Tax benefits draw investors to start-ups

The generous tax benefits
of enterprise investment schemes (EISs) are appealing to investors looking to diversify their portfolios beyond stocks and bonds before the tax year closes on April 5.

But advisers warn that some schemes are risky – and that weeding out the good from the bad can be difficult. Justin Urquhart-Stewart, director of Seven Investment Management, says: “The strength of a particular EIS rests on the abilities of its manager. It’s not even that the advisers themselves may be bad – what you’re investing in is so new. These are untried businesses and investments and, therefore, very high risk indeed.”

EISs are similar to venture capital trusts (VCTs)
in that they are investment vehicles that offer tax breaks in order to encourage investment in small companies. They pool money from investors and buy shares in companies. These companies could have assets worth as little as £50,000, and they are normally privately owned, although some EISs invest in companies listed on the Alternative Investment Market (Aim).

They are attractive as they offer a number of ways of reducing or deferring tax:

● income tax relief at 20 per cent on up to £500,000 invested in any tax year;

● a capital gains tax (CGT) exemption on disposals of shares that qualified for income tax relief, after they have been held for three years;

● unlimited deferral of CGT on gains from other investments that are reinvested in an EIS, up to three years after the gain was made (with no upper limit);

● 100 per cent relief from inheritance tax (IHT).

Traditionally, EISs invest in either a single company or a small portfolio of as many as six to eight start-ups. Managers tend to offer schemes on a “rolling” basis, closing them only after target funding levels have been reached.

But investors with more cash to hand can also pursue a bespoke option. The managers Calculus, Oxford, MMC and Octopus offer discretionary portfolios of EIS investments in companies listed on Aim, as well as unlisted companies, to those willing to part with tens of thousands of pounds.

If you join Octopus’s syndicate of financial backers, you pay an up-front 5 per cent fee as well as a yearly management fee of 2 per cent and at least £50,000 for the chance to invest in a selected clutch of companies alongside the firm.

A performance fee of 20 per cent plus value-added tax on a return in excess of the gross amount invested is also levied when your investment comes due after three years.

For those who prefer a simple approach, a select number of EIS funds are still on offer. They range from the Edge Performance EIS, which funds rock concerts, to Highgate’s EIS tech fund, which requires a £10,000 investment and backs high-growth tech companies in the UK.

You can also use an EIS to tap into the returns that private equity investments have delivered in recent years.

A portfolio of unquoted companies backed by Calculus Capital EIS funds, a private equity vehicle, is up 30 per cent from 2000 to 2009 while the Aim market fell 69 per cent over the period. But you have to pay for this performance with hedge fund-style fees of 2 per cent a year plus 20 per cent of the fund’s returns, as well as a 1.5 per cent annual management fee and an initial fee of 5 per cent for those buying shares through an adviser.

Among the funds concentrating on a specific sector are Foresight Environmental EIS 2 and Country Food & Dining 4, the fourth in a series of funding drives for start-up farm shops, brought to the market by Smith & Williamson.

Martin Churchill, editor of the Tax Efficient Review, believes private investors should favour generalist EISs, which spread funds across a range of sectors and hold shares for seven to 10 years. Calculus and MMC are the managers Churchill prefers. “Investors have to look carefully at a fund’s relevant track record,” he says.

But the risks attached to start-up businesses still deter some advisers from recommending EISs.

Justin Modray of CandidMoney.com, believes investors should only use EISs for capital gains tax planning. “If you have a large capital gains bill and you wish to defer it, then I would consider it,” Modray says. “But even then, there’s a strong argument for simply paying the capital gains tax: it is just 18 per cent.”

An EIS investment can be used to defer CGT liabilities as follows. Suppose you made a £20,000 profit by selling shares, and owe the Revenue £3,600 in CGT. If you put the £20,000 into an EIS, you will not need to hand over the £3,600 until you sell your investment in the EIS, when you may have more of your annual CGT allowance available.

Modray warns clients to steer clear of EISs that invest in higher risk start-up or technology companies. “You could struggle to find a buyer should you wish to sell,” he says.