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The joy of tax: how incentives have reduced investment risk and changed behaviour

Written by Edward Snow on Friday, 07 April 2017. Posted in Investment, Finance

Schemes like EIS, SEIS and VCTs don’t only allow investors to reduce their tax bills but they’re helping to foster investment in capital-hungry fast-growing startups

The joy of tax: how incentives have reduced investment risk and changed behaviour

Tax schemes have received a lot of attention of late, especially involving celebrities using financial sleights of hand to shelter large incomes. EIS and VCT investing is a world away from those – these weren’t dreamt up by a shady tax lawyer, all the details are on the government’s website and there are sections in your tax return specifically dedicated to them. By creating them, refining them over time and continuing to support them, successive governments of all flavours have encouraged enterprise and had a hugely positive impact on the financing of early-stage companies.

For many years, HM Treasury has encouraged individuals to back young companies by offering generous tax breaks through the Enterprise Investment Scheme, the EIS. The rough deal is you get 30% of what you invest knocked off your income tax bill immediately, any gain when selling your stake doesn’t get taxed and should the investment fail 70% of the investment you made gets set off against a future tax bill. The deal for the EIS’s younger sibling, the Seed EIS (SEIS) is even more generous. There are strings attached: if you sell your shares before three years have passed you have to repay the 30% and you get taxed on gains as normal. Also, certain businesses don’t qualify – for example property development and forestry – since the goal of the schemes is to encourage investing in fledgling and therefore risky businesses.

The EIS has succeeded in helping plug what’s called the ‘equity gap’: the lack of capital for small, young firms. Since the scheme’s launch in the mid-1990s close to 25,000 companies have received investment totalling more than £14bn. While the exchequer has received £4.2bn less in income tax as a result, I’d argue that this has been a worthwhile investment by the taxpayer: the economics of very early-stage investing doesn’t work with venture capital firms’ cost structures and smaller businesses generate three times the number of jobs that FTSE 100 firms do, according to research completed by economists at the University of Nottingham.

This scheme also produced some unintended outcomes. One that immediately comes to mind was the proliferation of solar power companies. They took the largest share of EIS investment for a period but since the risk involved in such projects is low and the government was also paying the bulk of their revenues in subsidies, they no longer qualify, rightly in my mind.

Another comes from the rise of crowdfunding. Obviously this fundraising tool wasn’t around in the 1990s when EIS was born but its arrival has transformed the landscape. Whilst crowdfunding has mostly been a positive force, making it easier to marry young companies with capital, combining easy access to tantalising concepts with the schemes’ tax breaks has provided motive, opportunity and means to invest without due care and attention. A survey of business angels conducted by the innovation foundation Nesta showed that 41% of their investments resulted in complete loss. Given these outcomes were for seasoned players, I worry a toxic brew has been cooked up for starry-eyed beginners and it is the taxpayer that ultimately foots the bill for these failures.

HM Treasury has also set up schemes to encourage individuals to invest in a number of young companies, spreading the risk: Venture Capital Trusts or VCTs. Broadly, the tax breaks here are that 30% of the amount invested in new shares of the trust will be deducted from your income tax bill – if the shares are held for five years or longer – and you will pay no tax on income or capital gains from the investment. The manager of the fund has some constraints too: 70% of newly raised capital has to be invested in businesses within three years, the companies that receive that capital have to be below a certain size and age and any one investment can’t be more than 15% of the whole fund.

Unfortunately, gaming the system occurred here too: backing relatively low-risk management buyouts became a common investment strategy. Given the purpose of offering the tax breaks was to encourage investment in situations where growth rather than financial engineering drove the returns, the rules were changed to stop this in 2015. When combined with the rules regarding the speed of investment, this change meant that many of the buyout-focused VCT firms subsequently chose to raise less. To their credit, VCT firms did the right thing, only seeking capital if confident they could deploy it rather than take money and lower their standards just to ensure they could utilise all the funds at their disposal. And the rule change didn’t halt those who were backing young risky companies; the market leader in VCT venturing, Octopus, recently raised a further £120m to continue its successful backing of UK tech startups. To put that in context, in the tax year ending April 2015, VCTs raised about £450m in total.

Could these schemes be for you? Well everyone’s affairs are different but if you are in the happy situation where you have a lot of tax to pay these are legitimate ways to reduce your bill – all without jeopardising that knighthood. 

About the Author

Edward Snow

Edward Snow

Snow has been involved with growth companies his entire career. Having floated his first venture aged 26, he has since made his name as a hands-on investor, attempting to ease the growing pains of more than 20 businesses.  He has a degree in engineering and an MBA from INSEAD, where he was a Sainsbury Management Fellow.

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