Strategies for investing in EIS

For those who have used their individual savings account (Isa) allowance, which rises to £10,200 in the new tax year (this limit has been in place for the over 50s since October), other tax efficient vehicles to consider include venture capital trusts (VCTs) and enterprise investment schemes (EIS).

For investors who can meet the minimum EIS investment this year - it ranges between £5,000 and £50,000 - with a small portion of their portfolio (advisers suggest 5 to 10 per cent of the total portfolio), EIS can provide further diversification and some tax benefits unavailable to VCTs.

Income tax relief of up to 20 per cent is available on an EIS if you hold it for at least three years, in contrast to 30 per cent for a VCT held for five years. However, the maximum investment limit on an EIS in any one year is £500,000 rather than £200,000, as is the case with a VCT. If you have not invested in an EIS in the previous tax year, you can carry your allowance forward and invest £1m. However, this is not necessarily advisable due to the high concentration risk.

EIS providers, such as Oxford Capital, say EIS can also play a part in your retirement planning with tax relief on pensions for those earning more than £150,000 set to be tapered back come April 2011. Financial advisers, however, suggest that EIS and VCTs should only be used as a complement to pensions and other retirement investments, due to their higher risk profile.

EIS investments are also exempt from inheritance tax if you hold them for more than two years, and you don't pay capital gains tax upon disposal if you hold them for at least three years.

Finally, if an EIS investment fails, it is in part mitigated by a relief which limits loss to 40p for every 100p invested.

Choosing a fund

A list of funds open for investment can be found on websites such as http://www.clubfinance.co.uk/ or http://www.taxefficientreview.com/eis/eis_open.asp. Choosing an EIS is fairly complicated due to the different types available, and the need for the investments to qualify to obtain the tax reliefs. HM Revenue & Customs (HMRC) is consulting on changing EIS legislation as it says a number of funds have been launched during the past few years which do not comply with the original aim: to provide finance to early stage companies.

Any fund that is found not to comply will have the tax benefits removed, potentially leaving investors with a large tax bill. So, it is important to ensure the fund you choose meets the requirements.

Some providers have withdrawn their EIS offerings because they were not certain their funds would obtain the tax reliefs. These include Octopus Investments, which closed its Octopus EIS fund in February, although investors can still access the Octopus Eureka EIS portfolio, which requires a minimum investment of £50,000.

A few funds have received advance assurance from HMRC that they will benefit from tax reliefs in the forthcoming tax year. However, as long as the underlying investments are early stage companies needing finance, or slightly later stage ones needing expansion capital, funds should qualify.

"Understand what you are investing in, ring the fund manager with your concerns and establish how the manager will provide feedback; communication is important," advises Philip Rhoden, director at discount broker, Club Finance.

Approved vs unapproved

A number of EIS funds are categorised as an "approved fund" as opposed to an "unapproved fund." An approved fund, however, is not the same as getting advance assurance from HMRC, although it has some of the same benefits.

An approved fund has its prospectus and proposed investments vetted by HMRC and, if approved, is guaranteed to qualify for income tax relief in the forthcoming tax year. However, to get approved status it has to invest 90 per cent of its assets in the 12 months following launch, whereas an unapproved fund does not have this restriction.

From an investment perspective, an unapproved fund is potentially in a better position as it has longer to choose its investments and build a more diversified portfolio. This can mean approved funds spread their risk over fewer investments due to the time restriction. Oxford Capital's approved EIS, for example, will have six to nine investments against 15 to 20 for its unapproved fund.

An unapproved fund gets its income tax relief on the date of each investment, provided it qualifies. Ultimately, when choosing an EIS, you have to balance certainty of tax relief with the potential for better returns.

Spread your risk

Some EIS have a single company investment as their underlying holding rather than a portfolio of companies. A single investment is, in theory, higher risk and advisers tend to suggest a portfolio of EIS unless you are very familiar with the single company and its business.

Advisers also suggest you hold a portfolio of EISs rather than one fund, or a mixture of EISs and VCTs. Also remember, that EISs are not listed, so you cannot sell your shares on the market as with VCTs, but will have to rely on the EIS company being sold or floated for an exit.

EIS investments open for the 2009-10 tax year

Source: Clubfinance