Overview of EIS, SEIS and VCTs video

/
Date16 Feb 2016
/
Categories

Created 25 January 2016

Hello and thank you for listening to this training video on EIS, SEIS and VCTs

Please take a few minutes to read this disclaimer as it is important that you understand the contents.  You can pause the video while you do so.

My name is Dermot Campbell and I am a chartered financial planner.  I am Chief Executive of Kuber Ventures Limited which offers a platform for investing in alternative investments including EIS, SEIS and other inheritance tax efficient investments.

The learning objectives of this presentation  are to compare and contrast EIS, SEIS and VCTs, to understand the changes for EIS and VCT investors announced in the 2015 Budgets and to understand which clients and planning scenarios are best suited to these investments.

These investments are all covered by a manual which is published on the HMRC website called the Venture Capital Schemes Manual.  Venture capital schemes, as we know them today, have been around in one form or another since the early 1980s when the then conservative government introduced the Business Expansion Scheme to encourage investment in private companies.  This was replaced by EIS and VCTs in the early 1990s and finally SEIS were added in 2012.  Today, these investments form a key cornerstone of the Government’s growth policy.

The 2015 Budget introduced a number of changes which are relevant:  it was confirmed that Entrepreneurs Relief can still be claimed if you defer a Capital Gain using EIS but there were few other changes to the personal taxation of these investments.

The number of employees that a qualifying company can employ was changed from 249 to 499, there was an age limit of 7 years imposed on companies and a lifetime cap on the amount of investment that a company can receive through the schemes was introduced at £12m.

Other important changes not directly connected to the venture capital schemes were the change in the taxation of dividends with the removal of the dividend tax credit, the introduction of a £5k tax free allowance and the change to the tax rates on dividends to 7.5%, 32.5% and 38.1% for 20%, 40% and 45% tax payers.

So, let’s look at the key risks associated with this type of investing.  Liquidity risk is the risk that you can’t access your investments when you need to.

There is a phenomenon known as the liquidity premium.  This is the concept that you may actually get a better return for investing in illiquid assets.  In the case of private company investing, your client’s money is going directly into the company to help it grow.  This is in contrast to a listed investment where you are simply buying the investment from someone else and the company derives no benefit out of this transaction.  The issue here is that no one wants to buy private company shares on the secondary market when they can invest directly into the company, hopefully getting a better return because their money is being put to work. Investors will then be relying on a corporate event to realise the profits from the investment.  This may happen quite quickly or it may take quite a while to materialise.  The key point is that investors have very little control over how quickly this happens and can’t simply cash in their investments when they feel fit.

Much of the returns derived from these investments are realised because of the tax treatment and so it is worth examining the tax risks associated with this investing:

For a start, you can’t get a tax benefit if you don’t pay tax so it is important that clients consider their personal circumstances to make sure they can benefit from the tax incentives.  There is also the risk that the company may exit before the investor has qualified for the tax benefits which would mean that they have to pay back any tax benefit they have received.  There is also the risk that the management team may do something with the company which  cause it to cease qualifying for the tax benefits.  This is why it is important that your clients invest through a fund unless they properly understand the company and have representation on the board of the company.

The last group of risks to talk about are investment risks.  You may be familiar with the terms Systemic and Specific risks.  Systemic risks are the risks that an entire sector or market are affected by and specific risks are the risks that an individual company  is affected by.  There is a limited amount that you can do about systemic risks but the good news about private company investing is that Specific Risks are more prevalent than Systemic risks and specific risk can be managed by building a diversified portfolio.

With Systemic Risks, these are more likely to have an impact on the level of the returns you receive and one way to manage this risk is to invest across a number of vintages.  Vintages are to all intents and purposes the year you invest.

There are a couple of other specific risks to consider:  getting the valuation right at the outset is very much an art but obviously has a marked impact on the return of the investment.  The other risk that you need to be aware of is Dilution Risk.  Dilution risk is the risk that the company does not raise enough money at the outset and has to bring in additional investors.  This will reduce the share of a company that the existing investors own.

Let’s now look at these 3 investments and compare them.

Venture Capital Trusts or VCTs are collective investments which are listed on the London Stock Exchange and are very similar to investment trusts.  They will typically invest in project finance offerings.

Enterprise Investment Schemes, or EIS, are investments in private company shares.  These companies will be small to medium sized businesses.

The last group is Seed Enterprise Investment Schemes or SEIS.  These are investments in very small and young companies with less than 25 employees.

From a regulatory perspective, investing in private companies has very little protection.  The directors do have to adhere to the Companies Act but there are a lot of risks if you are a minority shareholder with no representation on the board.

If the investment is listed there are more protections. Firstly, the management team is required to conduct an audit and, secondly, there are strict governance rules that are imposed by the listing authorities.

If you invest through a fund of SEIS or EIS, there are a lot more protections.  Firstly, the managers will normally be FCA authorised managers and your clients will have access to the Financial Services Compensation Scheme.  The fund managers will be charged with making sure that the management team of the underlying investments act in the investors’ best interests, not their own.

At the top of the regulatory pyramid is the VCT which has all of the benefits of the EIS and SEIS funds but also has the benefit of the requirement to have an independent board of directors whose job it is to appoint the investment manager and if necessary, fire them.

Let’s now move on to compare the different types of investments.  Starting with VCT, you can invest £200,000 per annum in VCT.  With SEIS, you can invest a £100,000 per annum and also carry back to the previous year. In other words, you can invest a total of £200,000 in SEIS if the client has not used them  the previous year.

With EIS, there is no limit to the amount of capital gain that you defer through an EIS and you can claim a maximum of £300,000 in income tax relief which equates to a £1m investment.  As with SEIS, you can carry back to the previous year.  In effect this means that EIS investment is only limited by the amount of income tax your client has paid unless they are very high earners in which case, the limit is £2m taking into account carry back.

The tax reliefs available for these investments are incredibly generous.  You get 30% up front tax relief with VCT and EIS and 50% up front tax relief with SEIS.  These reliefs act as a tax reducer so it doesn’t matter what rate of tax you pay, just how much.  For example, if you invest £10,000 in an EIS or VCT, you get £3,000 in tax relief providing you have paid £3,000 in tax.

To retain the initial income tax relief in the case of a VCT, you have to hold the investment for at least 5 years.  In the case of EIS or SEIS, the holding period is 3 years.

All profits on the investments are tax free providing you claim at least £1 of income tax relief on each investment you make.

Other than this, VCTs do not have any capital gains relief available.  In the case of EIS, you can defer a capital gain into the EIS.  We will talk about this in more detail in a few minutes.  In the case of SEIS, you get 50% capital gains tax relief which means that the rate of tax is reduced from 28% to 14% for a 40% tax payer.

Dividends paid by a VCT are tax free whereas dividends on an EIS or SEIS are taxable.

A very valuable tax relief is loss relief.  This applies to investments in SEIS or EIS but not VCTs.  Loss relief works so that you get tax relief on the net gain after income tax relief.  So in the case of an EIS, if the investment fails completely, you will get income of capital gains tax relief on the 70% portion that did not benefit from income tax relief.  This means that a 40% tax payer gets an extra 28p in the £1 back on any failures meaning that they recover a total of 68p in the £1 on failures.  For 45% tax payers, their recoupment is 61.5% of the investment.

In the case of SEIS, their recoupment is even better, with 40% tax payers getting 70p in the £1 from tax and a 45% tax payer with CGT will recoup 86.5% of their investment from failures.

Loss relief applies to individual investments, so the profitable investments grow tax free and the losses are relievable in isolation.  Let’s look at an example of a portfolio.

This investor spread £1000 across 10 investments making a £100 investment in each company.  The first investment failed and he received £61.50 back in tax rebates.  The next 2 lost 30% but tax relief meant that the investor came out flat.  4 broke even giving £520 from a £400 investment.  It is worth noting that these 7  investments have performed disappointingly.

The next 2 investments did OK, returning 30% profits each and the investors received £320 after tax.  The last one did what he hoped all of the investments would do: it returned 5 x his money.  As you can see, even taking out the home run, the portfolio still returned a profit in excess of 10% and a 63% return in total.

Before we finish on tax, let’s take a brief look at capital gains tax and inheritance tax.  With EIS, you are able to defer a capital gain into the EIS.  If you have incurred a capital gain up to 36 months before the date of the allotment of shares in the EIS, you are able to reclaim the tax you have paid and defer the gain until the tax year in which you realise the EIS.  CGT deferral is very flexible and allows you to choose how much of the gain you defer.

If you have a client who has incurred a loss and previously had capital gains, they can reclaim the CGT paid previously and defer the gain until after the loss.

Equally, you can defer the gain that you made in excess of your annual tax free allowance, gaining an extra CGT allowance in a future year.  You also do not pay CGT on death so if you defer a gain into an EIS and then die after owning the investment for at least 2 years, the gain is completely extinguished  and the beneficiaries will also benefit from inheritance tax relief.  The one thing that you should warn clients of is that CGT could go up in the future so deferring a gain is not always the right thing to do.

Before talking about the underlying investments, let’s briefly look at IHT relief. There is a more detailed video on IHT which you can study so I will just give a very brief overview here:

EIS and SEIS but NOT VCT qualify as Relevant Business Property after an ownership period of 2 years.  Cash waiting to be invested does not qualify and investments cease to qualify after there is a contract to sell them in place.  If you sell an investment and reinvest the proceeds within 3 years, you are able to claim Replacement Property relief and also reduce the IHT due on an estate.

So let’s now move on to consider the different companies which these investments will invest in.  The first group is Seed stage investments.  These are normally accessed by SEIS investments although some EIS also invest in start-ups and seed investments.

These are companies which are just being setup and will have high potential returns, although the risks are also high.  You should expect a significant number of failures but equally there should be some good returns from the successes.  Dilution is a significant risk here and you would only expect 2 in 10 investments to be successful.  Returns from the successes should be between 5 and 10 times your money while the failures will benefit from loss relief meaning that a top rate tax payer with capital gains will recover 86p in the £1.  This means that an investment really doesn’t have to do very well to make a profit.

The second group are Early stage investments of A round funding.  These companies are already generating revenue but are not normally profitable.  Failures and dilution remain relevant but will be less common while the returns can still be good with 2 to 5 x your investment being a reasonable expectation from a successful investment.

With seed and early stage investments, it is important that you diversify a lot.  You should be thinking in terms of 3 investments flying in every 30.  These will tend to be available through EIS and SEIS for seed companies but less common in VCTs.

The next group of investments that I am going to talk about here are mature growth companies.  These companies will already be profitable and be seeking to raise capital to expand.  Here the risk of dilution or failure is less significant but equally the profits are going to be in the range of 1.5 to 2x your money.  You can afford to diversify a little less with these, looking for between 20 and 30 investments in a portfolio.  You will find VCTs mostly concentrating on mature growth companies.

The last category of EIS and VCT investing  are project finance investments.  Here the companies will be financing specific projects and may be wound up when the project comes to an end.  Investments are typically in the area of media, energy or construction.  Although these seem like quite risky sectors, often the risks as passed on to the counterparties and may even be underpinned by some form of asset or contractual income stream.  Returns will be much lower, but after tax are still very attractive.  Typically you will be expecting 1.05 – 1.5 x your money back.

So what have we learnt here?  These investments carry fantastic tax benefits but there are certain rules that you need to follow when using them:

  1. You have to diversify. Remember the term 3 fly in 30.
  2. When structuring your firm’s offering, focus on choosing good quality managers
  3. Make sure that you do the full financial planning job, not just selling the product. It is not good having a tax efficient investment if your client is simply going to give the proceeds to their spouse in their will because they would not have paid tax in the first place!
  4. Remember to justify any increase in investment risk in your suitability letter.

So let’s summarise:

VCTs give income tax benefits only.

EIS are very effective for financial planning with CGT income tax and IHT benefits.  SEIS are great investment opportunities for higher and top rate tax payers who can use the loss relief.

As an investment platform specialising in SEIS and EIS, we receive 80% of our funds in the last couple of weeks of the tax year but there really is no need for this.  With VCTs it does make sense because they tend to spend the run up to the end of the tax year raising funds and then start the investment process.  There are often incentives to make early investments but your clients will benefit from the pooling of the fund.

In the case of EIS and SEIS, there are limited reasons for investing at the end of the tax year, particularly since the investment can be carried back to the previous tax year.  There may be sense if the investor had a large tax bill in the previous tax year and needs to carry back to access it, but otherwise, from a timing of the relief perspective, it makes little difference if you invest in May or March.

Kuber Ventures offers a platform for investing in EIS, SEIS and BPR investments.  Using a platform will help you for a number of reasons:  the main one being that it puts you in control of your client’s investments, making it possible for you to do a proper job for them.

Our platform is a simple fund platform that allows you to easily build a portfolio of investments for your client.  Funds flow into it the cash account of the platform, get allocated to the funds you choose for your client and the underlying investments get bought in a nominee and held for the benefit of your client.  When an investment is sold, the proceeds flow back to the platform and you will be in a position to re-invest the proceeds.

The platform helps you by simplifying the investment process overall but most importantly, putting you the adviser in control of your client’s investments.  When you diversify you should look to diversify across the underlying positions, but there are some other important rules of diversification: look to spread the investment across different funding stages and sectors as well as different managers.  If the client is in good health, consider spreading the investment across a number of vintages, or years so that they get exposure to different parts of the economic cycle.

So, what next?  Have a look at your client bank and consider which clients you should be talking to about this stuff.  Consider speaking to your professional connections such as solicitors or accountants.

Next consider what strategy you are going to adopt – perhaps meet Kuber and set up your own panel of preferred investments for the next few months.

Finally consider how you are going to market these opportunities to your clients.  Maybe send out a newsletter or arrange a series of CPD workshops.  Kuber is happy to help you put these together.

There is a lot of information available on the internet.  Have a look at our website where you will find a host of useful material, but also browse the HMRC website which is excellent.  The IHT manual or Venture Capital Schemes manuals are excellent and there is also a host of information on VCTs on the AIC website.

Thank you very much for listening and good bye.