Refresher on EIS / SEIS tax relief: more attractive than you think
Photo: Bonbon Langes (Pexel)
One of the items that got very little attention in last week’s Autumn Statement was the extension of the VCT and EIS sunset clauses to April 2035. This effectively gives a new lease of life to a very attractive tax relief while investing in exciting UK start-ups. I am often surprised how little this incentive is known, let alone understood. Used correctly, investments in EIS or SEIS qualifying companies significantly improve the odds and thereby the returns in favour of investors. This is before you consider, the more ancillary tax benefits such as IHT relief.
So we think it is important to remind investors of the highlights and benefits of these schemes. Please remember that this is not tax or investment advice and does not take account of any particular circumstances. Investments in small companies are very risky and even with attractive tax relief capital losses may occur. With this disclaimer out of the way, let’s go for it:
(Seed) Enterprise Investment Scheme (SEIS/EIS)
Overview:
The SEIS/ EIS are UK government initiatives designed to encourage investment in small, high-risk trading companies. Investors who participate in EIS can benefit from income tax relief, capital gains tax relief, and inheritance tax relief.
Investor Benefits:
Income Tax Relief: Investors can claim income tax relief of up to 50%/30% (SEIS/EIS) of the amount invested, subject to a maximum annual investment limit of £ 200,000/ £1 million.
Capital Gains Tax Relief: Gains realized on the sale of EIS shares are generally exempt from Capital Gains Tax if the investment has been held for at least three years.
Potential Loss and Gain Illustration:
Let's consider an investor who invests £10,000 in an EIS-qualifying company.
Loss Scenario:
If the investment fails, the value of the shares still fall to 0. However, the loss for the investor is significantly reduced by the upfront income tax relief and loss relief against Income or Capital Gains Tax. The investor will have already reclaimed 30% in the tax return. In addition, the investor can choose to set the loss amount, less any Income Tax relief already given, against their income. The effective loss would be closer to £3,000 / £5,000 depending on the individual investor’s tax situation
Gain Scenario:
If the investment doubles and is sold after three years, the investor's gain is £10,000 (initial investment) + £5,000 / £3,000 (50%/30% income tax relief) + £10,000 (profit) = £25,000 / £23,000. The capital gain of £10,000 is exempt from Capital Gains Tax if held for at least three years.
Other tax benefits:
Capital Gains Tax deferral: A gain made on the sale of other investments can be reinvested in EIS share and deferred over the life of the investment.
Inheritance tax relief: EIS shares can be left to beneficiaries free from inheritance tax as long as they have been held for at least two years at the time of death.
Why are SEIS / EIS so powerful?
Notoriously, the failure rate for new start-ups is 90% (explodingtopics). This success rate depends on a variety of factors but let’s go with this number for our calculation. We believe that picking a winner is a notoriously difficult business. The best professionals can do is sieve out the obvious losers. If this holds, then one portfolio of 10 seed investments would end up with 1 winner and 9 losers. The one winner would have to make up for of the nine losers, i.e. the successful exit would have to be at least 9x before the investor makes any money. The additional gains will be limited the capital gains tax charges.
A portfolio of SEIS / EIS companies has much better odds. Since of the £10,000 investment, only £ 3,000 / £ 5,000 are actually at risk (and that is before we include capital gains tax deferral), the return is more attractive. Let’s stick to a portfolio of EIS companies with a net exposure of £5,000. The nine losers would “only” have a net cost of £45,000. The portfolio would have a positive return if one investment returns 4.5x or more. The expected upside is significantly higher since the investor gets to keep 100% of the gains instead of the usual 70% or so. The odds get even more attractive when the portfolio contains SEIS companies where only £3,000 or so are at risk.
A return of 4.5x sounds like a lot and occurs quite rarely in the public markets. This kind of return is not that outlandish in the world of start-ups. We often see companies with a minimum viable product (MVP) and may some revenues at “pre-money valuations” (valuation before they get new investments) of £2-4.5 million. A typical “Series A” funding round which in the current environment occurs after 3-5 years at valuations of £17-20m. So our winner does not need to be a unicorn to make our profitable (although it helps!).
Should you do it?
If you are a UK tax resident with spare liquidity, you should definitely have a look at SEIS / EIS investment opportunities. The expected returns are good, the tax benefits are outstanding and the journey with the companies in your portfolio can be very exciting. Please bear that even in the best outcomes your money will be committed for at least three but more likely 5-10 years. We were generously using rough averages for this discussion and actual returns may vary quite significantly. So do not invest any money that you cannot afford to lose! And again, this blog is not tax or investment advice. If you have questions, get in touch with us in the Contact tab.
Comments