Enterprise Investment Schemes

With less than three weeks to go until the tax year ends on April 5, the annual rush to make tax-efficient investments is in full swing. This year, financial advisers are reporting particularly strong interest in the Enterprise Investment Scheme (EIS).

What is an Enterprise Investment Scheme?

An EIS is an investment vehicle that takes advantage of tax breaks to encourage investment in small companies. It pools money from investors and buys shares in companies. These companies could have assets worth as little as £250,000, and they are normally privately owned, although some EIS schemes invest in companies listed on Aim, the junior stock market.

Why are EIS schemes so popular this year?

They represent one of the few remaining ways that you can reduce your income tax burden through investing. The other main routes are venture capital trusts (VCTs) and pensions. However, the tax breaks on VCTs were watered down from 40 per cent to 30 per cent this year and pensions lock up your money until you retire.

What are the tax advantages of EIS schemes?

They reduce or even eliminate your exposure to three ways that HM Revenue & Customs reaches into your pocket – income tax, capital gains tax (CGT) and inheritance tax (IHT).

The main income tax benefit is upfront relief of 20 per cent. For example, suppose you invest £10,000 in an EIS scheme. The 20 per cent relief will reduce your income tax bill by £2,000.

To qualify for this relief, you must hold your EIS investment for at least three years. If you sell it within three years, you will have to give back the income tax you saved. Also, you must hold no more than 30 per cent of the shares in any company in which you are investing.

The other restriction is that you can only claim income tax relief for up to £400,000 in one tax year. However, if you have very large sums to invest, at this time of year you can “straddle” the cut-off date by investing £400,000 at the end of this tax year on, say, April 4, and another £400,000 a few days later at the start of the next tax year.

What about capital gains tax relief?

There are two strands to the CGT relief offered by EIS schemes. First, you use an EIS investment to defer CGT liabilities. For example, suppose you have made a £20,000 profit by selling some shares, and owe the Revenue £8,000 in CGT (which is charged at 40 per cent). If you put your £20,000 into an EIS scheme, you will not need to hand over the £8,000 until you sell your investment in the scheme.

As well as deferring the CGT liability, you can also even eliminate it altogether. Unfortunately, you can only do this by dying. Under EIS rules, any deferred CGT bill that is subsequently invested in an EIS disappears on death.

The second strand to CGT relief is more straightforward. If you hold your EIS investment for at least three years, any capital gains you make on your investment when you sell will be exempt from CGT.

How does the estate planning aspect work?

The main estate planning benefit of EIS schemes is that no inheritance tax is payable by your heirs on EIS investments in your estate, provided you held them for at least two years prior to your death.

What EIS schemes are open to new investments at the moment?

Brewin Dolphin, the stockbroker, offers a portfolio of EIS investments in companies listed on the Aim and Ofex stock exchanges, as well as unlisted companies. If you want to concentrate on the latter, there are a number of EIS funds available, such as the Axcess EIS Fund run by Pre-X Capital Management, which has an initial charge of 5 per cent and an annual management charge of 1.5 per cent, plus a 20 per cent performance fee.

You can also use an EIS scheme to tap into the stellar returns that private equity investments have delivered in recent years. Calculus Capital EIS funds, a private equity vehicle, outperformed the Aim index in each of the five years from 2001 to 2005. They made an impressive profit of 40 per cent in 2001 when the Aim index fell, and achieved a staggering 130 per cent return the following year. 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 an initial fee of 5 per cent.

What are the risks?

An EIS scheme channels your money into risky small companies, including start-ups with a significant chance of going bust. The risk should be reduced by the EIS fund manager’s selection of a range of companies in different sectors.

There are single-company EIS vehicles that put all their eggs in one basket. If you go down that route, you should spread the risk by buying shares in several different single-company EIS investments.

There are also risks associated with the rules for EIS schemes. A company taking EIS investors’ money should try to maintain its EIS eligibility, but it might fail to do so – for example, if its gross assets exceed the maximum of £7m laid down by EIS rules.

In addition, this government – or the next – could change the tax incentives surrounding EIS schemes, so your tax saving could end up being smaller than you expected.