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What is the best “vehicle” for venture capital investors to grow (and protect) their returns? According to a recent survey, the Enterprise Investment Scheme (EIS) is one of the leading options – even beating Venture Capital Trusts (VCTs).
11% of UK independent financial advisers use EIS exclusively, whilst only 2% say they only use VCTs. Around 31% use both equally. 26% mainly use EIS but may use VCTs occasionally.
Why the preference for EIS in 2023? Some recent changes in the economic and tax landscape might offer an explanation. Below, we explore these in more depth and show what they could mean for early-stage investors going forwards.
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Tax changes and EIS in 2023
Given the record amounts that investors put into VCTs in 2022, you would be forgiven for assuming that they were the preferred tool used by advisers for tax-efficient investment planning. Yet the prevailing economic climate in 2023 may offer a clue.
In late 2022, the Chancellor (Jeremy Hunt) announced a range of tax changes that would take effect in April 2023 – when the new 2023-24 tax year started. In particular, the threshold for the 45% Additional Rate of Income Tax would lower from £150,000 to £125,140.
Around 660,000 taxpayers paid this rate in 2022. Now, in 2023-24 with the new threshold, a further 232,000 are believed to have fallen into the tax bracket.
Not only does this mean more of these individuals’ earnings are lost to Income Tax. It also means that the rates they pay for Capital Gains Tax (CGT) and Dividend Tax will go up.
However, the Enterprise Investment Scheme (EIS) offers some comfort to taxpayers on the higher rates. For instance, up to 30% up-front tax relief is available on EIS investments up to £1m each tax year (or, up to £2m if the companies are “knowledge-intensive”).
For example, if an investor committed £1m in 2023-24 to EIS investments, he could claim back up to £300,000 using his Self Assessment Tax Return.
EIS also offers tax-free capital gains on EIS shares which are held for at least three years. Given that the Annual Exempt Amount has gone down in 2023-24 (from £12,300 to £6,000), EIS can provide another avenue for investors to generate tax-free gains outside of their ISA.
Admittedly, VCTs also provide tax-free gains when investors sell their shares. They can also provide some “shielding” against some recent changes to Dividend Tax. In 2023-24, the tax-free Dividend Allowance has gone down from £2,000 per year to £1,000. Dividends from VCTS are not taxed, however.
With that said, an investor can only invest up to £200,000 into VCTs each tax year – compared to £2m for EIS-qualifying companies. Depending on the investor’s tax situation, therefore, EIS arguably offers more opportunities for tax savings compared to VCTs.
EIS and the economic landscape in 2023
A lot of criticism has been levelled against the UK economy as of late. Things may not be as bad as they seem. Indeed, in 2022 the UK was the fastest-growing economy out of the G7 (at 4%).
Challenges do remain, nonetheless. In particular, interest rates remain at their highest since the 2008-9 Financial Crisis (at 4.50%) and high inflation also persists. Currently, it stands at 8.7%, although this is lower than the 10.1% recorded previously.
This makes the UK’s investment landscape more challenging for investors. Rising interest rates puts downward pressure on public stock prices, since investors may believe that the present value of future earnings will fall.
Rising inflation also puts pressure on many companies’ profits. This is partly because sales may suffer as customers experience greater pressures on their living costs – thus cutting spending. Also, companies may face higher input costs from suppliers.
EIS investments can offer a way forward in such a landscape. EIS funding can help founders fuel future growth without incurring debt (or, as much of it). This can make certain EIS companies less vulnerable to interest rate rises, which can make business loans more costly to service and also more difficult to access.
EIS investments can also offer higher potential returns compared to many public stocks. The latter have, typically, already matured and dominated their markets. The former, however, are likely to have a lot of “road” ahead of them for potential growth.
Target returns for an EIS investment may range from 1.3x to over 10x of the money invested. Therefore, provided investors can build a diversified EIS portfolio which delivers overall growth, the possibility to beat 8.7% inflation is higher than just investing in public stock markets.
VCTs can also offer a lot of growth potential given their concentration on unlisted, early-stage companies. However, given the focus on tax-free dividends, these are often seen as a supplementary “top-up” option for gradually-paid income.
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