EIS Q4 2020

7. Further learning

LEARNING OBJECTIVESCPD AND FEEDBACKABOUT INTELLIGENT PARTNERSHIP

MARKET UPDATE / WHAT THE MANAGERS SAY

WHAT THE MANAGERS SAY

So how are the managers feeling about the EIS market and overall investment market conditions? Here's what they have to say.

MANAGERS:

01

DR REUBEN WILCOCK

Following the EISAs fee transparency initiative, do you think we'll see some convergence on fees?

Ventures DirectorBlackfinch Ventures

There is a variety of ways that fees are charged for EIS portfolios and that can make comparison difficult. For our Octopus Ventures EIS Service we don’t charge the portfolio companies any fees, which ensures all fees are charged at the product level and clearly shown in the brochure and illustrations. To enable investors to claim EIS relief on as much of their investment as possible, we don’t set aside a pot to pay annual management charges upfront. Instead we only charge investors our annual management charge as each company is exited, and only then if it has grown in value. This also ensures we are completely aligned with our investors.

ANDREW ALDRIDGE

Partner & Head of MarketingDeepbridge

SHANE GALLWEY

Fund ManagerGuinness Funds

02

JESS FRANKS

What challenges do you see ahead?

Business Line ManagerOctopus Investments

This is clearly a very unusual year, and at the outset we had no visibility on how much appetite there would be from investors looking to invest in smaller companies. However, we’ve found both through our VCTs and initial conversations about our new EIS service, that there’s a really strong base of investors and advisers who see investing in UK smaller companies as a good opportunity this year. There is also a desire from some to be part of the solution to economic recovery, by investing in exciting early stage companies.

RICHARD ROBERTS

Head of Investor RelationsOxford Capital

03

Are you optimistic for 2021, and why?

We’re optimistic about the critical role UK early stage companies will play in driving the post-Covid economic recovery. We have steadily grown our specialist investment management teams to be able to support even more high potential companies with equity funding and strategic support at the point in their growth journey when it is needed most.

WHAT'S ON THE HORIZON? / OTS REVIEW

A LOOK AT TAX SIMPLIFICATION

We know that next year, the Chancellor is going to be looking to raise capital. The questions remains from where.

In November, the Office for Tax Simplification (OTS) released a review into Capital Gains Tax. This was requested by Chancellor Rishi Sunak back in June, and therefore it is likely he will be taking its recommendations seriously.

Although the review was not directly on EIS, where it did touch upon it, it was supportive.

MANY RESPONDENTS [TO AN ONLINE OTS SURVEY] SAID THAT THE ENTERPRISE INVESTMENT SCHEME ALSO ENCOURAGES REPEATED INVESTMENT, WHICH SOME DESCRIBED AS ‘ENTREPRENEURIAL ACTIVITY’, ESPECIALLY THROUGH THE CAPITAL GAINS TAX DEFERRAL RELIEF IT PROVIDES FOR THOSE WHO HAVE MADE
A GAIN AND WANT TO RE-INVEST.

- OFFICE FOR TAX SIMPLIFICATION, CAPITAL GAINS TAX REVIEW – FIRST REPORT: SIMPLIFYING BY DESIGN, NOV 2020

There are a number of recommendations it makes that could impact the appeal of EIS:

Changes to rates and boundaries

The OTS said its review found a range of areas where CGT is counter-intuitive, creates odd incentives, or creates opportunities for tax avoidance. In particular, it found significant issues around:

• The rates at which the tax is charged;
• The boundaries between income and gains arising from employment, business and entrepreneurial activity in different contexts;
• How Capital Gains Tax applies to transfers before and after a person’s death
• The strong interconnections between Capital Gains Tax, Income Tax and Inheritance Tax, which all have to be considered when changes are made

One example of this is the disparity in rates between income tax rates and CGT rates. The OTS argues this disparity can distort business and family decision making to arrange affairs in ways that re-characterise income as capital gain. The OTS made a number of recommendations to challenge this. Key would be to bring closer alignment between the two rates - in other words raising CGT.

As EIS allows for CGT deferral, and gains made in EIS investments are CGT free, such a move would increase the appeal of EIS. The slight issue here that the OTS points out is that higher CGT might cause business owners and shareholders to hold onto assets rather than sell. This could potentially increase the risk that EIS money gets trapped in an investment where the business owner does not want to incur a higher CGT charge, and therefore does not sell the company at an optimal time: Since sale of the business is one of the typical EIS exit routes. Although EIS investors and managers are at liberty to sell their shares when they choose, sometimes participating in the sale of an entire business to a third party can generate very attractive returns.

What is more, it could end up hurting EIS gains when exits are made. A US study from May 2020 found a 1% increase in CGT rates would typically result in a reduction in realised gains of between 0.3% and 1%.

To help make the system fairer, the OTS highlighted possible options open to the Government, including some form of inflation relief or increasing the flexibility with which capital losses can be used to offset income or capital gains.

TAX RATES IN ENGLAND AND WALES

Capital transfer at death

EIS has a number of advantages for inheritance tax planning. Not only do investments qualify for Business Relief, but as it has CGT deferral, it is possible to roll forward the CGT on a continuous basis, until death, at which point the CGT disappears.

The OTS suggests the way IHT and CGT interact at present is ‘incoherent’, as liabilities and reliefs of the two taxes are often viewed or developed without consideration on the effect of the

EXAMPLE OF CURRENT TAX PLANNING SCENARIO

SOLD IN LIFE -

DIES WITH

£68,800

£103,200

£28,000

£172,000

INHERITANCE TAX DUE IN CASH

NET BENEFICIARY PROCEEDS

£200,000

CAPITAL GAINS DUE

CASH

SECOND HOME BOUGHT FOR £100,000

NET BENEFICIARY PROCEEDS

£80,000

SOLD AFTER DEATH - NO CAPITAL GAINS DUE

ASSET RETAINED

DIES

INHERITANCE TAX DUE ON ASSET

£120,000

Source: OTS

From a CGT perspective, assets inherited are treated at their market value at time of death. Any previous uplift is wiped out. This is known as the capital gains uplift. The OTS suggests as an alternative a ‘no gain no loss’ approach where the recipient is treated as acquiring the assets at the historic base cost of the person who has died, as demonstrated below:

OTS'S RECOMMENDATION FOR FAIRER SYSTEM

SOLD IN LIFE -

DIES WITH

£68,800

£103,200

£28,000

£172,000

INHERITANCE TAX DUE IN CASH

NET BENEFICIARY PROCEEDS

£200,000

CAPITAL GAINS DUE

CASH

SECOND HOME (BOUGHT FOR £100,000)

SOLD AFTER DEATH

NET BENEFICIARY PROCEEDS

£68,800*

ASSET RETAINED

£28,000

DIES

INHERITANCE TAX DUE ON ASSET

£103,200

CAPITAL GAINS DUE

Source: OTS

*Assumes an adjustment for future tax liabilities

As EIS investments generally have both IHT (through Business Relief qualification) and CGT relief, these changes would not directly affect them. However it might result in EIS becoming more valuable as a form of tax planning. If holding an asset no longer results in lower net tax, instead it might make more sense to sell the asset, then invest in BR qualifying investments that also qualify for EIS. Although this would still incur CGT (which would be deferred in the case of EIS), it would reduce any IHT liability to zero, so long as those investments were made at least two year prior to death.

It’s worth remembering here that most EIS qualifying shares also qualify for Business Relief as the Business Relief qualification is much broader than that applies to EIS. However, by the same token, many Business Relief qualifying shares, may well not qualify for EIS.

In addition, the risk profile of EIS would need to be carefully considered in terms of suitability for an older person looking to retain as much wealth as possible in an estate planning scenario.