For investors willing to take a chance on smaller and less well-established companies, venture capital trusts (VCTs) and enterprise investment schemes (EIS) offer the opportunity to support up-and-coming businesses.
EIS and VCTs can complement other long-term investments like ISAs and pensions, and can be used as an overspill for extra cash once those annual allowances have been used up. EIS and VCTs offer much bigger tax incentives than ISAs, but also come with a very different risk profile that investors need to understand.
Venture capital trusts
The main attraction of investing in venture capital trusts is the tax relief. To reward (and encourage you) to invest in smaller, higher-risk companies, you get income tax relief when you buy newly issued VCTs – a hefty 30% on investments of up to £200,000 per tax year.
For example, an investor who makes an £100,000 investment in a VCT and who has a tax liability of £30,000 could reduce that to zero.
Tax relief is given as credit against your total income tax liability, and it can’t exceed how much tax you owe for the tax year. Tax relief only applies to investing in new VCTs, if you buy existing VCT shares you don’t get it. Plus, you have to keep your shares for at least five years or you lose the right to the relief and will end up with a sudden bill.
Another tax bonus – you won’t pay any capital gains tax (CGT) on profits from selling your VCT shares. This is true even if you sell them before the five years required to get the income tax relief, as long as the company you invested in still has its VCT status.
The reason VCT investors get such juicy tax rewards is because of the risks involved in backing smaller, often less well-established or what may turn out to be loss-making companies.
When you want to sell your VCT shares, because it is more of a niche investment, it can be hard to find buyers, unlike with shares listed on a main stock exchange like the FTSE 100 for example, which are bought and sold by thousands of people every day.
VCTs also often come with higher fees attached, and complex layers or ways of charging. For example, you might also be charged performance fees depending on how well the VCT does.
Finally, there’s no guarantee your investment will keep its original value, so you may lose some, or all, of your capital when you come to sell.
Enterprise investment schemes
Tax relief is also a big feature of enterprise investment schemes, and for similar reasons. The structure for EIS was set up by the government to get investors to back early-stage companies and help them get off the ground.
Investors into EIS-eligible companies get 30% income tax relief, as with VCTs. But the total tax relief available with EIS is much higher than with VCTs – investors can get relief on up £1m invested per tax year, or £2m a year as long as at least £1m of this is invested in knowledge-intensive companies.
For seed enterprise investment schemes (SEIS), the part of the government’s EIS structure designed specifically to encourage investment in start-ups, the enticement is even greater, providing 50% income tax relief – potentially knocking £50,000 of your income tax bill for every £100,000 invested.
Profits earned on EIS shares are exempt from capital gains tax if held for at least three years. CGT is also deferred on any gains you make elsewhere that you go on to invest in an EIS. Plus, once you’ve held your EIS shares for two years, they can be passed on free of inheritance tax.
You are investing in newly-established companies with as yet no reliable track record of making a profit. This is inherently high risk, and you could easily lose your capital.
EIS do offer a bit of a sweetener to this danger, known as loss relief. This enables investors to offset any loss when they sell their EIS shares against their income tax or CGT liability, minus however much they benefited from the initial income tax relief on investing.
To keep the generous income tax relief, EIS investors have to hold their shares for three years. But investors should be aware that, with far fewer buyers around for EIS than the shares of large companies on the main stock markets, they will likely have to keep them for much longer, and so should be prepared to have their money tied up for an extended period.