EIS vs VCT

By Leonora Walters, 12 April 2011

Until last week, the most attractive option for those with higher risk appetites and larger portfolios seeking tax efficient investments was venture capital trusts (VCTs). However, changes set out in the recent budget have added substantially to the attractions of enterprise investment schemes (EIS), previously considered to be the higher-risk relation to VCTs.

EIS had offered income tax relief on investments of 20 per cent, but as of the current tax year (2011/2012) they now also offer a 30 per cent tax break like a VCT. However, there are still many differences between the two types of funds and a number of factors to consider when choosing which fund to invest in.

Vying attractions

One of the major differences between the two vehicles is the holding period to qualify for tax relief. VCTs have to be held for five years, whereas EIS only have to be held for three years. However, claiming your tax relief on VCTs is much simpler; your tax relief certificate comes with your share certificate, and the timing is likely to be a matter of weeks after you buy the shares. With many EIS you get the relief when they put money into an investment and it has started trading, so the waiting period can be much longer.

You also have a tax relief certificate for every underlying investment, instead of one for all investments, as is the case with a VCT.

EIS currently allow you to invest up to £500,000 a year, and this is expected to rise to £1m from the next tax year starting April 2012. You can only invest £200,000 a year into VCTs. In both instances, the annual allowance is much higher than what you can put into a pension on a yearly basis, and neither have a lifetime limit, unlike a pension.

EIS also allow you to use your previous year's allowance if unused in the current tax year so for example, if you invested nothing in EIS in 2010/11, you could invest £1m in 2011/12, and when the upper limit goes up eventually you should be able to put £2m a year into EIS if you have not used your previous year's allowance.

Retirement income

Advisers suggest that you hold EIS and VCTs in addition to your pension as these are venture capital investments and therefore likely to be higher risk than what you hold in your pension.

If you are thinking of using one of these types of funds for income in retirement, then generalist or Alternative Investment Market (Aim) VCTs which pay good dividend streams are probably the best option, because the dividends are tax free. EIS dividends are not tax free, so in general, if you are an income investor, VCTs are best.

"VCTs offer a tax free income stream which makes them a good complement to a pension," says Matthew Woodbridge, head of investment products at Chelsea Financial Services. "EIS are better for tax planning than pensions, in particular inheritance tax (IHT) and capital gains tax (CGT)."

An investment in an EIS can be passed onto to your heirs without incurring IHT if you have held the investment for a minimum of two years, whereas VCT shares, like most other investments, would incur IHT after you use up your £325,000 allowance.

If you have incurred CGT on a profit, but invest that profit into an EIS you can defer paying this tax bill until you realise your EIS gains. If you die before realising the EIS investment the CGT liability will die with you – so you heirs will receive the EIS investment without the CGT. Neither of these can be done with a VCT, though profits on both VCT and EIS investments are free of capital gains tax.

EIS also offer loss relief on the underlying investments if they make a loss, which you can offset against your income tax in the same year or the preceding one. You can also offset it against capital gains of the same year or carry it forward to offset against future gains. The net effect is to limit the investment exposure to 48p in the £1 for a 40 per cent tax payer and 40p in the £1 for a 50 per cent tax payer if the shares become totally worthless.

VCT vs EIS

* Subject to State Aid clearance

Source: Clubfinance

Getting out

A major structural difference between the two vehicles is that VCTs are listed funds like investment trusts, whereas EIS are not. This means that in theory it should be easier to exit a VCT, as you can sell your shares when you no longer want the investment, though you should hold it for five years to get your tax reliefs. However, in practice, VCTs are illiquid and you might have a problem finding buyers for your shares. They also tend to trade at a discount to the net asset value of their investments.

With an EIS you have to wait until the underlying investments are realised to get your return, usually via a trade sale or stock market flotation. Although you only have to stay in an EIS for three years to get your tax reliefs, in practice you may have to hold it for a good bit longer till the companies are realised, although some EIS providers such as Braveheart Investment Group may buy back your investment or redistribute it to the other shareholders.

"You should not expect to get out of an EIS early," says Julian Hickman, partner at EIS and VCT provider Longbow Capital. "The managers of EIS should make clear to potential investors that this is the case, especially as there is no benefit in getting out before three years. Investors should consider EIS as an illiquid part of their portfolio."

Some EIS also invest in smaller and earlier stage companies than VCTs, and more esoteric areas, for example vineyards, which does give them the edge in terms of lending diversity to your portfolio, albeit with a good dollop of risk. "Some providers do not offer VCTs but only EIS funds, so you could also diversify your portfolio with respect to manager," adds Philip Rhoden, director at discount stock broker Clubfinance.

Risks

The general perception of EIS is that they are riskier funds than VCTs, in particular because they are harder for investors to access. In reality, you really have to assess this on a fund by fund basis as there are many types of both. Factors you may want to consider include:

■ Number and variety of investments: some EIS invest in just one company or venture, which makes them a riskier proposition than VCTs, where the risk is spread. But then, VCT investments tend to be in the same sector or industry - and some EIS take a portfolio approach. There is no hard-and-fast rule.

Another factor is the rules on investment. EIS, in particular 'approved' status EIS, have to invest 90 per cent of their assets in the 12 months following launch, so will not have as many investments as a generalist or AIM VCT which have three years to invest 70 per cent of their funds in qualifying investments, and may hold 40 investments or more.

For example, Oxford Capital's approved EIS tend to have six to nine investments compared 15 to 20 for its unapproved EIS, which have longer to make investments. But even unapproved EIS typically have fewer investments than generalist and AIM VCTs.

■ Approval. Approved EIS are guaranteed to qualify for income tax relief for the year in which you invest. Unapproved EIS get their income tax relief on the date of each investment, providing it qualifies. Ultimately, when choosing an EIS, you have to balance certainty of tax relief with the potential for better returns.

■ Underlying investments. Some EIS also invest in very esoteric investments, such as vineyards or TV production, or specialist healthcare which can be more speculative than the areas mainstream VCTs invest in.

"The investment risks and poor liquidity of EISs is even greater and while they merit consideration for some investors, it should only typically be for wealthier ones who have used their annual Isa and pension allowances," says Patrick Connolly, head of communications at independent financial advisers AWD Chase de Vere. "However, there is a real danger that we could see industry hype related to EISs, resulting in the wrong people investing in them and potentially suffering the consequences."

■ Transparency. EIS are not listed on the stock market which means they are not obliged to report regularly like VCTs. The investments an EIS has, their progress and performance can be far less transparent. Some managers, an example being Braveheart Investment Group, may choose to publish their audited results, but they don't have to.

It is also harder to get details of the performance of EIS funds and managers than for VCTs, whose historic performance you can check on websites such as the Association of Investment Companies (www.theaic.co.uk), as well as via the VCTs' regular stock market updates.

Now, how do you do it? See

visible-status-Public story-url-BigTheme_EISVCT_15.4.11.xml