Up to £300,000 income tax rebate plus longer-term tax savings
Investing in small companies is not for the faint-hearted. Whilst some of these companies will do very well, others will struggle and some will fail.
The tax incentives the government offers provide a valuable buffer against this risk for Enterprise Investment Scheme (EIS) investors. They mitigate the impact of investments that don’t work out and amplify the impact of investments that do well.
Here we explain EIS tax benefits in more detail with examples, based on current rules. Please remember though: tax rules can change.
30% income tax relief
This tax year you can invest up to £1,000,000 in EIS and receive an income tax rebate of up to £300,000. In addition, the ‘carry back’ facility allows you to use your allowance from the prior tax year and effectively double both investment and tax relief.
To benefit, you must have paid or owe sufficient tax (in both tax years if you are investing across two tax years). To keep the relief you must hold the investment for at least three years.
Capital gains deferral
If you have realised a taxable gain (e.g. by selling investments or a second home) and invest the proceeds in an EIS, you can defer the capital gains (and so the tax bill) for as long as the money stays invested. You can defer gains of any size, made up to three years before and one year after the EIS investment.
This, in conjunction with the new lower rate of CGT introduced from April 2016, opens up an opportunity for EIS investors. They could pay the new rate of 20% (rather than 28%) CGT on gains already realised, except those accruing on the disposal of residential property and carried interest.
Take someone with an investment gain of £100,000 (over their tax-free allowance) and an income tax liability of £30,000 in the 2015-16 tax year. If they did nothing, they would face a £28,000 capital gains tax bill and a £30,000 income tax bill.
If they invested £100,000 in EIS and used the ‘carry back’ facility, they could erase their £30,000 income tax bill. In addition, their capital gain could be deferred and the tax would only be payable when they exit the EIS investment, after at least three years. By then, unless rules change again, the capital gains tax bill would be £20,000 rather than £28,000.
If they preferred they could reinvest the proceeds of their EIS investment into another EIS and defer again. Current rules allow investors to do this over and over again, and potentially defer a capital gain indefinitely.
Any gains made upon exiting an EIS are tax free – there’s no capital gains tax to pay, provided you hold the investment for at least three years. This could be particularly valuable if your EIS portfolio includes a rising star.
However unlike the case with VCTs, dividends are taxable.
Inheritance tax relief
Two years after you invest, your investment can become IHT free, provided you still hold it on death and the companies are still qualifying. This is a potential saving of 40%.
If the investments do not go as planned you can offset any losses against income. This means even in the worst case scenario (100% loss) the effective loss can be as little as 38.5% of the original EIS investment for an additional-rate taxpayer.
The example below shows how loss relief works:
- Initial investment
- Income tax rebate
- Effective net cost (investment less income tax rebate)
- Value of investment on exit
- Gain/loss on paper
- Loss relief (45% taxpayer)
- Effective gain-loss (value of investment on exit, less effective net cost, plus loss relief)
How do I claim EIS tax reliefs?
The 30% income tax rebate is generally claimed via self-assessment once you have received your EIS3 form from the provider. There is often a time lag of at least six months between the date of investment and receipt of the form. Capital gains deferral is also generally claimed via self-assessment.
Please remember: tax rules can change and benefits depend on your circumstances. EIS tax benefits are only available if the company maintains its EIS status.