Investment Focus: Enterprise Investment Schemes in tax planning strategies
EIS now is recognised as a mainstream investment that is being routinely adopted to fulfil client s financial planning needs. It can no longer be considered a niche investment that is only applicable to a tiny minority of clients, says Dermot Campbell, CEO Kuber Ventures. In particular, in a low interest rate environment, EIS benefits in regard to minimising the tax on income, capital gains, savings and estate is a real consideration for clients, and is one of the factors driving increased investment into EIS. 2 adviserbusinessreview.com ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES
It is now 21 years since the Enterprise Investment Scheme (EIS) was first introduced. The market has now grown to over 11 billion in assets and the most up-to-date statistics (2013/14 tax year) show a record level of investment, with over 1 billion raised last year alone. In addition, the most recent statistics show HMRC received 87,868 EIS applications from companies looking for investment in the 2011/2012- tax year. This is compared to just 482 in 1995. With the economy recovering and EIS rapidly increasing in popularity, it amazes me however that there is still such an apparent lack of awareness and knowledge of EIS amongst the adviser community. I m often asked by Advisers questions such as, what s the most my clients can lose?, how easy is it to get out?, what s the typical success rate, what happens if my client dies, what if the company goes bust, what if the government pulls the plug, etc. With individual intricacies of each EIS offer meaning that rarely any two products are the same and thereby making it very hard to do like-forlike comparison as a result; and with what feels like continual adjustment of the rules and reforms under the scheme, its little wonder that there is confusion. One thing s for sure, that in this climate of low interest rates teamed with higher personal levels of taxation, a clamp down on pension contributions and modest returns from many investments, minimising the tax your clients pay on income, capital gains, savings and estate is a real consideration for most, and it is these factors driving increased investment into EIS. What are the tax benefits of EIS? EIS is a tax-mitigated investment solution for individuals backing SMEs, and one that, of course, is not without risk. The government appreciates these risks, which is why it has associated generous tax reliefs to qualifying investors to encourage investment via EIS and subsequently back British businesses and boost the economy as a result. The EIS tax benefits include: Income Tax Relief. 30% income tax relief on a maximum investment of up to 1,000,000 in any one year per individual investor (not per household). ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES adviserbusinessreview.com 3
(It s worth noting that the income tax relief can only reduce the income tax liability to zero, and does not offer rebates). Tax-free Capital Gains. As long as shares held for at least three years, the sale of the shares at a profit will be capital gains tax-free (a reduction of the current rate of 28% to 0%). Capital Gains deferral relief. Any size of capital gain made on the disposal of any kind of asset can be deferred by re-investment into EIScompliant companies. The deferred gain is then due on the sale of the EIS shares unless the sale is to a spouse or on the death of the shareholder. Capital Loss relief. Capital loss on EIS shares can be set against income or capital gains in the year the loss arises or carried back / applied to the previous tax year. For a top tax rate payer this equates to 31.5% value of the EIS shares and in the case of a 40% tax payer, the relief is 28%. Combined with income tax relief, the top rate taxpaying investor has a downside loss protection of 61.5p in the 1 invested. For example: If you make a loss on your investment, you can offset that loss against income tax. So let s say you lose your entire 10,000 investment. Because of income tax relief (30%), your actual loss is 7,000 ( 10,000-3,000). So you can, if you choose, reduce your taxable income for the year in which you disposed of the shares by 7,000, resulting in a saving of 2,800 (40 per cent of 7,000) for a higher-rate taxpayer. If you want to offset your loss against other capital gains in the normal way, you can do this instead. Inheritance Tax (IHT) mitigation through business property relief. Investments in EIS-compliant shares can attract IHT business property relief (BPR) of 100% value of investment on gift or on death. Provided the shares have been held for a minimum of two years. Investee companies So what sort of investee companies are we talking about? There are some excluded activities which an EIS may not invest in, for example property development; the operation and management of hotels and nursing homes; and most recently 4 adviserbusinessreview.com ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES
businesses in receipt of Feed-in-Tariffs, (unless from hydro power or anaerobic digestion until 6 April 2015). But generally speaking, there are a vast array of offers out there from pubs, gaming, wine, horse show jumping, medical technologies, in-vessel composting - to highlight only a few! Many are recognising the potential for growth that EIS offers, especially since an increasing number of personal pension restrictions are leading investors to look for an alternative home for their money. In ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES adviserbusinessreview.com 5
the last couple of years, George Osborne s tax tweaks have seen positive changes to the profile of the companies in which an EIS can invest, meaning that we are no longer necessarily talking about early-stage or small companies. The annual maximum funding that a company can now receive is up to 5m in a single company in any 12 month period (up from 2m). These are also businesses with a maximum of 500 employees (was 50) and businesses with gross assets of up to 15m now qualify (previously 7m). This means that investors may access established businesses and these types of businesses could be considered as lower-risk under EIS. EIS is high-risk, isn t it? Unsurprisingly there is no such thing as a risk-free investment, but there are varying degrees of risk within an EIS, which reflects a number of factors. With past performance being no guarantee of future performance for a manager, the underlying strategies, how the investor agreements are structured and the types of assets within an investment/portfolio should be under particular scrutiny. But, of course, if you go back to economics basics, it really is the principal of higher the risk, the potential for higher returns, the lower the risk, the lower the returns, at what point you invest depends on your clients suitability, circumstances and appetite for risk. For example, for the more cautious, perhaps consider asset backing, i.e. whether there are any bricks and mortar or stock etc. associated with a particular investment strategy. In the event that a company is dissolved, you may be provided with some comfort that there are assets to sell which may cushion some of the downside. This is compared with something such as high-growth technology, which is likely to be more reliant on intellectual property. When we talk about risk, we need to consider the potential loss that an investor may incur. Investors with a one off capital gain who do not routinely utilise annual capital gains tax allowance would in reality only have a very small amount of capital at risk assuming the size of the investment was small: 1,950 for every 10,000 invested. This is the upfront tax relief, which amounts to 30% Income Tax relief plus 28% Capital Gains Tax 6 adviserbusinessreview.com ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES
deferral i.e. 58% initial tax relief. Providing the size of the investment is less than the annual CGT allowance and the client does not utilise their CGT allowance annually then you can assume that the CGT deferral is actually a relief. In the event the investment fails, loss relief can be utilised, and which for a top rate tax payer will give a further 31.5% relief making the total recovery 89.5% from tax alone. Loss relief is 28% for a 40% tax payer and 14% for a basic rate tax payer meaning that the tax recovery for these 2 groups is 86% and 72% respectively. So on a 10,000 investment, only 1,050 is completely at risk for a top rate tax payer, 1,400 for a 40% taxpayer and 2,800 for a basic rate taxpayer. Putting it another way, in this example, a top rate tax payer will be in a profitable position if the investment recovers more than 20% of the original investment. 40% or 20% taxpayers would need their investment to recover in excess of 23% or 35% respectively to be in a profitable position. If your client does not have a Capital Gain to defer, then the client will be in profit if they recover at least 70p in the 1. The importance of diversification Before we discuss client suitability and protections, one important factor to consider is Diversification invest in a number of companies and across a range of asset classes and economic cycles. For purposes of this article, I ve been talking about EIS Funds, however most are technically Discretionary Services. What I am referring to here for arguments sake are Portfolios i.e. a pooled collection of investments, whereby each Fund / Discretionary Service comprises a number of underlying investee companies within each Portfolio. For some advisers this will beg the question of whether these are then classified as UCIS (unregulated collective investment schemes) and generally speaking, EIS is not (but definitely check in each case!). The technicalities often classifies these as Complying Funds, which means that they would be collective ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES adviserbusinessreview.com 7
investment schemes, but for the fact that they offer investors withdrawal rights and make EIS qualifying investments as such they benefit from a statutory exemption and are not CISs. Many take the safe option as they see it, of putting their money with one provider/investment manager. What they might not realise is that high fees might be associated with that particular offer which might eat into their profits, or there may be a long-term hold-period associated, which might not reflect their financial goals. Likewise, some investors will invest a lump sum in one tax year, whereas it is worth looking at whether they would be best served in spreading their investment year on year. In any EIS portfolio, the general consensus is that a few investments will fail, most will break even and a few will be high-fliers. Even with this level of failure (and not necessarily accounting for the tax reliefs) it is those high-fliers that can return a good multiple return in their own right, reflecting positively to investment in a portfolio. At Kuber, our platform has been designed to spread this risk even further by constructing multimanager portfolios which consist of a number of providers / investment managers offers, and therefore the investor further benefits from a far greater spread of underlying investments, typically between 15-30 companies, and not being heavily weighted in any single company investment as a result. What s interesting, is the reasons behind why investors invest. Some 47% of our clients are investing to defer capital gains tax bills. But the prominent factor for investing in our case is for IHT mitigation with 72% of clients using this as the prime financial reason for investing. What protections are in place? Although the vast majority of EISs are not considered UCIS or NMPI there are some exceptions. Broadly speaking however, those considering an EIS investment should not invest if they are relying on Protections under the FOS from the EIS Provider. As every EIS disclaimer warns, investors capital is at risk (but there is of course the tax reliefs available to help mitigate some of the downside). Financial Ombudsman Service stats Interestingly, when researching the Financial Ombudsman Service (FOS) website for complaints 8 adviserbusinessreview.com ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES
over the period 1 January 2012-6 March 2015, there are a whopping 6,260 complaints made on the general filter option of Investments and Pensions. Of these, the Ombudsman upheld 2,104. Narrowing the search further to find out how many of these were EIS related, only 18 cases were EIS related in over a three-year period. The cases make for interesting reading. Whilst there are two cases relating to the EIS manager / provider (although not to the actual performance of the EIS), the majority of the cases are in relation to the advice received in regards to their investment. For example, one client was advised to invest in an EIS for IHT mitigation, however the client had no need to lock up their investment for two years as they were under the IHT threshold anyway, and as a consequent, they did not have readily realisable funds to pay for care. Illiquidity was another cause for complaint, in that the client was not advised that there is no secondary market for EIS shares. not without risk but that there are various riskmitigation factors to take into account, especially through diversification. The Ombudsman statistics also reflect the fact that when it comes to client suitability, it is really important to understand what your clients would like to achieve financially and where they sit on the risk/reward scale, as EIS is not suitable for everyone. However, for most people it is the choice of the actual funds which can provide a big duediligence headache and again, this will come down to research, preference and appetite of each individual adviser/advisory firm to decide their preferred criteria. Leave it to the experts I hope that I have demonstrated that EIS holds some very compelling tax incentives for consideration with tax planning, and to highlight that EIS is ENTERPRISE INVESTMENT SCHEMES IN TAX PLANNING STRATEGIES adviserbusinessreview.com 9
For more information on David J Scarlett click here: Adviser Website: Business www.soulmillionaire.com Review Editorial: Email: david@soulmillionaire.com Rob Kingsbury Email: robkingsbury@kgrms.co.uk Tel: Adviser 01256 Business 411677Review Advertising: Editorial: Rob 0203 Kingsbury 478 4651 Website: Email: robkingsbury@kgrms.co.uk adviserbusinessreview.com LEARN MORE Tel: 01256 411677 Advertising: 0203 478 4651 Published by KGR Media Services Ltd KGR Media Services Ltd 2015 Published by KGR Media Services Ltd KGR Media Services Ltd 2014