wife is still alive (and holding the EIS Fund) two years from the date of his original investment into EIS qualifying companies. Upon her death, the assets pass to the children free of IHT. If gifted prior to her death, they would constitute a PET. 15

Example 2: Mr S. is widowed with two children. He wishes to undertake some estate planning but is wary of making outright gifts to the children as he is concerned that he might require funding for residential or nursing care in his later years. By investing in an Approved EIS Fund he can create a potentially growing asset that will be exempt from IHT provided he has held the assets for at least two years. The investments remain in his name so he could, of course, elect to take the cash proceeds for his personal use if he so wishes when the Approved EIS Fund is wound up. Alternatively, the business property treatment can be retained through reinvestment of the proceeds the two years qualification (relating to the original investment amount) is not lost provided reinvestment occurs prior to death. Of course, only those funds held for two years or more would be exempt but this represents a useful approach for younger clients in good health. The annual gift allowance of 3000 could be used, for example, allowing the donor to exercise some control over the intended gift whilst the recipients are considered too young (or irresponsible!) to use the money wisely. Example 3: If Mr S were asset rich but did not have sufficient liquid funds to make a large investment, the EIS holdings could be built up piecemeal over a number of successive EIS funds in effect, an IHT savings plan. 16

Bespoke EIS Portfolio Service For substantial investments, Lacomp are able to offer an openended EIS portfolio service for investors where it is considered to be a preferable strategy by their advisers. Please contact us to discuss our special terms for portfolio investors. Whilst the investment selection and monitoring are similar to those of the Lacomp British Enterprise EIS funds, the portfolio can be tailored to meet the investors individual objectives and chosen risk profile. Even with the new restrictions on market capitalisation and staffing levels, it should be possible to identify suitable qualifying companies from the AIM market in order to provide asset-backed and income-producing constituents if a client prefers a less aggressively growth orientated approach. Lacomp would draw on Investment Advisory Panel member Nigel Milton s close knowledge of the AIM market in selecting such investments. 17

EIS and VCTs Compared Risk / Reward Maximum Allowance Income Tax Capital Gains Deferral Capital Gains Exemption Inheritance Tax A VCT is a listed investment trust, subject to market sentiment, whereas investments in an EIS Fund stand or fall on their merits, with negligible correlation to the market. Typical VCT holdings will comprise AIM listed investments, whereas the Lacomp EIS Funds chiefly invest in early stage opportunities, prior to the capital uplift usually associated with a listing on AIM. Now that the market capitalisation of qualifying companies has been restricted to 7m, the scope for VCTs to invest in larger asset-backed companies has been significantly curtailed. Taken with the restriction on employee numbers, this brings the risk profiles of the two vehicles considerably closer. Full tax relief is granted on the first 500,000 in the case of EIS but remains at 200,000 for VCTs. Relief is at 20% on EIS, and at 30% for VCTs. No longer available with VCTs a point often overlooked. EIS can defer unlimited gains crystallised in the 36 months prior to, or in the 12 months after, the date of investment into EIS qualifying companies. The maximum limit is 500,000 for EIS but remains at 200,000 for VCTs. EIS is IHT exempt after a two-year holding period under Business Property Relief rules. Because the VCT is a quoted security, those assets held in a VCT do not qualify as Business Property and always form part of the taxable estate at death. 18

Loss Relief Qualifying Period Subscribers When a constituent of a VCT portfolio fails,it depresses the net asset value ( NAV ) of the trust. In the case of an EIS Fund, the loss can be crystallised out of the portfolio and offset against either income tax or CGT. EIS tax reliefs are secured once the investment has been held for three years whereas VCT tax reliefs require that the investment is held for five years. This places a restriction on early exit from the VCT. Any encashment within the qualifying period would negate the tax breaks for either vehicle. VCTs can only be held by individuals and are non-transferable. EIS funds can be held by individuals or Trustees, both of whom can defer unlimited gains. Please note that neither Income tax relief nor CGT Exemption is available to Trustees. SIPPS (Self Invested Personal Pensions) are able to invest in unquoted companies including EIS Funds. 19

Important Notice Unquoted shares carry a higher risk than quoted securities or shares. You are advised to consult your own professional adviser if considering investment in this field. This Guide is intended as a short summary and is not intended to be comprehensive. The views expressed are based on Lacomp s understanding of the current taxation regime, and specialist taxation advice should be sought on specific issues. The levels and bases of taxation may change in the future and the value of any relief will depend on personal circumstances. Similarly, HMRC working practices are subject to amendment, addition or change. This Guide should not be construed as an invitation to subscribe for shares in the Lacomp British Enterprise EIS Funds. Such investment may, or may not, be suitable for an individual investor and advice should be sought from an Independent Financial Adviser or other professional intermediary authorised under the Financial Services and Markets Act 2000. As mentioned above, this Guide is based on our understanding of the current taxation regime, as modified by changes proposed in the Budget of March 2008. It should be noted that the increase in the EIS allowance to 500,000 is subject to approval from the European Commission. This guide is NOT intended to be, and should NOT be construed as investment advice. It is for distribution to intermediaries and investment professionals only. For further information, contact Lacomp at: 77 High Street, Bagshot GU19 5AH Website E-mail www.lacompeisfunds.co.uk info@lacomp.co.uk Telephone +44 (0)1276 475123 Fax +44 (0)1276 475273 20

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77 High Street, Bagshot, Surrey, GU19 5AH TEL: 44 (0) 1276 475123 FAX: 44 (0) 1276 475273 E-mail: info@lacomp.co.uk Website: www.lacompeisfunds.co.uk Registered In England No. 1851201 Registered Office: 77 High Street, Bagshot, Surrey, GU19 5AH, England Authorised and Regulated by the Financial Services Authority