Jessica Franks, Head of Retail Investment Products at Octopus Investments, talks through a client planning scenario to highlight how an adviser can help a client to reduce his tax bill for the prior tax year by using an Enterprise Investment Scheme (EIS).
Let’s consider a client scenario…
Chris is self employed. He’s in his forties and a high earner. However, his income can go up and down from one year to the next.
The nature of his work means he won’t always know what his tax bill will be until the tax year is over.
He’s already an experienced investor. He has a diversified portfolio and Chris has made it clear he’s open to being adventurous with a portion of his investments. For this part of his portfolio he’s happy to take on more risk to target significant growth.
Now the tax year has ended, Chris is keen to get ahead of his tax planning and is looking for opportunities that would allow him to offset his income tax from the previous tax year, while also supporting his wider planning objectives.
Chris makes a call to his financial adviser.
What Chris’s adviser suggests
Chris meets with his adviser, Helena. She considers his needs and goals, along with his appetite for risk. She suggests a potential investment that might work for him.
Helena asks if he is familiar with Enterprise Investment Scheme (EIS) portfolios, which would give him access to a diverse portfolio of early-stage companies with high growth potential.
She explains that a benefit of investing in companies that are EIS-qualifying is that investors get 30% income tax relief on their investment in the year each underlying investment is made, or they can carry back income tax relief to the previous tax year.
As such, EIS qualifying investments are one of the few reliefs that can be carried back to the previous tax year. And applying to a portfolio early in the tax year should mean that the funds are expected to be invested in the current tax year, enabling carry back to the prior year.
That means Chris could invest in a portfolio now that he has more certainty over his prior year position, and still claim relief against this earlier tax year. He can claim relief as each underlying investment is made using the EIS 3 certificate.
The Enterprise Investment Scheme
EIS is a government-supported initiative that provides a valuable source of funding to early-stage companies.
It offers attractive tax benefits to investors in return for taking on the risk of investing in small businesses. Investing in early-stage companies can come with significant growth potential because they’re at the beginning of their growth curve.
But with this growth potential comes greater levels of risk. To compensate for some of this risk, EIS-qualifying investments allow investors to claim several tax reliefs.
It’s the combination of two of these reliefs – tax-free growth and loss relief – that make EIS such a powerful structure through which to target high growth from a high-risk investment.
On a per-company basis, a client can invest in an EIS company with high growth potential and pay no capital gains tax on growth.
The client can also make use of loss relief (against income or capital gains tax), on the difference between the amount invested net of income tax relief in an individual company, and the proceeds on sale should the investment underperform. On a portfolio basis, this is incredibly valuable, as each company is considered separately.
Even if an EIS portfolio grows overall, loss relief can be claimed against individual EIS companies within the portfolio.
It’s worth noting the other potential tax benefits attached to EIS investments:
• Claim upfront income tax relief on up to 30% of the investment amount, either in the year a company is invested in or the prior tax year.
• Defer a capital gain.
• Benefit from relief from inheritance tax, provided the investment is held for at least two years and at death.
Bear in mind that EIS investments are high risk investing in EIS qualifying companies is unpredictable and suited to experienced investors who are comfortable with high risk.
EIS investments could fall in value, potentially to zero, and investors may not get back their investment.
Investments in smaller companies can be volatile, meaning the shares could fall or rise in value more than shares of larger, established companies. EIS shares are unquoted, and they may be harder to sell than shares listed on the main market of the London Stock Exchange.
There are also tax risks to consider.
For example, EIS tax rules could change in the future. Tax relief depends on investors’ personal circumstances. And there’s no guarantee that companies invested in will maintain their EIS qualifying status. If a company loses its status within three years of investment, investors will be asked to repay income tax relief claimed.
The minimum holding period for a number of EIS tax reliefs is three years from the date of investment in each company. However, investors should be prepared to hold their investment for a longer period, potentially ten years or more.
How clients can invest in EIS
Clients can invest in individual EIS-qualifying companies. Of course, they’d have to conduct their own research and it’s unlikely they’d have access to the same kinds of opportunities as an investment manager.
For these reasons, many clients elect to invest with a specialist manager. EIS services invest funds on behalf of multiple investors in a portfolio of qualifying companies. Investing through a specialist manager means ongoing oversight of the companies in the portfolio, the potential to influence board-level decisions (if the manager is large enough – as is the case for Octopus – to have a seat on the portfolio company’s board) and the expertise needed to successfully exit portfolio companies.
Key questions to ask an EIS manager
If you’re considering EIS for a client, there are a range of factors you’ll want to consider when choosing the right specialist manager.
You’ll want to ask: what’s the EIS manager’s experience of choosing and investing in smaller companies? Of course, past performance isn’t a guarantee of future returns, but you’ll want to see a network of potential investments and a highly experienced investment team.
What about the manager’s track record of deployment and selling successful investments?
It takes time to both deploy a client’s money and to sell EIS shares. It might be worth checking whether an EIS manager has a good track record here.
Finally, EIS can be a complex investment. How does the manager make the investment as easy as possible for your client?
Jessica Franks, Head of Retail Investment Products, Octopus Investments.