Get a break backing small firms

If you’ve filled your Isa and pension, VCTs and the EIS offer good tax perks – but make sure you understand the risks

If you've filled your Isa and pension, VCTs and the EIS offer good tax perks but make sure you understand the risks.

Private pensions and individual savings accounts (Isas) offer generous tax incentives to savers and investors putting money by for the long term, but if you're putting aside a lot of money each year, you may find that you've used up your tax allowances. In that case, you may want to consider other tax-efficient vehicles, such as venture capital trusts (VCTs) and the enterprise investment scheme (EIS), which can offer attractive opportunities.

Indeed, increasing numbers of savers have been turning to VCTs and the EIS in recent times, with the rules on pension contributions having become less generous. Three years ago the annual allowance the amount you may invest in a private pension in any one tax year was cut from £50,000 to £40,000. And since last year even tougher rules have applied to high earners the allowance reduces once you start earning over £150,000, to just £10,000 for those with incomes of £210,000 a year or more.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

While the Isa allowance went up to £20,000 this year, for many people the increase wasn't sufficient to compensate them for lost pension allowances. And while there are a whole range of investment opportunities to consider beyond Isas and pensions for those who've used their allowances in full, the tax advantages of VCTs and the EIS are undoubtedly attractive.

Still, there's an important caveat. VCTs and the EIS are designed to boost investment in small companies often young businesses looking to raise money for growth. Tax incentives are on offer because governments have recognised investors are wary of the high failure rate of businesses of this nature. There have been success stories, but also plenty of setbacks, and the tax perks are meant to compensate investors for the additional risks they're taking.

Introducing VCTs

A VCT is a collective fund run by a professional fund manager who builds up a portfolio of qualifying companies. Investors get 30% upfront tax relief so it costs only £700 to invest £1,000 and income and profits are tax-free. You can invest up to £200,000 in VCTs in any one tax year.

The rules on qualifying companies underline warnings about the higher risk profile of VCTs. Fund managers must invest 70% of money raised from investors in such businesses within three years; to qualify, companies must usually be no more than seven years old, have no more than 250 employees and have assets worth no more than £15m. Most such businesses are privately owned, though some companies listed on Aim, the junior market of the London Stock Exchange, also qualify.

Some companies backed by VCTs in the past have gone on to become household names. Virgin Wines, Picturehouse Cinemas and the property website Zoopla have all received VCT funding in the past, for example. However, other investments have been less successful, with VCT managers forced to write off some or all of their value. Moreover, investors have little choice but to gamble on fund managers' ability to pick the winners from the losers.

VCTs are stockmarket-quoted funds, so you can buy shares in the best-performing funds on the secondary market. But the 30% upfront tax relief is only available on purchases of new shares, and you must hold on to this stock for five years, or you'll have to repay the relief. That said, the new VCTs launched each year largely come from a relatively limited number of specialist fund managers, and existing funds often raise additional capital to invest through C share issues. So it is possible to study past performance records when choosing a VCT either of the fund itself or its manager.

Investors may also be able to narrow the search by deciding that a particular type of VCT is the right option for them. The funds broadly fit into three categories:

"Tax incentives on VCTs and the EIS are high because the failure rate is high"

Generalist VCTs invest in a range of unquoted companies across different sectors, though some specialise in particular industries healthcare and technology are two favourites. Investments are made according to the fund's stated mandate some funds might focus on very early-stage businesses, say, while others may concentrate on more mature companies. The detail of the approach will determine the fund's overall risk and reward portfolio.

Aim VCTs stick to investments in Aim-listed companies. These businesses tend to be more mature, and the funds are buying shares that can be freely traded, so they might be considered less risky. But the reported value of Aim VCTs can sometimes be more volatile, since share prices move up and down every day; by contrast, valuations of unquoted investments are carried out only periodically.

The third option is a limited life VCT sometimes known as a planned exit fund. These funds set a specific date in the future for winding up and returning investors' money, typically just after the five-year income tax qualifying period has come to an end. Often, limited life funds invest in a business by taking a charge on its underlying assets a property, say which can mitigate the risk of investing.

Bigger breaks and bigger risks with EIS

The EIS comes with a higher annual allowance of £1m and can be used to put money into individual firms or a managed fund. Like VCTs, the EIS offers 30% upfront tax relief and tax-free returns, but the scheme also enables you to defer paying tax on previous capital gains and to set any losses you incur against tax. EIS shares are exempt from inheritance tax once you've owned them for two years.

The rules about which companies qualify for EIS status are broadly the same as those governing VCTs, except that the businesses must not be listed on a stock exchange. This is important, particularly if you're investing in qualifying companies individually the growth of crowdfunding platforms such as Seedrs and Crowdcube has seen a big increase in investment in individual companies under the EIS. Because the investments are unquoted, you can't sell them when you like: you'll have to wait for an exit opportunity a takeover of the company, say, or its flotation on a public market to realise a return on your investment. Investors to whom crowdfunding appeals may look for investments offering EIS status and some companies on the platforms qualify for a separate initiative, the Seed Enterprise Investment Scheme (SEIS). This operates similarly to the EIS, but only covers investments in the very smallest businesses; it has a lower annual investment allowance, of £100,000, but more generous upfront tax relief of 50%. However, for simplicity, most EIS users choose to invest through a managed fund.

As with all investments, it's important to choose funds carefully. As well as managers' track records, pay close attention to charges, which tend to be much higher than on more mainstream investments. Initial charges of 5% are typical, along with annual fees of 1.5%-2.5%. Some funds also levy performance-related fees of up to 20% of realised gains, which can eat into your returns very quickly.

VCTs and the EIS may suit investors with a long-term outlook five to ten years at least who have already maximised other tax-efficient investment opportunities. Some investors in that demographic are confident about making investment decisions and are keen to take control themselves but if you're not sure, consider taking independent financial advice from a specialist in the sector.

Above all, you should never invest simply to get a tax break. Make your investment decisions on the basis of your attitude to risk, your ambitions and needs, and your current circumstances, such as the investments you already hold. Once you have decided a particular type of investment is the right one for you whether small, high-growth companies or something else it makes sense to invest as tax-efficiently as possible. But don't get your decision-making process the wrong way round.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.