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VCT or EIS: which is best?

Key differences between VCTs and EISs mean it is important to use the right one for your plans
VCT or EIS: which is best?
  • VCTs and EISs can be very useful as part of a tax planning strategy
  • They are high-risk investments so generally you should turn to other options first
  • It is important to pick the right type of vehicle for your financial planning needs

Venture capital trusts (VCTs) and enterprise investment schemes (EISs) are often cited as the next port of call after you have used up allowances for pensions and individual savings accounts (Isas). But there are some key differences between VCTs’ and EISs’ tax reliefs and investment approaches, so it is important to use the right one for your financial and tax planning needs. 

The main tax reliefs these vehicles offer are as follows:

 

VCT and EIS tax reliefs
BenefitVCTEIS
Tax free capital gains YesYes
Income tax relief 30%30%
Maximum annual investment eligable for income tax relief£200,000£1m or £2m if anything over £1m is in knowledge intensive companies
Minimum hold period for income tax relief5 years3 years
Tax free dividendsYesNo
Capital gains deferralNo Yes
Loss reliefNo Yes 
IHT reliefNo Yes after holding for two years
Source: Association of Investment Companies/WealthClub

 

VCTs are listed funds whose shares can be subject to volatility, and trade at premia or discounts to their net asset values (NAV). While this should mean that VCTs are more liquid than EISs, to benefit from the tax reliefs you need to hold VCT shares for five years after you have bought into an issue. Even then, there is very little secondary trading of VCT shares, so it may not be easy to sell them – and you may get a lower price than you paid for them.

EISs are a wrapper within which you directly invest in unquoted companies and are harder to exit. Although you only need to hold EISs for three years to qualify for all their tax reliefs it is unlikely that you will be able to exit at that point. EIS exits are generally achieved when their managers sell a company, for example via a trade sale. So it could take eight years or longer before an EIS investment is realised. If you invest in EISs, it is particularly important to have a long-term investment horizon and not to invest money in them that you might need in the short term.

VCTs are more diversified than EISs as they typically invest in 30 to 70 companies. Some EISs just hold a single investment and, although some managers offer portfolio EISs enabling you to invest in a number of unquoted companies, typically it is not more than about 10. VCTs are arguably less risky because the impact of one company failing has less of an effect on their overall returns. But if a holding does well it also contributes less than would be the case with a smaller number of investments. So EISs have the potential for both bigger losses and gains. 

VCTs' returns may be more regular, meanwhile, because they can pay a steady stream of dividends and can be considered as more of an income investment. EISs are very much about growth so, for example, you might receive nothing for years and then a big payout after a successful exit. 

However, following investment rule changes between 2015 and 2019, the new investments VCTs have been making are more growth-orientated. 

EIS investors can claim loss relief at their marginal rate of tax which, with the income tax break, provides some compensation for investment failures. This means that you are less likely to lose all of your initial investment.

 

Example of EIS loss relief for additional rate (45%) income taxpayer
Initial investment£100,000
Income tax relief£30,000
Cost of investment £100,000 - £30,000 = £70,000
Value of investment at exit following loss£0
Loss relief at marginal tax rate45% of £70,000 = £31,500
Loss after all reliefs£70,000 - £31,500 = £38,500
Source: WealthClub/Investors Chronicle

 

VCT uses

VCTs can be a tax-efficient way to save for retirement if you have used up your annual or lifetime pension allowances, and annual Isa allowance. They can be particularly useful for higher earners whose annual pension allowance has been tapered back to between £4,000 and £40,000. Robert Hird, head of investment strategy at wealth manager Premier, uses VCTs, for example, for investors in their mid to late careers whose pension annual allowance has been curtailed. You could also consider VCTs if you are close to using up your pension lifetime allowance.

VCTs that pay an attractive level of tax-free dividends could provide income, alongside other sources, in retirement. 

The income tax relief means that VCTs could help higher and additional-rate taxpayers offset income tax. Hird uses them in this way where they can be a broad diversifier in larger portfolios for clients with the right risk appetite. 

Reclaiming tax is simpler with VCTs than EISs. So if a client’s reason for investing is mainly because of income tax, and there are no capital gains or inheritance tax (IHT) considerations, Hird tends to favour VCTs over EISs.

Because VCTs invest in early-stage companies they are high-risk. So if you hold them the rest of your portfolio should include some more defensive investments to offset this. Also think about when and how you want to exit VCTs as this might not be possible on favourable terms after five years. 

VCTs also tend to have higher charges than pension products, another reason why Hird encourages clients to use up pension allowances first.

 

<box out> VCT case study

Due to high earnings Ben’s annual pensions allowance has been tapered back to £4,000 per tax year. And the size of his pension savings mean that future growth and contributions could result in a breach of the lifetime allowance. He has also used up his annual Isa allowance and has a large investment portfolio on some of which he has made significant gains. 

Ben wants to retire in the next few years and receive retirement income in the most tax-efficient manner. 

“He is able to take a tax-free income from his Isa, a tax-free lump sum from his pension and income up to his personal allowance from the residual pension fund,” says Scott Palmer, chartered financial planner at Walker Crips. “He could also take withdrawals from his unwrapped investments with gains up to his annual capital gains tax (CGT) allowance.”

But Ben's desired retirement lifestyle requires a high level of income and he is comfortable with exposure to high-risk investments, so he allocates £100,000 to a VCT. He gets immediate income tax relief of 30 per cent, giving a rebate of £30,000 if he holds the VCT for five years. Any growth in the VCT is free of CGT and the dividends are tax-free.

The VCT provided a yield of 3 per cent at the time of investment, which would provide a tax-free income of £3,000 a year based on a £100,000 investment. Ben is able to repeat this process in following tax years, if appropriate, for further tax-free income.
Source: Scott Palmer, Walker Crips

EIS case study
Claire has sold her business for £500,000, which included net gains of £300,000. She is entitled to Business Asset Disposal Relief so paid CGT at a reduced rate of 10 per cent, resulting in a £30,000 bill. The proceeds from the disposal are part of her estate and pushed her over the nil-rate band threshold by £200,000, giving a potential IHT liability of £40,000. She has Isas worth £200,000 and a pension worth £900,000 invested in balanced risk solutions, and has used her full allowances for the current tax year.
 
Due to the size of her Isas and pension, from which she will get sufficient retirement income, she invests proceeds from her business sale worth £200,000 in an EIS. She would like to take advantage of EIS tax benefits and is prepared for higher investment risk as her other assets are not as high-risk, although doesn’t wish to put all the sale proceeds in EISs. 

Claire gets income tax relief of 30 per cent, providing a tax rebate of up to £60,000. She is eligible for CGT deferral, entitling a reclaim of £20,000, although this will have to be paid when she disposes of the EIS investment. Any growth on the initial investment is not subject to CGT.

The £200,000 investment will fall outside her estate after two years and become exempt from IHT, giving her heirs an IHT saving of £80,000. But the income tax rebate will fall back into her estate and potentially be subject to IHT.
Source: Scott Palmer, Walker Crips<boxout>