Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS): risks, tax relief and more

VCTs and EIS might appeal to high earners, but it’s vital investors understand the risks and fees involved, explains Alex Davies, founder of broker Wealth Club.

Why consider VCT and EIS

With restrictions on pensions, changes to buy-to-let and the ever-shrinking Dividend Allowance, it has become increasingly difficult for wealthy investors to invest tax efficiently and simply.

As a result, considering Enterprise Investment Scheme (EIS) investments and Venture Capital Trusts (VCTs) are becoming more popular – despite the risks.

So what are VCTs and EIS? How do they work? How do they differ? Is either really suitable for you?

A brief summary

Both Venture Capital Trusts and the Enterprise Investment Scheme are Government schemes designed to encourage retail investors to back UK businesses that aren’t listed on any recognised stock exchanges.

The Government wants to encourage investment into these types of firms in the hope of creating more jobs and boosting economic growth.

However, these businesses are obviously far riskier to the investor.

To help mitigate some of this risk, the Government affords investors generous tax reliefs.

The higher the risk, the more generous the tax reliefs.

How a VCT works

Venture Capital Trusts

A Venture Capital Trust is a company listed on the stock market that invests in unlisted businesses.

It is most akin to an investment trust.

It has a fund manager who invests in a basket of unquoted and/or AIM companies and helps them grow.

Upon investment, you acquire shares in the trust, not in the underlying companies.

Every so often the trust will raise new funds under a new share offer.

Those funds will then be deployed by investing in new businesses or by providing follow-on funding to existing portfolio companies.

VCTs have been around since 1995 and were the brainchild of Chancellor Ken Clarke.

To date, more than £7.3 billion has been raised in VCTs.

Well-known fund managers include the likes of Northern, Octopus and Maven. Last tax year a near-record £728 million was invested.

High-profile companies that have received VCT funding including Zoopla – the first VCT-backed £1 billion company – GO Outdoors and Secret Escapes.

Whilst some VCTs initially had a shaky start, over the last 10 years performance has been good.

The average VCT has outperformed the FTSE 100 over five and 10 years, and better-performing funds over 10 years will have doubled investors’ money with dividends re-invested.

VCT tax relief

When you invest in a VCT you get up to 30% Income Tax relief.

So, invest £10,000 and you should be able to claim back up to £3,000 on your tax return, assuming you have paid enough tax in the first place and you hold the investment for at least five years.

Any returns will come mostly in the form of dividends, which are also tax-free.

Current dividend targets are up to 5% a year.

To put this in context, that’s equivalent to a taxable dividend of over 8%.

You can invest up to £200,000 a year into VCTs claiming up to £60,000 in tax back.

The risks of VCT

Investing in smaller businesses is riskier than investing in large ones.

Statistically, they are more likely to fail and can be illiquid.

That said, a typical VCT has a portfolio of between 30 and 60 companies, generally in a few sectors, which gives you some diversification.

What’s more, we would always suggest investors spread their annual contribution over a number of VCTs.

If you invest in three you could easily have a spread of 100-plus investments.

In addition, when you invest in a VCT you get exposure to the whole portfolio.

In many cases, this includes historic investments in larger, more mature and therefore less risky companies than current rules allow.

Finally, there is the matter of fees.

These can be extraordinarily high in this sector – it’s even been claimed that one in four investors shell out more in charges than they get back in tax relief – so it’s vital you understand what you’ll be paying before committing.

How an EIS works

Unlike a VCT, when you invest in EIS you invest directly into a particular company or basket of companies.

You can choose the companies yourself or invest through a fund run by a discretionary manager who will typically spread your money into five or six companies.

Successful companies that have benefitted from EIS funding include software company Tracsis, now valued at £200 million, Brewdog with a valuation of more than a £1 billion and the recently floated City Pub Group with a valuation of more than £100 million.

EIS tax relief

EIS offers even more generous tax relief than VCTs.

Like VCTs, when you invest you get up to 30% income tax relief and any growth is completely tax-free.

But EIS offers additional benefits.

You can defer capital gains you have made elsewhere, for instance by selling an investment property or shares.

The tax only becomes payable when you sell your EIS investment.

However, if you invest in EIS again, the gain is deferred again and so on, potentially indefinitely.   

Another advantage with EIS is that, if things don’t go to plan, you can choose to write off any losses against your Income Tax bill in the same tax year – this is known as “loss relief”.

This could be extremely valuable.

On a £10,000 EIS investment, even if the value went to zero, the effective loss for a top-rate taxpayer could be limited to £3,800.

Another benefit of EIS is an IHT one.

If you’ve had the investment for at least two years and still hold it on death it can be passed on to your heirs free of inheritance tax.

Investors can potentially invest up to £2 million into EIS each tax year, claiming up to £600,000 in initial tax relief.

Table comparing the main tax benefits of VCTs and EIS

Risks of investing in EIS

EIS funds tend to invest in a limited number of companies, so they tend to be less diversified than a typical VCT.

In addition, many EIS investors choose single companies.

Having said that, the maximum loss you can make through EIS is heavily reduced by the tax breaks on offer.

So for the right type of investor, EIS investments are far from insanely risky.

And, of course, if you make the right decisions, the returns could be very juicy, giving you many multiples of your original investment.

Who are VCT and EIS suitable for?

If you have sufficient assets elsewhere, you have already used your pension and ISA allowances, and have a certain level of financial sophistication, VCTs and EIS are likely to be a sensible option for you to consider.

Conversely, if you can’t afford to lose money, these investments aren’t for you.

As a rule of thumb, VCTs should represent no more than 10% to 15% of your total portfolio.

Which is more suitable?

In my opinion, it is not a question of choosing one over the other, many of our clients have both VCTs and EIS.

Broadly speaking, if income is your priority, VCTs are a more obvious choice.

If you prefer potential long-term capital growth, and perhaps you have capital gains as well as income tax liabilities, EIS could be more advantageous.

Alex Davies is the founder of broker Wealth Club.