When can a tax break end up costing you more?

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There is a certain human appeal in potentially investing in the next Google or similar tech start-up or in owning a share of a biotech firm commercialising some aspect of research for the good of mankind. 

Intuitively, we know it’s a risky, dice-rolling business and that for every winner there are bound to be some losers and some also-rans.  But the tax breaks afforded by HM Government via VCTs and EISs, risk clouding the due diligence that these investments duly deserve.

Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) represent tax-advantaged opportunities to invest equity capital into very small and often very early stage – or even start-up – privately held businesses.  The words ‘equity’, ‘privately held’, ‘small’ and ‘early stage’ immediately point out some of the risks.

Don’t think that these tax breaks are altruistic in nature. Their purpose is to encourage the supply of capital to these companies in the hope that they will employ more people – who will pay income tax, make NI contributions (individual and company) and pay VAT on goods bought with their wages – and that they will generate higher corporate earnings on which corporation tax can be charged.  The tax breaks are provided to improve the risk-return relationship that potential investors in these companies face.

Since EISs began, they have raised over £10.7bn for 21,000 small companies, with an estimated £1 billion raised in 2013/2014 for around 2,400 companies. This compares to around £22bn of retail investments into UK mutual funds in the 12 months to October 2014.

Introduced in 1995, VCTs are similar to investment trusts, raising capital by the sale of shares in the trust, which is then invested into qualifying trading companies. Total funds raised from 1995-6 to 2013-4 were £5.5 billion, with record funds raised in 2000-1 of £450 million.  In 2013-14, funds raised were £440 million, via 66 funds, out of 97 funds in existence. This is around half of the funds raised for EISs in 2012/13.

Recent research points out that around three quarters of advisers recommend EIS investments and over 90% of advisers stated that tax benefits were one of the main reasons why they recommended EISs to clients.  These findings are surprising – even alarming – to us.  The tax tail seems to be wagging the investment dog, particularly the fact that 70% believe these investments should be considered before other more mainstream tax breaks (ISA and pension) have been fully utilised.

The same piece of research also polled 6,000 private investors (the database of ‘Angel News’), who classified themselves as sophisticated or reasonably experienced investors; 61% held EIS investments and 93% had considered them. When choosing an investment, 92% stated that the expected level of return was one of the most important criteria.

These findings also alarm us.  Even self-selected ‘sophisticated’ investors are probably taking far higher risks than they are aware of, not least the risk of real disappointment that returns are poor (or their capital is lost entirely, before the tax breaks they receive).  Direct investment is a game of Russian roulette with a tax break on your funeral costs!

There is a large gap between the reality of returns delivered and returns expected.  Our research indicates that only around one-in-three of existing and crystallised VCT funds managed to deliver a positive return.  It is evident that the history of VCT investing is littered with disappointment.  Public data for EISs is virtually non-existent.

The fees on EIS and VCT funds are, as one might expect, high in comparison to passive funds.  Annual management charges in the region of 2% to 3% and around 3.5% in terms of total costs strip out considerable upside, and that is before any form of performance fee is deducted.  Don’t forget that there are often arrangement fees representing around 2% of each transaction.  In the end, investors only receive returns net of costs.  When costs are high, as they are in this case, intermediaries take, in our opinion, an unjustified share of the upside.  The proof of the pudding is in the eating.

The risks of VCT and EIS investments are varied and considerable, as they both invest in very small unquoted companies, many investors do not have a clear insight into the risk they are taking on.  These range from the risk of failure, to owning minority stakes in illiquid private businesses and the risk of changes in the tax regime that may affect the attractiveness of the tax breaks on offer.

It would be extremely rare for us to recommend EIS and VCT investments if a client’s other tax reliefs (e.g. pension, ISA, CGT) had not yet been maximised.  These products should only be offered in very client specific circumstances where all other avenues have been explored, and only for those clients who meet stringent net worth and investor sophistication criteria.

Does the tax tail wag the investment dog?  On balance, and on the evidence, yes.

To find out more about the risks and rewards of EISs and VCTs, see our latest Acuity newsletter, now available for download.

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