This article is taken from Investors Chronicle, where Intelligent Partnership’s research was highlighted. Click here to read the full article
If you have used up your annual or lifetime pensions allowance, and annual individual savings account (Isa) allowance, you may be familiar with venture capital trusts (VCTs) as an additional tax advantaged wrapper. This can be useful in particular for saving for retirement, especially as VCTs offer tax free dividends.
But there is another government sanctioned scheme to consider: Enterprise Investment Schemes (EIS). These offer a number of generous tax reliefs, but have a slightly different emphasis to VCTs so can be used in different ways for tax preparation.
EIS invest in private equity investments and the companies they give exposure to are typically earlier stage than those in some VCTs, so could offer better growth prospects though are higher risk. EIS and the companies they invest in are not listed on the stock market.
EIS offer 30 per cent income tax relief if you hold the investments for three or more years. But for the tax relief you have to wait until the money goes into a company and starts trading, so in reality it could be longer than this. EIS do not pay tax free dividends so profits are usually rolled up and paid as a capital gain.
Tony McGing, partner at EIS provider Downing, says that if you take out money from your pension after 6 April and incur tax at your marginal rate, you could put some of the money into EIS or VCTs and offset some of it if you are a higher earner. When you realise your EIS investments there is no tax on this, but EIS investments are much higher risk than what you are likely to be holding in your pension. Mr McGing also emphasises that EIS are not a replacement for pensions.
He suggests that if you do this then you go for a lower-risk capital preservation EIS, that for example, invests in pubs. You can read our EIS recommendations here.
You can defer capital gains tax (CGT) if you reinvest them in an EIS. You only pay CGT once you realise gains on the EIS, and if you die before this happens the CGT liability dies with you. This could be useful if you are selling a business, second home or large share portfolio. Make sure to get in contact with the seafarers tax deduction for more information.
The deferral can be applied to gains which occurred up to three years before the date of the EIS investment or one year after. Gains which occur up to 12 months after the EIS share purchase can also be deferred.
If you hold EIS shares for at least two years they do not form part of your estate for inheritance tax (IHT) purposes and, if you die while invested in an EIS, you can pass them to your heirs in full.
IHT relief on an EIS investment is not a given. The shares must qualify for Business Property Relief and there are a number of conditions that need to be met for this, but it is an added advantage of EIS and very useful for tax and estate planning.
SIX WAYS TO USE EIS IN TAX PLANNING
1. Offsetting tax on a capital gain*
James, a higher rate taxpayer, has made a taxable gain of £20,000 due to the sale of an investment property. With the CGT tax-free allowance of £11,000 for the 2014/15 tax year, he would be liable for CGT at 28 per cent on £9,000 (£20,000 – £11,000) which is £2,520.
If this £20,000 is invested in an EIS qualifying company within three years of the sale of the property then the CGT can be deferred, saving £2,520, and it only becomes due when the EIS investment is exited. But he could roll this over into a new EIS investment and defer the CGT defer indefinitely. In this case the tax bill dies with him.
2. Selling a buy-to-let property**
Tim purchased a small buy-to-let flat back in the early 2000s but he isn’t enjoying being a landlord so is thinking about selling the property. He bought the flat for £100,000 and he’d make a capital gain of £44,000 if he sells.
Tim plans to use his original investment amount of £100,000 to invest in a portfolio of diversified investments, and as a higher rate taxpayer would be liable to CGT of 28 per cent on the £44,000 gain. He’d like to try to mitigate some of this liability and treat himself and his wife to a holiday and a new car.
Tim can keep the first £11,000 of his gain which will be covered by this year’s annual CGT allowance. The remaining £33,000 of the gain can be invested into an EIS and will be deferred for as long as he holds the investment. Tim should also benefit from upfront income tax relief of up to 30 per cent of the value of the EIS which amounts to £9,900.
The annual CGT allowance combined with the upfront income tax relief gives Tim over £20,000, enough to pay for a holiday and new car.
Once sales opportunities are available Tim may choose to sell all or part of his EIS investment. If he chooses to sell up to £11,000 of his shares – his annual CGT allowance – in years four, five and six, he’ll have realised all of his original investment after year six, without incurring any CGT liability on the deferred gain.
Tim could also transfer half of his EIS shares to Susan, his wife. They could each sell shares annually to their combined annual CGT allowance of £22,000 without incurring any CGT liability. So, together Tim and Susan would be able to sell all of their EIS investment tax free even sooner, just two years after the minimum holding period ends.
3. Sheltering investments from inheritance tax*
A widow has an estate valued at £1m. Her late husband left the whole of his estate to her, keeping intact his entire tax free allowance of £325,000 which passed on to her. Her tax-free allowance increased to £650,000 as a result. There is therefore a 40 per cent tax liability on the assets of her estate above £650,000 on death.
This is a significant tax bill of £140,000 and will reduce the value of the estate being passed to her loved ones. By investing into an EIS investment with shares that qualify for business property relief, she can potentially reduce that IHT bill, providing that the shares have been held for a minimum of two years and she still holds the shares on death.
A £100,000 investment into an EIS would reduce the taxable value of her estate by £100,000
Only £250,000 would therefore be liable, reducing the IHT bill by £40,000.
4. Selling shares**
Ben retired from a legal firm last year and his wife Rebecca decided to give up her job as a teacher. They’re looking forward to an active retirement but want to make sure that their two children won’t face a large IHT bill.
Their house is easily worth enough to swallow up their combined IHT nil-rate band of £650,000. This means their portfolio of shares, recently valued at around £250,000, could result in an IHT liability of £100,000. They could sell the shares and set up a trust to mitigate the IHT, but this would take seven years to become fully effective. They might also have to pay £28,000 capital gains tax (CGT) on the £100,000 profit that has built up in the portfolio.
Ben and Rebecca could invest the £100,000 gain from their shares in an EIS. This could defer the CGT liability for as long as they keep the investment and allow them to claim £30,000 of income tax relief. The relief can be applied to the previous tax year, when their incomes were higher.
If they invest the remaining £150,000 from the shares in an inheritance tax service (offered by a number of asset and wealth managers such as Octopus, Puma and Downing) it is expected to become exempt from IHT after two years. This will also apply to their EIS shares, and in both cases the exemption depends on them still having the investments at the time of their death. Any deferred CGT liability will be eliminated at death as well.
Read more on inheritance tax services
5. Extracting profits from a business**
Marian is director of a PR and marketing company, has a salary of £50,000 a year, and is a 40 per cent rate taxpayer. She wants to take some profits out of the business and invest them elsewhere so that in 10 years or so she can help her children with deposits for their first homes. She has £50,000 of profit in the company that she wants to extract for this purpose.
Marian is already receiving a salary that puts her into the higher rate banding for income tax so a further £50,000 dividend payment from her company would be taxed at an effective rate of 25 per cent. This means that she’d pay £12,500 in tax and her £50,000 would shrink to £37,500.
If she invests in a VCT or an EIS she should be eligible to receive income tax relief of 30 per cent if the investment is held for at least five years for in a VCT or three years in an EIS. If Marian invests the £50,000 dividend paid to her she’ll be eligible to get tax relief of £15,000. This offsets the £12,500 personal tax due on the dividend, and provides additional relief against her salary income.
6. Managing chargeable events for single premium investment bonds
If you have surrendered a single premium investment bond the resultant tax liabilities could be mitigated through an investment in an EIS. If you are a higher rate tax payer, the gain on surrender of an onshore bond will be taxed at 20 to 25 per cent. For offshore bonds, the gain can be taxed at up to 45 per cent.
In cases where the surrender goes ahead you may consider investing part of the proceeds into an EIS. The 30 per cent EIS income tax relief helps reduce the tax impact of the surrender, and the balance of your overall portfolio could potentially benefit from the addition of an alternative investment such as an EIS.
Hazel*** holds an onshore bond with a surrender value of £100,000. The bond was purchased for £40,000 and its value has risen by £60,000 over the years.
Because Hazel is a higher rate taxpayer, surrendering the bond triggers a £12,000 income tax liability – 20 per cent of the £60,000 gain.
Hazel invests £40,000 of the capital into an EIS. This allows her to claim £12,000 of EIS income tax relief – 30 per cent of £40,000, effectively making the surrender of the bond tax neutral. The remaining £60,000 from the surrender of the bond is freed up for further investments or other purposes.
*Case study sourced from Intelligent Partnership
**Case study sourced from Octopus Investments
***Case study sourced from Oxford Capital