Opportunities in growth EIS companies are great, but the risk reward profile is different, warns Oxford Capital’s Simon Ruthers.
As we approach tax year-end, the focus of many clients will turn to ensuring they are using the generous range of tax reliefs and allowances to which they are entitled. Alongside pensions and ISAs, in recent years Enterprise Investment Schemes (EIS) have increasingly formed part of a client’s tax and retirement planning strategies.
Fuelled partly by changes to pension allowances, together with an increased range of investment options within the EIS “wrapper”, EIS is now part of many advisers’ core advice proposition. In light of this growth in popularity, we have seen a number of changes to the EIS rules which, in turn, have impacted product availability and the advice process.
Before addressing these recent changes, it is important not to lose sight of the fact that the EIS remains at the core of the government’s strategy to support small and growing businesses. It provides an invaluable source of business finance, particularly at a time when other funding avenues may be closed.
Equally, the core building blocks of EIS have remained unchanged over an extended period and where there has been change, these have enhanced the scheme.
Income tax relief has increased from 20% to 30%, bringing EIS into line with venture capital trusts. The amount that individuals can invest each tax year has increased to £1m, while pension limits have been falling. The amount of money that a company can receive, and the size of the companies eligible (both in terms of assets and employees), have increased.
Where the scope of the scheme has been narrowed, these changes were preceded by a period of consultation and were not applied retrospectively.
Targeting tax relief
Against this backdrop, HM Revenue & Customs (HMRC) remains committed to ensuring that reliefs are targeted at areas where alternative sources of funding may not be available and which will support growth and employment.
To provide some context, the annual cost of EIS reliefs is approaching £500m (2015-16), but this is tiny when compared with pension tax reliefs, which amounted to around £23bn over the same period.
HMRC has issued revised guidance based on a number of core principles. A “growth and development test” has been introduced to ensure the money raised by a company is used to support its growth and development.
Companies are now required to submit detailed business plans to HMRC, evidencing how the capital is to be used.
The reliefs are also being targeted at earlier stage businesses. Companies must raise money through EIS, or another state aid initiative, within seven years of starting to trade. This extends to 10 years for knowledge-intensive businesses (those expending significant amounts on research and development).
There is also a limit on the total funding that a company can receive during its lifetime – previously, only an annual limit of £5m applied. For most businesses, the new lifetime limit is £12m, rising to £20m for knowledge-intensive businesses.
For many investors, their first experience of EIS may have been investing in companies that owned and operated renewable energy infrastructure, in particular solar. While this was an emerging industry a number of years ago, it is now flourishing, partly due to the contribution made by EIS.
Having successfully supported this sector, energy generation was recently added to the list of non-qualifying trades for new investments. We have also seen the introduction of changes which prevent money being raised to fund the acquisition of an existing business and trading assets.
Impact on capacity
When considering what these changes mean for the market, the question is best answered by dividing the EIS market into two parts:
• Limited life – structured solutions, such as former energy investments, that are designed to offer relatively predictable, but modest, returns while providing investors with some visibility of exit
• Generalist – these solutions typically pursue a traditional venture capital strategy where investment return is the main driver.
Limited life solutions offer more limited investment options under the new legislation. Consequently, we have already seen capacity fall and the levels of risk increasing in many cases.
While EIS managers continue to seek innovative solutions, it is now more difficult to access scalable opportunities, resulting in some managers choosing multiple investment themes with a single offer in order to secure meaningful capacity.
We are also likely to see investment duration increase and, in many cases, this is now over four years.
This is in part due to the restrictions on acquiring existing assets.
The impacts are less significant in the generalist sector, where investment is typically targeted at early stage businesses which offer the potential to deliver significant growth and employment.
The lifetime cap on funding may influence the type of business a manager supports and discourage investment into companies that require significant capital investment over extended periods.
The restrictions on funding management buyouts, plus maximum age limits, may drive managers to invest a bit earlier.
Impact on advisers
As with any changes, it is important to consider how the changes will impact on your advice model. At a practical level, when market capacity is lower, it may be appropriate to plan earlier to avoid a rush at the end of the tax year when capacity is under most pressure.
There may be movement towards generalist strategies. While this will be a logical step for many, it is vital to ensure clients fully understand the risks and are comfortable with how these strategies operate.
When recommending generalist strategies, greater consideration is often needed in terms of asset allocation and portfolio weighting. It may also be appropriate to phase investments over a period of time as this helps to mitigate economic cycles and builds a more diversified portfolio.
Throughout the advice process, it is important to build an appreciation that investments in early stage companies take time to build value, with five to seven year holding periods not uncommon.
A proportion will fail or deliver modest returns, but the winners may deliver significant tax-free returns.
When recommending a generalist EIS strategy, it is important to appreciate that it will typically take at least 12 months for a client’s subscription to be fully invested, particularly if looking to carry back income tax relief or defer a capital gain.
In addition, EIS3 certificates may not always be available before a tax liability becomes payable, so making sure the client has resources available to pay the tax is important.
Retirement planning
EIS still provides investors with the opportunity to add diversification to their portfolio while accessing valuable tax relief. For many advisers, it forms a core retirement planning proposition.
As the market evolves, it is important for advisers to continue to engage with clients and align them with these developments.
Simon Ruthers is director, business development at Oxford Capital
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