Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCTs) represent tax-advantaged opportunities to invest equity capital into very small and often very early stage, or even start-up, privately held businesses. The words ‘equity’, ‘privately held’, ‘small’ and ‘early stage’ immediately point out some of the risks.
There is a certain human appeal towards investing in the next potential Google or similar tech start-up or to own a share of a biotech firm commercialising some aspect of research for the good of mankind. Intuitively, one knows that this is a risky, dice-rolling business and that for every winner there are bound to be some losers and some also-rans. However, the tax breaks afforded by HM Government, for these schemes, risk clouding the due diligence that these investments duly deserve.
It is a mistake to think that these tax breaks are noble in nature. Their purpose is to encourage the supply of capital to these companies in the hope that they will employ more people, who will pay income tax, make NI contributions (individual and company) and pay VAT on goods bought with their wages – and that they will generate higher corporate earnings on which corporation tax can be charged. The tax breaks are provided to improve the risk-return relationship that potential investors in these companies face.
EIS was launched in 1993-1994, as an evolution of the Business Expansion Scheme that went before it. Since it began, it has raised billions of pounds for thousands of small companies. In fact, according to the EIS Association, the official trade body for the Enterprise Investment Scheme, in May 2018, HMRC released the first of its estimates in respect of the number of companies raising funds and the amounts raised through EIS for 2016-17: 3,470 companies raised a total of £1.8mn of funds under the EIS scheme in 2016/17. Remember this is an estimate and judging by previous years, we can expect these numbers to increase.
The VCT scheme was first introduced in 1995. VCTs are similar to investment trusts, raising capital by the sale of shares in the trust, which is then invested into qualifying trading companies.
Researchpoints out that around three quarters of advisers recommend EIS investments and a great majority of these advisers stated that tax benefits were one of the main reasons why they recommend EIS to clients. These findings are surprising and even alarming to us. The tax tail seems to be wagging the investment dog, particularly because a majority believe these investments should be considered before other more mainstream tax breaks (e.g. ISA and pension) have been fully utilised.
Furthermore, it seems a high percentage of private investors who regard themselves as sophisticated or experienced hold EIS investments and an even greater percentage had considered them. When choosing an investment, a high percentage stated that the expected level of return was one of the most important criteria. This alarms us. Even self-selected ‘sophisticated’ investors would appear to be taking far higher risks than they are aware of, not least the risk of real disappointment that returns are poor (or their capital is lost entirely, before the tax breaks they receive).
The fees on EIS and VCT funds are, as one might expect, high in comparison to passive or systematic mutual funds. Annual management charges in the region of 2% to 3% and around 3.5% in terms of total costs strip out considerable upside, and that is before any form of performance fee is deducted. Don’t forget that there are often arrangement fees representing around 2% of each transaction. In the end, investors only receive returns net of costs. When costs are high as they are in this case, intermediaries take an unjustified share of the upside. The proof of the pudding is in the eating.
The risks of EIS and VCT investments are varied and considerable as they both invest in very small unquoted companies. It is our belief that many investors do not have a clear insight into the risk they are taking on. These range from the risk of failure, to owning minority stakes in illiquid private businesses and the risk of changes in the tax regime that may affect the attractiveness of the tax breaks on offer.
The conclusion that we arrive at is that we would not recommend EIS and VCT investments in the event that a client’s other tax reliefs (e.g. pension, ISA, CGT) have not yet been fully utilised. When it comes to investing, diversification, keeping costs low and only taking risks supported by evidence is what matters, yet EIS and VCT products don’t tick these boxes!
These high-risk, tax planning products should only be considered and recommended in very client specific circumstances where all other avenues have been explored, and only for those clients who meet stringent net worth and investor sophistication criteria.
Is the tax tail wagging the investment dog in the UK? From what we can see the answer is yes.