Backing UK business – tax-efficiently

Anyone who has ever watched the BBC hit series Dragons’ Den will be familiar with watching nervous entrepreneurs pitching business plans to tough-talking dragons.

A stack of cold hard cash sits on the table while they do so. Their aim is to secure a chunk of it – and the dragons’ business nous – for their venture.

For most businesses, however, getting finance this way is not an option. The finance “dragons” of the real world tend to be managers of Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS).

The pile of £50 notes is put up by the private clients who invest in these vehicles, and who are handsomely rewarded by the taxman for doing so.

The idea behind the investment process is straightforward. VCTs are listed companies, run by a fund manager, which invest in small businesses.

EISs allow direct investment in small businesses. To encourage this, the government offers 30 per cent income tax relief on both VCTs and EISs.

Eventual gains are exempt from capital gains tax and, additionally, EISs are eligible for business property relief for inheritance tax purposes.

The run-up to the end of the tax year has always featured launches of tax-efficient products, but this year advisers report a rise in the number of VCT and EIS offerings coming to market.

Mobeus, Puma and Northern all have new VCTs on offer and Oxford Technology, Rockpool and Parkwalk Opportunities are among the many managers to launch EISs.

With bank lending likely to remain scarce in the near future, these vehicles are likely to continue to play a major role in supporting smaller UK companies. What is more, the latest changes in regulation have increased the size of qualifying companies that can benefit from EISs and VCTs from £7m to £15m and with up to 250 employees, which has also increased the investment opportunities for EISs and VCTs.

David Glick, director of Edge Performance VCTs, argues that this is the perfect time for better-off investors who are comfortable with the risks to invest in a VCT.

“Growing companies are finding it difficult to raise bank borrowing, so deals are priced competitively,” he adds. “An upturn in the economy will happen in the next investment cycle, and history shows that venture capital investments made at the right time outstrip the best investment made at the wrong time.”

-------------------------------------------

Which is best?

Many have commented that changes introduced in last year’s Budget made EISs more attractive compared to VCTs. In reality, the choice boils down to the individual.

The key features are shown in our graphic, but basically EISs allow investors to invest more, confer more tax benefits, and allow more carry-backs of prior years’ reliefs. The flip side is that they are dependent on capital growth – there are no dividends – and the investor has to invest for the full term. In contrast, VCTs pay dividends and are listed companies, but the holding period for tax relief is longer.

The Association of Investment Companies says 59 per cent of its member VCTs currently yield more than 5 per cent, and the dividends are not taxed. The average VCT is up 4 per cent over one year, 21 per cent over three years, 2 per cent over five years, and 61 per cent over ten years, it adds.

“In a low interest and annuity rate environment, as we are in now, the tax-free dividends provided by VCTs are particularly attractive,” says Michael Provin, head of investor relations at Baronsmead VCTs, which have yields ranging from 6.5 to 8.5 per cent.

But alongside the potential for high returns there are risks with these investments, warns Jason Hollands at Bestinvest. VCTs tend to be more expensive than most other types of investment with an initial charge of 0.5 per cent and annual costs of 2.5-3.5 per cent.

“Also, although VCT shares are listed on the London Stock Exchange, the volume of shares traded tends to be low so investors may have difficulty in realising their shares at the true value,” he explains. This is partly because investments in VCTs bought on the secondary market do not attract income tax relief.

-------------------------------------------

The season starts

Investment into both products peaks towards the end of the tax year.

Gordon Smith at Killik says the VCT sector has had a strong start to this year’s tax planning season with offerings from Northern already reaching capacity.

Baronsmead is almost at capacity and Puma, Albion and British Smaller Companies are all ahead of the run rate seen at this time in previous years.

Martin Churchill, editor of Tax Efficient Review, likes Mobeus VCT, ProVen and Northern VCT in the generalist sector, and Ingenious Entertainment and Puma VCT 9 in the “planned exit” sector (where the managers plan to wind up the fund after a certain period).

Advisers also report EIS offers coming through in large numbers at the moment and an influx of Seed Enterprise Investment Schemes (SEISs) – designed to provide finance to very early stage companies – coming on to the market via specialist companies such as Seedrs.com.

SEISs have caught investors’ attention because an investor can claim income tax relief at 50 per cent even if her or she is not a 50 per cent taxpayer, says Andrew Penman, head of London clients at PKF.

Capital gains are also exempt from CGT at 28 per cent, although the maximum amount investable is only £100,000

“Getting tax relief of up to 78 per cent on an investment sounds attractive, and there is no need to rush to make an investment before April 6 so that it can be matched with a capital gain in the current tax year,” says Penman.

“A purchase of shares made in one tax year can be carried back to the previous tax year and full tax reliefs claimed in that tax year.”

Listen to Lucy Warwick-Ching interview David Kaye of Puma Investments on VCTs on the FT Money Show podcast

But experts warn that to invest in these sort of companies you really need to know what you are getting into. The companies are very small, with gross assets before investment of less than £200,000 and will have been operating for two years or less.

Many will demand proof that you are a sophisticated investor before they will allow you to invest.

“These investments are often described as being suitable for ‘friends, family and fools’,” Adrian Lowcock, at Hargreaves Lansdown explains. “Basically, if you don’t know the person who is setting up the business and therefore don’t have a lot of access to the company, you would be a fool to invest.”

Regulatory cloud

The Financial Services Authority’s plan to ban the distribution of some investment products to retail investors could also restrict the sale of some Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs), warn managers. An FSA consultation paper proposes to limit the promotion of unregulated collective investment schemes (Ucis) and similar unregulated funds to sophisticated, wealthy individuals. While VCTs and EISs were not specifically mentioned in the consultation paper, they appear to fall within that definition. David Kaye, chief executive of Puma Investments VCT, argues that VCTs should not be included in the proposals. “To limit their distribution solely to sophisticated investors is to restrict them from their potential market and thus threaten their viability,” he explains. “VCTs exist for an important economic purpose, supporting small and growing businesses and thus fuelling much-needed job creation, which is why the government has allowed the tax relief.” Those backing VCTs argue that since the trusts are listed companies that are accountable to independent boards of directors, it would be a mistake to restrict investor access to them.