The UK Government introduced the Enterprise Investment Scheme (EIS) in 1994 in order incentivise investment in early stage UK companies.
Since investing in early stage companies is deemed riskier than investing in solve larger, established companies, investors are offered a range of tax reliefs:
Income tax relief
Income tax relief at 30% of the amount invested in subscribing for new shares (maximum annual investment of £1 million). By to election, where an EIS investment is made in one year, investors can carry back some or all of their investment, for tax relief purposes, to the previous tax year (subject to the £1 million limit for that tax year).
Capital Gains Tax Deferral
The capital gains tax due on a gain arising from the sale of an asset can be deferred by subscribing for shares in EIS qualifying companies. This can be done in a period beginning one year before and three years after the disposal of the original asset. Crucially, this is only a deferral; if investors sell shares in EIS qualifying companies where a gain is being deferred, the capital gains tax liability will reappear at the prevailing rate.
Business Relief (IHT shelter)
Shares in EIS companies held for at least two years, and at the time of death, will normally qualify for 100% business relief and will not be taxed from an IHT perspective.
Relief is given for losses arising on the disposal of the shares against either income tax in the tax year of disposal (or of the previous tax year) or chargeable gains. Any income tax relief obtained under EIS and not withdrawn reduces capital loss.
Capital Gains Tax Relief
An EIS investor is entitled to exemption from CGT on a disposal of their shares, provided the investor has held them for three years prior to sale. Therefore, any growth in value is effectively tax-free.
The EIS market has grown significantly in recent years, with almost 22,900 companies having received a total of over £12.2 billion since its introduction.
There are two distinct types of EIS in the market: those aiming for capital growth and those aiming for capital preservation. Whilst the criteria by which a company will qualify for EIS funding is consistent, it is important that advisers and investors understand the differences between the two when assessing their risk, liquidity and suitability for a client.
This is often seen as the ‘traditional’ or ‘venture capital’ EIS, whereby investments are made into a portfolio of early stage, high growth potential companies. These companies are often in the seed or early stage of their life cycle and are aiming to deliver significant capital returns to their shareholders.
The process of finding a suitable portfolio of high growth businesses can take time, and there is a certain level of competition between investment managers to win the support of investee companies. As such, it could take 12-24 months for a client to become fully invested and this can dramatically extend the 3-year minimum holding period.
Not only does this delay the receipt of EIS3 certificates (meaning investors often have to wait longer to attain their tax relief), but it also makes it difficult to plan for tax purposes – since providers cannot give guidance as to which tax years investments will be made in. Moreover, it can take much longer to provide liquidity in this environment (more on this below).
For these reasons, investors are advised to view Capital Growth EIS investments as 7+ year investments.
Selling shares in unquoted companies can take a significant amount of time. In order to provide liquidity the provider must find a buyer for the shares the EIS investor owns.
Providers often try to sell their position in a particular company in bulk, which can cause delays for investors.
Naturally, investments in small, unquoted, high growth businesses should be considered very high risk. The failure rate of companies within a Capital Growth EIS can be as high as 50%. It is likely that a number of companies within a client’s portfolio will underperform, or even fail altogether.
Vastly the more popular of the two, a Capital Preservation focused EIS will seek to mitigate as much risk as possible, whilst still allowing the investor to attain the tax reliefs available through EIS.
Usually, the provider will set up and control the trading activity of the EIS companies, thus enabling the provider to exercise control and ensure the activities of the company are focused on capital preservation and a predictable rate of return.
Since providers often create the companies in which the clients invest, they can control when the investments are made. As such, there is a much higher level of visibility as to which tax years the investments will be made, allowing advisers to plan effectively for their clients.
Since providers exercise control over the EIS company’s trading activity, they can attempt to provide liquidity as quickly after the three years period as possible. More on liquidity in the next section.
Investors often view Capital Preservation EIS as 4-4.5 year investments.
At the end of the 3-year period, the provider will often look to sell assets owned by the EIS company. Since they control the company’s activities it is likely the assets the company owns will have been partly selected on their attractiveness to a third party buyer.
As such, often liquidity can be provided within 6-9 months after the 3-year trading period.
Since providers control the company’s activity, they can carefully select a trade which is conservative in nature. By creating a conservative trading strategy, which provides as much predictability over future returns as possible, many of the risks associated with EIS investments can be managed.
It is really important that advisers and investors are aware of the differences between the capital growth and capital preservation strategies and have a proper look under the bonnet of any EIS they are looking to recommend.
If you have any questions or would like to discuss these issues in more detail, please call the Mariana sales team on 0207 065 6699.