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Venture Capital Trusts VCT & Enterprise Investment Schemes EIS

Suitable investors willing to take a high risk can put capital into smaller start-up companies through Venture Capital Trusts VCTs or Enterprise Investment Schemes EISs - in return for a variety of attractive tax breaks. VCTs were launched in April 1995 and EISs came into being in January 1994.

What are the charges investment trusts in that they have a set amount of initial capital and so are closed-end funds. But the companies in which they invest are usually younger smaller firms or those that are being bought out from previous owners. Each company in a VCT cannot have more than 50 employees and may raise no more than £2 million via venture capital schemes in the 12 months ending on the date of the relevant investment.

British Venture Capital Association is the industry body for Venture Capital Trusts. Moneyextra.coms Investment Centre contains all you need to know about investing in the stock market.

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Enterprise Investment Scheme Association is the industry body for Enterprise Investment Schemes.

Want to know more about the way you are being taxed

What is a Venture Capital Trust VCT

Venture capital trusts VCTs aim to make money by investing in new share issues. The underlying companies tend to consist of unquoted companies those traded on the Alternative Investment Market AIM - the stock market for small and young companies - and those traded on PLUS Markets formerly Ofex the off-exchange trading facility for even smaller companies.

There are strict limits on the size of companies in which VCTs may invest. In 2006 the gross assets test was set at £7 million immediately before investment and £8 million afterwards to focus on the companies most in need of improved access to finance. This effectively cut in half the size of companies that VCTs were able to invest in. Previously VCTs could invest in companies with gross assets of up to £15 million at the point of investment and £16 million thereafter.

Within three years of a VCTs launch its manager must invest at least 70 of its assets in qualifying companies meeting the criteria outlined above. No single holding is allowed to represent more than 15 of the VCTs assets. Typically a VCT will hold shares in 25-35 companies when fully invested. Some may hold more but it is rare to find a VCT with a variety of holdings not in double figures - the idea is to diminish risk by diversification.

In order to benefit from the generous tax breaks on offer with VCTs you are required by the taxman to hold your VCT investment for at least five years. The

Most VCTs fall into three main categories

  • AIM VCTs investing in companies that are quoted on the Alternative Investment Market. VCTs can only invest in AIM companies that are raising new finance for example companies that are seeking their first listing. VCTs investing in AIM shares are likely to be fully invested sooner than other VCTs.
  • Specialist VCTs investing mainly in unquoted technology companies. A portion of the money raised may also be invested in some AIM-quoted technology companies to reduce risk.
  • General VCTs spreading investments between unquoted and AIM-listed companies. Many have a policy of investing in companies that are already or very nearly profitable in an attempt to reduce risks.

There are three types of VCT launch. A new launch is when a brand new VCT is launched. A new share class launch is when an existing VCT raises additional funds for a new portfolio. A top-up offer is an additional issue of shares by a VCT which may involve buying into an existing portfolio.

 

Whats the tax incentive with VCTs

VCTs enjoyed a period of relatively high popularity amongst suitable investors after then-Chancellor Gordon Brown chose to increase the income tax relief available from 20 to 40 in 2004. This tax break was reduced to 30 in 2006.

 

The key tax provisions 2008 09 are

 

  • No liability to higher rate tax on dividends.
  • No tax on realised gains or capital gains tax on disposal.
  • Income tax rebate of 30 on investments of up to £200000 in any tax year for investing in new VCT shares held for at least five years three years for shares purchased before 6 April 2006 provided that the investor has paid this amount of tax.
  • Capital gains tax deferred relief is available up to the annual investment limit on VCT shares purchased before 6 April 2004.

For suitable investors these tax incentives may encourage investment in VCTs but the tax incentives do not make investing in VCTs any more suitable to people who would not normally invest in them due to the high risks of the underlying investments.

 

What is an Enterprise Investment Scheme EIS

An Enterprise Investment Scheme EIS is an investment in a single company which is unquoted privately held. EISs were introduced to replace a broadly similar regime the Business Expansion Scheme that had been originally introduced in 1981. In common with the rules governing VCTs EIS companies must have no more than 50 employees and raise no more than £2 million in a 12 month period.

 

In 2006 the gross assets test of £15 million which applied to EIS companies was halved to just £7 million before the investment or £8 million afterwards. This is the same restriction that applies to VCT shares.

 

Enterprise investment schemes should not be entered into without careful forethought however as they are high risk and highly illiquid you cant easily get your money out. There is no standard mechanism in place through which individual investors may sell unquoted EIS shares which means it may be difficult or even impossible to sell them. The

 

There are four different types of EIS a single EIS which is just one company a protected EIS fund an EIS portfolio and an EIS fund. Each of the latter three invest in different numbers of companies and vary in their level of risk.

 

Whats the tax incentive with EISs

Investing in an unquoted trading company via an EIS offers income tax relief at 20 on qualifying investments of up to £500000 per tax year. In order to benefit from the tax breaks EIS investments must be held for a minimum of three years.

 

Investors with large capital gains may in theory shelter an unlimited amount and the rules introduced in 2006 doubled the amount of income tax relief they could benefit from - provided they still have income tax liabilities against which to set the relief.

 

In addition to the income tax relief Enterprise Investment Schemes offer

 

  • Gains on disposal exempt from capital gains tax CGT.
  • Income tax or capital gains tax relief on losses on disposal.
  • Relief on up to 50 of the amount invested between 6 April and 5 October in any tax year may be carried back to the previous year up to a maximum of £50000.
  • Chargeable gains may be reinvested into an EIS to defer CGT.

Suppose for example that you are a very wealthy individual with a well-diversified portfolio that you had made a £50000 profit selling some shares and have already used up your capital gains tax allowance for the year and you owe HM Revenue & Customs £9000 in tax on the gain. However if you are comfortable with the risks of EISs and invested your £50000 into one you will not need to hand over the £9000 until you sell your investment in the scheme bearing in mind it might be difficult or impossible to sell.

 

If you then hold your EIS investment for at least three years any capital gains you make on the actual EIS investment itself when you sell will themselves be exempt from CGT. Its also worth bearing in mind that shareholdings in EIS qualifying companies may fall outside of Inheritance Tax IHT after two years due to the interaction with Business Property Relief.

 

Tax relief at 100 is available for transfers of certain categories of business and of business assets "relevant business property" if they quality as "relevant business property" and the transferor has owned them for a minimum two-year period.

 

For suitable investors these tax incentives may encourage investment in EISs but the tax incentives do not make investing in EISs any more suitable to people who would not normally invest in them due to the high risks of the underlying investments.

 

Suitable investors should seek appropriate tax advice before making any investment to ensure the availability of the relief.

 

How risky is investing in a VCT or EIS

Venture Capital Trusts and Enterprise Investment Schemes are high risk investments due to the small size of the companies they invest in. Realistically investors can expect that at least one in 10 start-ups will not survive. This is the main reason why the tax breaks have been made so attractive. Investors may get back less than they invested even when taking the tax incentives into account; and could even lose the lot. If you are considering investing in either type of scheme taking both independent financial advice and appropriate tax advice are of key importance.

 

The small companies that VCT and EIS investments are made in are less likely to have built up reserves to tough out the hard times. They are also less likely to be diversified so setbacks in a single sector are more likely to wipe them out completely.

 

Another factor to beware of is that if you sell your VCT within five years you will have to pay back all the tax reliefs received. The same applies to EIS shares but the period you have to hold onto them for is three years before the tax relief is clawed back.

 

With a VCT 30 of its assets may be invested in non-qualifying companies and these might carry greater risks than the 70 in qualifying companies. Investors should therefore satisfy themselves that these risks are acceptable.

 

Suitable investors must read any VCT or EIS providers prospectus carefully. Remember to check the charges as they tend to be higher than those on for example

 

On the EIS side there is generally no liquidity so you are locked into the investment with no easy means to dispose of the shares. The usual exit routes for EIS investors are a flotation on the stock market a trade sale or through the providers share buy-back facility which will be at a discount to their Net Asset Value.

 

There is also a very limited secondary market in VCT shares as the main tax breaks are only available for investments made in new VCTs and therefore would not be on offer to anyone to whom you sold your VCT shares. Therefore anyone looking to sell VCT shares before the fund is formally wound up risks selling them at a substantial discount to their underlying value.

 

For these reasons VCTs and EISs are unlikely to be suitable for most people. They may be suitable for some very wealthy "high net worth" people who already have a well-diversified portfolio who understand the risks associated with VCTs and EISs and are prepared to risk losing their capital when investing in them.

 

You should seek appropriate advice from a financial adviser and a tax adviser if considering investing in a VCT or an EIS.

 

How have VCTs changed

As Chancellor Gordon Brown was unable to leave VCTs alone. In 2004 he doubled the tax break creating a bubble in VCT investment which only ended when he chose in 2006 to cut back the income tax relief from 40 to 30 and increased the minimum holding period to qualify for this relief from three to five years.

 

This hit the venture capital trust industry hard. By the end of the 2006 07 tax year around £200 million had been raised compared to the £775 million raised in 2005 06.

 

The size of companies in which VCTs may invest was also reduced from £15 million to £7 million making them even more risky.

 

Previously all existing VCTs were able to invest £1 million per company in a 12-month period. However for VCT funds raised after 6 April 2007 this limit has changed. The underlying company is now only able to receive a maximum £2 million from all VCTs in a 12-month period.

 

In addition previously qualifying companies for EIS and VCT purposes had no restriction on the number of staff they employed but now the rules require a company to have fewer than 50 full-time employees.

 

Whats in it for suitable investors

The income tax relief on VCTs is still attractive despite being lowered from 40 to 30 and any profits are free from capital gains tax. This means for every £100 invested the taxman in effect gives you a rebate of £30 on condition that the investment is held for five years. Invest £25000 for example and the net cost to you is just £17500.

 

But although VCTs still offer attractive tax breaks they should not be viewed solely as tax avoidance vehicles. It is important to understand the underlying investments and remember never to let the tax tail wag the investment dog.

 

The EIS offers 20 tax relief on an investment up to £500000 provided the shares are held for at least three years. The EIS can also be used to shelter capital gains and the holdings are free of inheritance tax. This makes the EIS one of the remaining tools left in the bag for suitable investors wishing to defer a capital gains tax liability.

 

While the EIS offers more tax reliefs than the VCT these vehicles will each appeal to different investors depending on their needs. The EIS is fundamentally more focused on capital performance whereas VCTs concentrate on income tax concessions.

 

Overall the tax benefits associated with the EIS might be particularly valuable to suitable investors with large incomes large well-diversified portfolios with substantial gains and substantial estates. However they will be less suitable to those seeking income from their investments as dividends are not tax-free as is the case with VCTs.

 

So how do you reclaim your tax relief When you complete your tax return there is a VCT section so you can be repaid the income tax either as a cash rebate or an alteration of your tax code. All you need is the investment certificate.

 

Whats the difference between EIS and VCT investments

An EIS is made up of one small company whereas a VCT must invest in a number of companies with no more than 15 of its assets in any one. In fact an EIS company could be one of the underlying companies in a VCT as they have the same size restrictions as those which qualify for VCT investment.

 

Any capital growth is free of tax within an EIS but dividends payable by an EIS are potentially liable to higher rate tax unlike a VCT.

 

Their high-risk nature makes an EIS a potentially unsuitable part of an investment portfolio for most people with the possible exception of suitable high-net worth individuals who already have well-diversified portfolios understand the risks and are prepared to risk losing some or all of the capital invested in them.

 

You may choose to invest in an individual EIS yourself or through an approved EIS fund with a range of four or five or there are also EIS portfolios available which can include up to 20 different companies.

 

What are the charges

Charges on VCT and EIS investments tend to be higher than those on unit trusts and investment trusts. Annual costs for generalist VCTs range from 2.5-4 and 2.5-3.5 for AIM VCTs.

 

The higher charges are meant to reflect the work that goes into researching small unquoted companies. VCTs should be viewed as a long-term investment.

 

Total upfront charges on an EIS fund are about 6. On an individual EIS there are no explicit standard running costs as it is a company rather than a fund.

16 May 2008

 

Moneyextra.com recommends you take independent financial advice before acting on any article

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2009-03-09 16:56:21 © Moneyextra.com