Look beyond pensions and Isas to VCTs and EIS for (higher risk) tax-efficient saving

 
Rebecca Williams
Children touch a giant model globe in th
High earners face restrictions on what they can put into their pension piggy bank (Source: Getty)

In advance of the new tax year, starting on 6 April, many people will be thinking about how to make the most of the tax-efficient investments available to them.

Traditionally, this has been the time of year to make pension contributions, taking advantage of tax relief offered by the government. However, times have changed, with restrictions on high earners and pension Lifetime Allowance protection rules which have limited the tax relief available.

Fortunately, there are alternatives open to the prudent investor that boast tax efficiency, in lieu of paying into a pension.

For those who have used their Isa allowance and who are looking for a tax-efficient investment opportunity outside of pensions, consider a Venture Capital Trust (VCT) or Enterprise Investment Scheme (EIS).

Both schemes were introduced by the government to encourage investment into newer, smaller UK companies by offering investors a range of tax incentives.

What are VCTs?

VCTs are listed companies that invest in the shares of other companies. The VCT manager will research and select companies in which to invest. The headline tax advantage for investors is 30 per cent income tax relief on the amount they invest, up to a maximum of £200,000 each tax year. Tax relief is given as a credit against the investor’s total income tax liability.

Read more: This was the year alternative investments went mainstream

Take the example of an investor, Susan, who has an income tax liability of £30,000 in the current tax year. Susan invests £100,000 into a VCT and receives 30 per cent relief, equivalent to £30,000. Her income tax bill is thereby reduced by £30,000 to zero. Furthermore, any dividends paid by the VCT on the shares Susan holds will be tax-free. When Susan comes to sell the VCT, any gains she makes will be free from capital gains tax.

There are some important elements to bear in mind with VCTs. Investors must hold the VCT for a minimum of five years to keep the income tax relief. So, if you sell before the five year mark, you will lose the benefit.

What is the EIS?

The EIS is similarly designed to encourage investment in small, unquoted companies. Typically an EIS is considered to be a higher risk than a VCT because it focuses investment in fewer companies.

Like a VCT, an EIS affords the investor a 30 per cent reduction in their income tax liability, but it also offers capital gains tax advantages by allowing an investor to defer a capital gains tax liability.

Read more: Cut capital gains tax with EIS investment

To bring this to life, let’s consider another example investor, John. At the end of 2016, John sold his rental property and made a taxable gain of £50,000. He invests £50,000 into an EIS and defers paying CGT at 20 per cent thereby avoiding a liability of £10,000.

In John’s case, he invested in the EIS primarily to defer paying a capital gains tax liability but he will also be entitled to 30 per cent income tax relief, as long as he holds the investment for three years. John’s income tax liability in 2016-17 is £20,000. This is then reduced by £15,000 (30 per cent of his £50,000 investment) to £5,000. What’s more, any gain John makes on the EIS investment itself will be tax-free. A further advantage is that after holding the EIS for two years, it will also qualify for Business Property Relief for inheritance tax purposes.

If John encashes his EIS investment five years later, the gain of £50,000 will no longer be deferred and the capital gains tax liability will become payable again at the capital gains tax rate(s) applicable at that time.

VCT and EIS are attractive investment propositions, providing generous tax relief. However, they are sophisticated and higher risk. It is important to note that investing in smaller, newer companies carries a higher level of investment risk – it’s not for everyone – so do seek out proper advice before committing your money.

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