Henry Emson: VCTs vs EIS – compare and contrast

Within the tax-efficient investment arena there are two leading products for those seeking to benefit from government investment incentives – venture capital trusts (VCTs) and companies that qualify under the Enterprise Investment Scheme (EIS) rules.

While VCTs and EIS share the ‘tax-efficient investment’ status, the advantages they offer are entirely different, so it should come as no surprise they are appropriate for separate client circumstances and investment strategies.

Both structures offer income tax relief and tax-free capital gains, but the similarities stop there. While these may be important drivers for an investor, beyond this point VCTs and EIS behave differently giving distinct client journeys. The following table lists their respective characteristics:

 

 

EIS

VCT

Investment limit

£1m

£200,000

Income tax relief

30%

30%

Capital gains deferral

Up to 28%

Nil

IHT-free?

Yes after two years

No

Tax-free exit?

Yes

Yes

Tax-free dividends?

No

Yes

Share loss relief?

Yes

No

Minimum holding period

Three years

Five years

 

VCTs: Pros And Cons

VCTs attract those seeking tax-free dividends (an attribute not shared with EIS), with immediate deployment and qualification for income tax relief in the current tax year. They also offer liquidity for exiting your investment – though typically at a slight discount to the initial sum invested (no use of tax-free exit status), so VCT performance is measured purely by investor dividends.

Some caution is required when choosing a VCT provider due to a recent change in rules disallowing VCTs from participating in management buyouts and acquisitions – a historically easy target for finding cash-generative businesses.

In response, VCT providers have had to pivot into the early-stage investment sector, which carries a greater prospect of capital growth but is an unlikely source of dividends in the short to medium term, and carries a greater risk of capital loss.

This change has meant that dividend payments to investors can only arise from maturing portfolio businesses or from selling portfolio companies at a profit, which by its very nature is unpredictable and can put considerable pressure on fund managers.

There are VCT providers that have been successfully investing in the early-stage growth sector for many years – however, many do not share this track record and require considerable investor scrutiny.

EIS: Pros And Cons

EIS investing offers greater investment protection and a wider selection of tax reliefs, but is more administratively burdensome and does not provide a liquid market for exiting the investment, so returns only occur as portfolio companies are sold.

What is particularly attractive about EIS is that multiple tax advantages can be aggregated within one investment to create truly compelling specific cases for investment. As an example, an investor can benefit from income tax relief (30%), capital gains tax deferral (up to 28%), and inheritance tax (IHT) planning (40%) all within the same subscription.

From a straight investment perspective, what stands EIS out from VCTs is share loss relief. If a portfolio company experiences a capital loss, then that loss can be offset against an individual’s taxable income, irrespective of whether the rest of the portfolio is in profit. This means that, within a diversified portfolio of several companies, an investor can benefit from both the downside protections and the upside benefits.

This loss relief also means an underperforming company – or even the whole portfolio – cannot return less than 62.5% of the invested sum – in other words, only 38.5p in every £1 invested is at risk. That is substantial downside protection – especially at a time when there is so much volatility in publicly traded markets where a 38.5% stock price slump is not altogether unusual.

Financial planners also use EIS as an appropriate IHT planning product, and for capital gains tax (CGT) deferral. Perhaps the more topical of these is the CGT deferral, given the current change in the buy-to-let market whereby interest payments will cease to be an allowable deduction from rental income on residential properties, forcing many owners to sell.

These two very different products serve two very different purposes. VCTs allow for deployment and the associated tax relief guaranteed in the current year of investment, with a clear objective to generating regular tax-free dividend payments, where some liquidity exists at par, but where there is not a significant wealth-generation event.

In contrast, EIS is focused on wealth generation and making use of the tax-free gains status. Full deployment typically occurs within 12 to 18 months generating multiple EIS3 certificates for claiming income tax relief, and only returns capital once portfolio companies are sold.

EIS benefits from considerably greater downside protection (31.5% more than VCTs in a total-loss scenario) and is well suited to longer-term planning for IHT and CGT deferral, with growth funds seeking triple-digit returns.

(This article first appeared on Professionaladviser.com)


 

Disclaimer

The information in this article makes reference to EIS relief, IHT relief and CGT Deferral relief. The tax reliefs are those currently available and may be subject to future change and their availability is dependent on upon the individual circumstances of each investor.

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