The 5th April has come and gone, and the use of EIS for tax efficient capital preservation is no more. But as one door closes another opens – and it’s now a tremendously exciting time for growth investing, thanks to a number of enhancements for investors that the new rules have introduced.
Below, we’ve provided three reasons why investors and advisors should be excited about the possibilities of EIS in 2018 – and for each, we’ve provided an exit to give an example of the principle in action.
Diversification means that EIS investments can still offer excellent tax efficiencies
Thanks to the new ‘risk to capital’ condition that investments are required to meet to qualify for EIS, the scheme can no longer be used as a low-risk shelter – but it still offers a number of opportunities for creating tax efficiencies.
There remain a total of five tax reliefs available to investors in qualifying companies:
- EIS income tax relief: reducing investment cost by 30% by claiming tax relief on the income tax paid
- CGT freedom: if shares are held for a minimum of 3 years, no CGT is payable
- EIS CGT deferral relief: available to investors who have received gains over the previous 36 months, or are expecting gains over the subsequent 12 months
- EIS loss relief against income or capital gains: limiting exposure to loss for 45% tax bracket payers 38.5p in the pound
- EIS inheritance tax relief and business property tax relief: EIS investments are exempt from the usual 40% inheritance tax after 2 years of holding
However, it’s when spread across a diversified portfolio of EIS investments that these extremely valuable reliefs become more even more useful – particularly the EIS loss relief, which significantly offsets the increased risk that investments which qualify for EIS in 2018 onwards will carry. Indeed, a 2017 EU Commission Report noted that “tax relief for capital gains or the provision of loss relief on a more favourable basis than the baseline tax system could support the derisking of investments in young, growing and innovative businesses”.
The important point here is that, as with the stockmarket, picking the winners is incredibly difficult. To counter this, your best solution should be to take the same investment approach as you have probably already adopted with your pension and ISA investment portfolio and invest across a portfolio of EIS funds and/or single companies.
For example, most advisors will invest their clients’ monies in a risk managed portfolio. Rather than worrying about a single fund’s exposure, they see it as one small part of a portfolio where risk is controlled through limited correlation between the funds and asset classes – with the returns distributed evenly around the centre.
By comparison, an individual EIS investment is unbalanced, asymmetric in its risk profile so that the returns are spread much wider. But investing across a number of EIS’s in a portfolio, as is standard with a pension or ISA, combines the individual EIS risks and aggregates the probability weighted returns. The diversification benefits now kick in due to the uncorrelated natue of the EIS investments – so as your portfolio grows, the chance of you losing money falls as only one or two EIS investments need to take off in order to provide a return.
To put this into context, research from Oxford Capital has shown that:
- half or all smaller companies will fail to provide return of capital
- but 1 in 10 will return 10x capital.
- In a portfolio of 10-12 companies, the possibility of getting nothing back is virtually zero and the returns are clustered around 1.5 to 2.5 x initial investment.
2) The opportunities for increased gains and better exits promise to be better than before
Perhaps foremost among the benefits of the new rules for investors is the doubling of the investment limit to £2 million. This is especially significant considering the generous gains that investors EIS investors already generally see – with a British Business Angels Association report touting early stage companies giving an internal rate of return of 22%, and EIS provider MMC Ventures boasting successful exits which multiplied initial investments by up to 8.7x. And a further study by Syndicate Room tracked a cohort of 519 small businesses which maintained an overall growth rate of around 30% between 2011 to 2017. The doubling of the investment limit means a potential doubling of these already generous returns.
There is a catch to the Treasury’s sudden generosity however – at least £1 million of the £2 million must be invested in ‘knowledge intensive’ companies, firms which have invested at least 15% of their operating costs in R&D in the three preceding years. But with many of Britain’s best investment opportunities now falling into this category, this need not be a hardship.
3) UK entrepreneurship is booming, and the new rules can only help
Britain is becoming a more and more vibrant place for investors willing to operate diverse portfolios – between 2006 and 2016, the number of startups founded in the UK rose from 256,000 to 414,000, a 62% increase. Perhaps even more strikingly, research from the Scale Up Institute and Beauhurst highlight that small companies that receive equity investment are more likely to grow faster, particularly in terms of turnover. In both studies, companies with turnover growth of more than 100% each year had more often used equity financing than those growing less quickly. Similarly, companies with employment growth of between 80% and 100% annually were more likely to have taken an injection of equity.
The new EIS rule changes show that the Government has an active desire to build on this and further enhance Britain’s business-friendliness. Mel Stride, Financial Secretary to the Treasury, confirmed this recently when he commented that “we [in Government] also need to encourage our entrepreneurs and help their bright ideas to become productive businesses . . . building an economy fit for the future relies on our harnessing technology, new ideas, and the expertise we already have; these changes will help to make that happen.”
And while the initial beneficiaries are entrepreneurs – particularly those starting knowledge intensive companies – savvy investors are not far behind. The ever increasing range of companies to invest in means that fulfilling the requirements for optimised use of EIS from 2018 onwards, i.e. diversification, emphasis on scale-ups and investment in knowledge-intensive firms as a priority, should not necessarily be too painful an adjustment.