Tax breaks for early-stage investors with VCTs

If you've already used your Isa and pension allowances, then VCTs and the EIS may be the investment vehicles for you.

If you are willing to accept the risks of investing in early-stage companies that are yet to prove they can deliver sustainable profitability (which is just as risky as it sounds), then venture-capital trusts (VCTs) and the enterprise-investment scheme (EIS) offer some very attractive tax reliefs. The annual allowances are generous too: you can put up to £200,000 into VCTs in the 2017-1208 tax year and up to £1m into the EIS.

Both schemes are designed to help smaller companies attract vital funding. To qualify as a potential holding for VCTs and the EIS, a business must be unquoted (with the exception of some Aim-listed stocks), have fewer than 250 employees, and assets of less than £15m. It may not usually raise more than £5m in any one financial year.

VCTs are professionally run, stockmarket-listed investment funds that must invest 70% of the money they raise into qualifying companies within three years. The funds typically spread risk by building portfolios of 20 such companies or more. Investors in new shares issued by a VCT get 30% upfront tax relief so it costs only £700 to invest £1,000 though they must hold onto these shares for at least five years or repay the relief. In addition, all income and profits generated by VCTs are tax-free.

The EIS, meanwhile, is most often used to put money into individual businesses; for example, most of the companies raising money on equity crowdfunding platforms have EIS-qualifying status. In addition, several specialist asset managers run managed funds that consist of EIS-qualifying businesses that they choose on the behalf of investors. Like VCTs, the EIS offers 30% upfront tax relief and tax-free returns on income and profits.

The scheme also enables investors to defer paying tax on previous capital gains if they reinvest the profits on which the bill is due. In addition, investors can set any losses incurred against tax. EIS shares are exempt from inheritance tax too.

A separate initiative, the Seed Enterprise Investment Scheme (SEIS), 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%.

The tax incentives are alluring for a reason

While these tax breaks are alluring, remember why successive governments have felt the need to offer them: the failure rates on small, early-stage businesses are high. A recent study by researcher Beauhurst of 500 start-ups raising money over the past six years found that 73 had already gone out of business.

These are also very much long-term investments. VCTs are a more liquid option than the EIS, since they're listed on the stockmarket, although the loss of tax relief for investors who sell up after less than five years is punitive (and rather defeats the purpose in some ways). With the EIS, by contrast, you will probably require some sort of exit event, such as the sale of the business, to get your capital out.

Still, if you're prepared to tie up your money for an extended period and to take on the risks of early-stage investment, the long-term returns are potentially attractive. Even taking the failures into account, the Beauhurst research found that the businesses in its sample delivered average annualised returns of around 30% between 2011 and 2017. With tax relief included in the calculation, that figure would be higher.

Do choose your investments with care, however. The Association of Investment Companies publishes extensive past performance data on VCTs on its website. You will need to invest in new VCT shares to get the upfront tax relief, rather than an existing fund, but this data will at least give you a good feel for which VCT managers are delivering strong returns.

How to pick an EIS

Picking an EIS investment is harder. If you're investing in individual companies with qualifying status, rather than through a managed fund, you will need to research each business very carefully. Look to build a portfolio of these companies rather than putting all of your eggs in one basket. Alternatively, if you prefer the managed fund option, spend some time studying the performance records of providers before choosing a vehicle and scrutinise fund charges.

The bottom line is that VCTs and the EIS are not for widows and orphans. For most investors, it will make sense to explore other tax-efficient savings options first; investors will typically have used their annual individual savings account (Isa) and pension allowances before moving on to these schemes.

Nevertheless, both VCTs and the EIS are increasingly popular, particularly with higher earners who have seen their pensions annual allowance fall sharply in recent years. The AIC says that, in the first nine months of 2017-2018, VCTs raised £483m, more than twice as much as in the same period of the previous tax year. The EIS is also attracting high levels of interest, raising more than £1.5bn a year in recent tax years.