By Kimberley Malin DipPFS Cert CII (MP)
Have you ever watched Dragons’ Den, where entrepreneurs are seeking an investment into their business in return for an equity stake through pitching their ideas and business to the dragons – yes? Ok, well welcome to the world of Enterprise Investment Schemes. This is a simplified example of an EIS, and, of course, they are a very complex solution that needs careful consideration.
We see EIS used as a tool within financial planning often; however, being able to identify when and how to recommend these is not as simple as with an ISA or GIA.
EIS was an initiative set up by the Government as a way of providing help to smaller, unquoted, higher-risk businesses that were seeking investment to aid their growth and expansion.
The Government put in place certain incentives to encourage private investors to invest money into companies that meet strict criteria for this type of investment.
Investments within the EIS can be in one single company, or they will be diversified across a broad range of companies and sectors.
To achieve the tax benefits, an EIS must be held for a minimum of three years, although in reality, they are a much longer-term investment and often illiquid.
There are five main tax incentives of an EIS:
v Income Tax relief is given to investors for qualifying investments. Relief is available up to a max of a £1,000,000 investment in most cases and £2,000,000 if you are investing at least half in knowledge-intensive companies – this will provide maximum tax reliefs incentive of £300,000 and £600,000 respectively per tax year. Note that the tax relief is given as a tax-reducer, so you must have an Income Tax bill equal to the relief you are trying to claim. An investor can carry back this relief to the previous year, provided sufficient Income Tax was paid.
v Profit from EIS is free from Capital Gains Tax (CGT), provided the investment remains qualifying.
v You can defer a capital gain by re-investing it into an EIS. The re-investment must take place within the period beginning one year before and ending three years after the gain occurred. CGT will eventually be payable, and this will be paid at the prevailing rate at the time. The money from an EIS can be re-invested multiple times, which will defer the gain each time. If you have already paid CGT, this can be reclaimed.
v Loss relief – if the value of the EIS was to drop below the original amount invested or to nil, loss relief would be available. This allows the investor to offset the loss against either their Capital Gains Tax bill or their Income Tax bill, depending on which is more appropriate for their individual needs at the time.
v The final tax relief is Business Relief, which provides relief against Inheritance Tax– if you hold the EIS for at least two years, you still hold it on death and the company remains qualifying, then the EIS should be free from Inheritance Tax, which could potentially save you 40% in tax.
EISs are risky, however…..
EISs are usually very high risk, and investors should not invest money they cannot afford to lose. They are usually highly illiquid and may be hard to sell. Tax rules can change in the future, and the above tax incentives may not always be available. They are not for every client and not for inexperienced or nervous investors.
What does a client look like where EIS could be considered?
v Clients should have a sophisticated grasp on businesses and investments.
v The client should be able to take the highest level of investment risk and expect that there will be losses in the portfolio. Although you can segment a need and the rest of the client’s portfolio can remain lower risk, the client needs to understand that this type of investment is very high risk, possibly, compared to what they are used to investing in, particularly if they are a first-time EIS/VCT investor.
v The client should have a longer-term investment horizon. As a minimum, the investment needs to be held for three years to benefit from tax incentives, but as the investments are usually highly illiquid, the investor needs to be prepared to hold the investment for much longer periods.
So where can an EIS fit into a client’s Financial Plan?
The big, obvious reason to invest in an EIS is the tax-planning opportunities available due to the incentives on offer; however, where else does this specialist product fit in?
EIS can add diversification to a client’s portfolio if they are willing to accept the risk associated with the investment and can be useful for clients with particularly large investable assets. Smaller companies typically follow different investment cycles compared to other parts of the investment market, so this is what creates the extra layer of diversification. An EIS can be used to complement the other products the client has (however, should not be seen as a replacement for other mainstream investments such as ISAs & pensions but an addition).
Although risky, EISs do have high growth potential. The sort of companies looking for EIS funding are generally aiming for significant growth and scale, so for investors, this is an opportunity to share in that potential success.
Furthermore, by investing in these smaller companies, the investor is contributing to the future of the economy and country through their new, exciting and innovative ideas. People love to see others do well; they like to see success, and being part of that journey can bring huge satisfaction.
Clients have their standard stock-market investments, and, as they are aligned to their agreed level of investment risk, they roughly know what to expect, but with an EIS, clients have an element of excitement around this, as the potential for growth can be huge.
In summary, of course, EISs have their place in some clients’ Financial Plans, but this type of product requires careful consideration of both the risks and benefits associated with it before a recommendation is made.
EISs are a complex specialised product that should be carefully considered before proceeding with an investment. Information quoted is based on the tax rules in place at the time of writing (Feb 2024), and this article should not be considered as advice.
