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John Spiers: The trouble with tax shelters

John Spiers: The trouble with tax shelters

Not so long ago people would openly boast of how little tax they paid; it was almost a badge of honour. Now only the very brave (or thick-skinned) would contemplate any kind of aggressive tax shelter.

Two avenues that should still offer near certainty of getting the relief without attracting public opprobrium are enterprise investment schemes (EIS) and venture capital trusts (VCTs).

Demand for both seems brisk. Bestinvest estimates total VCT capital raised last tax year was around £393 million – an increase of 44% – and EIS funding was significantly larger. This makes the total tax shelter market over £1 billion. However, chancellor George Osborne announced rule changes in the last Budget, designed to focus the reliefs more tightly, which might affect supply and demand this tax year.

A risky venture

EIS have generated a surprising amount of investment for high risk ventures, as well as considerable sums for supposedly low risk ventures designed to return the original capital plus a small uplift after three years.

Much of this has been employed in renewable energy projects but the legislation will outlaw activities that already benefit from government subsidies from July. So unless EIS promoters find another golden goose, we can expect future offers to be more traditional early-stage ventures.

Data on EIS performance appears non-existent, but inevitably there will have been many individual failures. If you think investing in small unquoted companies has been a goldmine, check out the long-term stats on the BVCA website. Its November 2013 review concludes ‘venture funds, taken in aggregate, have underperformed relative to the public market’ which, of course, is why the tax relief is available.

An absolutely critical element in maximising the success of small businesses is to provide high quality mentoring and the lack of this is a big drawback with most EIS opportunities.

When I review some of the EIS offers currently being promoted, I am surprised at the glib references to target returns.

For most of these schemes, any such target is pure conjecture. If you are considering investing, I suggest you completely disregard such comments.

The key to the success of any of these ventures is the quality of management. Check out their history and look for tangible signs of success, not generalist comments like ‘enjoyed a successful career in the financial sector’. Check their interests are aligned with yours and they have real skin in the game.

If you do decide to invest, then be prepared for some disappointments. Fortunately, EIS tax reliefs provide a useful additional layer of protection in the case of unsuccessful investments in the form of loss relief. You can do rather well by backing a load of EIS losers and a handful of winners.

The Seed EIS offers even more generous terms, including a 50% upfront tax rebate regardless of your marginal tax rate – but the risk level here will be even higher.

VCTs offer much more diversified risk. Some of the original backers, such as Baronsmead and Northern, have stuck to their well-tested policy of providing development capital to established businesses and have produced good returns.

Others have attempted to produce a low risk, asset-backed vehicle, relying on tax relief to generate most of the return. These seem to have just about delivered, but whenever they have an investment that goes wrong there is not enough growth potential in the rest of the portfolio to repair the damage.

An unfortunate feature of the VCT market is it has become a closed shop. The fixed costs associated with promoting and running VCTs are so high that you have to raise at least £8 million to be viable (and even that is marginal). The existing managers have the market to themselves, which is never an ideal scenario. 

Tax changes 

The latest tax changes seem pretty logical from my viewpoint as a taxpayer. The ruse whereby you could sell your shares in a VCT after the end of the qualifying period and buy new shares in the new trust for about 5% more – trousering a 30% tax rebate on the way – was unnecessarily generous, since many of those shareholders would have stayed on board anyway to enjoy the tax-free income (or avoid selling out at a large discount).

So will VCTs still be attractive under these rules? As I see it, more than half of the 30% tax rebate is wiped out by initial costs, the discount on NAV when you come to sell (and that’s taking the best case of 5% discount) and the high running costs compared with other collectives. So half of the initial tax relief is lost in the friction of the transaction and the rest is the compensation for the likelihood of sub-par returns.

 Where VCTs can really score is in the generation of a regular tax-free income, since that is so hard to find elsewhere.

 John Spiers was the founder of Bestinvest.

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