Start 2021 With Smart Investments

* Mainly targeted at UK investors

As we are entering a new decade of XXI century it is worth reflecting on the last year and realising it has been a tremendously difficult one for those who lost their jobs, businesses and was left out on the periphery of the economy and social life. I bet financial independence and money management has been on the majority of resolution lists for the year we have just entered.

In order to avoid financial distress and ensure your financial freedom in the coming years it is advisable learning the ropes of managing and multiplying your money here and now. So let's dive into several ways UK investors can make their money work for them and enjoy significant tax reliefs:

1. Individual Savings Accounts (ISAs)

Individual Savings Accounts, or ISAs, will almost certainly be the most widely recognised investment method on this list. The government set them up in 1999 to encourage saving and investment by offering generous tax breaks. With an ISA you can invest up to ￡20,000 a year without paying tax on the investments. Personally I started my ISA this August and got it to ￡25,000 by the end of 2020, which is 20 % gain from stock market. Obviously, you can do a much better return depending on the amount of time you can dedicate to learning the market.

Check with your bank, most UK banks offer ISAs and it is very easy to open one. There are various types of ISAs and you can compare them and the banks that offer them at investment aggregator platforms such as MoneySuperMarket.

2. Pension Funds

The next well known way to invest in a tax efficient way is through pensions. Pension contributions up to the annual allowance of ￡40,000 - the annual allowance is a limit on the amount that can be contributed to your pension each year, while still receiving tax relief. It's based on your earnings for the year and is capped at ￡40,000 and at ￡4,000 if you have already started receiving your pension.

Your pension pot is allowed to grow in a tax free environment, so as with ISAs, once you have paid into a pension scheme this amount can be invested into allowable assets, which can provide an income or growth without needing to pay tax. Any gain made from investments through these schemes will be free of capital gains, meaning any shares in the pension can achieve a growth without any risk of paying capital gains when they are sold.

Thus, even without directly accessing your pension at the time of retirement - 66 at this time - you can still use your pension fund tax free to purchase specific assets. Moreover, according to new UK regulations savers have the ability to withdraw their entire funds – or a tax-free lump sum - which is 25 % of your overall Pension Fund – from age 55.

To bring some sobriety into the discussion, it is worth mentioning that unless you are approaching pension age, Pension Funds should be in reality each investor's very last resort due to the unpredictability of economic and societal situation and in fact very low probability of having any pension whatsoever. Every decade or so retirement age keeps rising and probably the last thing you want is using your hard earned money when you can barely move. Moreover, lately there has been a proliferation of Pension Fund scams and an overall financial illiteracy makes Brits fall prey to the other unknown consequences of using your annuity such as losing Housing Benefit, Income Support, income based Jobseeker's Allowance, income related Employment and Support Allowance and so on.

Venture Capital Schemes

Unlike the first two investment vehicles VC Schemes on average offer a much more lucrative return explained by a riskier nature of those investments. Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS), as Venture Capital Trusts (VCTs) and VCFs (Venture Capital Funds) are potentially the riskiest and the most lucrative investment schemes currently on the market, which were designed to kill 2 birds with one stone - promote growth in the next generation of exciting and innovative British businesses as well as provide you with a very high upside should you pick your startups or VC Funds correctly and reach the point of cashing out.

Experienced angels may be happier investing directly into a company and taking an active role, but high network individuals actively managing other projects might benefit more from outsourcing most analytics and money management work to experienced VC Funds or crowdfunding platforms. So what are the differences between EIS, SEIS, VCTs, CVFs and how do you pick the best option for you?

3. Enterprise Investment Scheme (EIS)

The first of the Venture Capital Schemes, EIS was created as the successor to the Business Expansion Scheme in 1994 and is designed to promote investment into unlisted early-stage businesses.

Read more: 10 common questions on EIS investing

This offers investors the ability to back unlisted businesses, which generally represent higher risk due to their early stage and lack of liquidity. This is offset by a raft of tax reliefs, including the headline income tax relief of 30% on the value of your investment, as well as capital gains deferral on invested gains and exemption on growth achieved. To further mitigate the risk, EIS shares are eligible for loss relief - up to 61,5 % - on the net invested amount if the investment doesn't produce a return, potentially reducing the total exposure to 38.5%.

Sum Up EIS:

• 30% income tax relief to the value of your investment
• Requirement to hold shares for 3 years to benefit from the income tax relief
• Loss relief at your marginal rate of tax, potentially reducing capital at risk to 38.5 %
• Exemption from inheritance tax (for the current tax year the IHT rate is 40%, paid on everything over ￡325,000 - the personal estate tax-free threshold, - on estates worth ￡2 million or more, homeowners will lose ￡1 for every ￡2 of value above ￡2 million), which kicks in for your investment after shares have been held for min 2 years - this is because, generally speaking, these shares qualify as eligible property for Business Property Relief (BPR) and as a result will become up to 100% IHT exempt after two years of holding

The criteria for EIS eligibility for individual investors:

• Tax relief of 30 % claimed on investments of up to ￡1,000,000 in one tax year (excluding the knowledge intensive focus where it goes up to ￡2,000,000 if you are investing at least 50 % into knowledge intensive companies)
• Maximum tax reduction in any one year of ￡300,000, assuming the investor has sufficient income tax liability to cover it (excluding the knowledge intensive focus)
• No minimum investment through EIS in any one company in any one tax year
• To qualify for EIS tax relief you should be an individual investor and not a company
• EIS allowances allocated individually - married couples could therefore invest up to ￡2m each tax year and be eligible
• Shares must generally be held for at least 3 years from the date of issue to benefit from the available tax reliefs and incentives
• The individual investor can be a non executive director of the company or a board member, but not an employee
• Growth in the value of an investment is not subject to capital gains tax when it is sold
• Investors should check in advance whether the company has ‘advanced assurance’ - an HMRC certificate confirming that it is EIS eligible
• Money can be claimed back once the business has traded for 4 months, or 70 % of the investment has been spent
• It can be claimed up to 5 years after the 31st January in the year the investment was made

The criteria for EIS eligibility for company

A company can use the scheme to encourage investors if they:

• Has to be trading less than 7 years
• Have a UK permanent establishment. This means that non-UK companies can in principle also qualify under the EIS, if they have a UK permanent establishment
• Carry on a qualifying trade on a commercial basis - certain activities including property development, banking and leasing are specifically excluded from qualifying under the scheme
• Not be listed on a recognised stock exchange (although companies quoted on the Alternative Investment Market (AIM) can still qualify)
• Not be more than 50% controlled or owned by another company
• Have gross assets worth less than ￡15 million
• Have fewer than 250 full time employees (increased to 500 employees for knowledge-intensive companies)
• A company can only raise up to ￡5 million (￡10 million for knowledge-intensive companies) in aggregate under the EIS and the other VC tax schemes on a rolling 12-month basis. There is also a lifetime cap of ￡12 million (￡20 million for knowledge-intensive companies) which a company can raise under the VC tax schemes

4. Seed Enterprise Investment Scheme (SEIS)

The younger sibling of the EIS, SEIS was launched in 2012 to cater for the earliest of all businesses seeking investment. This scheme provides support for the first ￡150,000 of external equity capital a business raises within its first 2 years of trading. Thus to qualify you should be looking for very early stage companies or VC Funds focusing on seed and growth stage startups.

Representing this highest level of risk for investors, the SEIS tax reliefs are similar, to but greater than, those of EIS, with 50% income tax relief upfront and reinvestment relief that allows investors to reclaim 50% relief on a reinvested gain. These, along with the similar capital gains exemption on disposal and loss relief, ensure a potential total exposure as low as 13.5%. However, it should be stressed that these are the earliest of the early businesses and are therefore the riskiest, with limited liquidity and a potentially long wait to an exit, sometimes over 10 years.

What are individual eligibility criteria & benefits of SEIS tax relief?

• Investors can receive initial income tax relief of 50 % on investments up to ￡100,000 per tax year
• In order to claim tax relief, you must have sufficient income tax liability, and hold the shares for at least 3 years
• Growth in the value of an investment is not be subject to capital gains tax when it is sold
• After being held for 2 years, SEIS investments become inheritance tax-free
• The individual investor can be a director of the company, but not an employee
• The investor’s stake in the company can be no more than 30 %
• Investors with taxable capital gain can halve their capital gains tax liability by reinvesting their taxable capital gain into SEIS-eligible company, - if you reinvest gains from a non-SEIS-eligible investment (say EIS investment or any other) into an SEIS-eligible business, you could receive 50% capital gains tax relief on the original investments
• If your SEIS investment is realised at a loss, it can be offset against the same or previous year’s income tax - loss relief at your marginal rate of tax, potentially reducing capital at risk to 13.5%
• As with EIS, investors should check in advance whether company has ‘advanced assurance’ - an HMRC certificate confirming that it is SEIS eligible
• Money can be claimed back once the business has traded for 4 months, or 70 % of the investment has been spent
• SEIS can be claimed up to 5 years after the 31st January in the year the investment was made

What's the criteria for SEIS eligibility for company?

• to qualify, the company must have been trading for less than 2 years, in a genuinely new trade - certain activities including property development, banking and leasing are specifically excluded from qualifying under the scheme
• a company can only raise a maximum of ￡150,000 under the SEIS, although once a company has used up the ￡150,000 lifetime limit it may be able to raise money subsequently under the EIS
• are a business established in the UK
• aren't trading on the stock exchange and have no arrangements to be a quoted company
• have less than 25 employees and less than ￡200,000 of gross assets
• don't control, and isn’t controlled, by another company
• haven't seen any investment through the EIS scheme or other venture capital trust

So what are the key differences between EIS and SEIS?

1. Age of the business

SEIS business have to have been trading for less than 2 years to qualify for the scheme, whilst businesses looking to qualify for EIS can be within 7 years of trading commencing.

From an investor's point of view, this means an EIS business could be up to 5 years more established than an SEIS business, which in turn means that the business, team, idea and growth curve will be more stable and more embedded. Although still a higher risk investment, such stability can help to reduce the level of risk involved.

2. Size of the investment

Companies raising investment with SEIS are limited to a total of ￡150,000. In comparison, businesses under the EIS banner can generally apply for up to ￡5m each year until the business has raised a total of ￡12m.

As an investor, if you’re looking to invest in excess of ￡150k into a single business, you're focus would be on embracing the EIS, with only the first ￡150k benefitting from SEIS.

3. Level of tax relief

The actual workings of the tax reliefs for EIS and SEIS businesses function in the same way, but the level of tax reliefs that can be benefited from by investors differ significantly.

Income tax is the most notable tax relief offered, and with EIS it's an appealing 30% - but with SEIS, it increases to 50%. That means an investment of ￡1,000 could provide an immediate amount of tax relief of ￡300 and ￡500 respectively.

Moreover, SEIS investors could actually achieve 64% relief. This is the combined total when taking into account capital gains tax reinvestment relief, something that isn't available under EIS.

In essence, this is tax relief at 50% of your CGT (capital gain tax) rate that's possible to benefit from if you invest a capital gain (or part thereof) into SEIS. If we assume you're paying CGT at 28%, you can claim 50% of that - 14% - back. On a ￡1,000 investment, that's ￡140. Coupled with your 50% income tax relief and you've got 64%.

As we see to support early stage businesses UK government made such an incentive for SEIS as to bring your at risk capital to just 13.5p in every pound in some instances (due to loss relief, claimable should the worst happen and the company you've invested into folds).

5. Venture Capital Trusts

Launched in 1994, shortly after EIS, a VCT is a listed company in its own right that pools investment to then distribute to build a managed portfolio of investments into eligible companies. Being a managed investment structure, the VCT will hold a diverse portfolio of investments mainly into businesses listed on AIM (Alternative Investment Market).

As this structure allows investment into slightly later stage businesses, the reliefs offered are slightly less generous, but this represents the reduced risk profile of these companies. Income tax relief of 30% can be claimed upfront and the dividends paid are not subject to income tax without affecting your dividend allowance for the year.

Similarly, the growth that is achieved is not subject to capital gains tax, however the loss relief offered through the more risk-focused investments is not available for this managed approach.

6. Venture Capital Funds

Venture capital funds are pooled investment funds that manage the money of investors who seek private equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.

Venture capital funds differ fundamentally from mutual funds and hedge funds in that they focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat. VC funds therefore play an active and hands-on role in the management and operations of the companies in their portfolio.

Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merger and acquisition. Two and twenty (or "2 and 20") is a common fee arrangement that is standard in venture capital and private equity. The "two" means 2% of AUM (assets under management), and "twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. If a profit is made off the exit, the fund also keeps a percentage of the profits—typically around 20%—in addition to the annual management fee. 

Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%. The list of UK's most active VC firms can be found here.

Some funds may have non-economic investment criteria, for example:

• Industry-specific or geography-specific investment criteria
• With a focus on social impact
• Meeting environmental, social and governance (ESG) criteria

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When choosing between EIS, SEIS or VCTs and VCFs it is worth remembering that first two investments vehicles usually require the investor to choose how they invest and to carefully assess each opportunity as part of their due diligence while VCTs and VCFs are more convenient for investors looking to enjoy the tax relief benefits while having their money managed for an agreed fee.

All these approaches have their own limits, both in terms of holding time (5 years for VCTs, VCFs and 3 years for SEIS or EIS), and the amount that can be invested in each (￡200,000 for VCFs and VCTs, ￡100,000 for SEIS and for EIS, this is more complex - there's an annual limit of ￡1,000,000 each year, but a further ￡1,000,000 can be invested if this additional amount is into a knowledge intensive company).

7. Philanthropy & Impact Investing

In the UK, the angel’s investment may qualify for tax breaks under the Social Investment Tax Relief (SITR) scheme. Investors making an eligible investment can deduct 30% of the cost of their investment from their income tax liability, either for the tax year in which the investment is made or the previous tax year.

Qualifying organisations must have a defined and regulated social purpose. They must also have fewer than 500 employees and gross assets of no more than ￡15m. Individuals can invest up to ￡1m per year in social enterprises to receive the tax break.

Environmentally focused enterprises, meanwhile, are increasingly well represented among the army of startups seeking investment.

Worldwide issues like plastic waste, global warming and food sustainability are being challenged by growing numbers of bright new businesses. For investors, they represent an opportunity deliver a positive impact alongside potentially strong returns. While SITR may not be applicable, other tax breaks could be – including those delivered through the Enterprise Investment Scheme (EIS) and Seed EIS, both of which offer healthy income tax breaks

If an investment of five, six or seven figures in such businesses is beyond your personal wealth, however, you could take advantage of crowdfunding.

Following the explosion of crowdfunding platforms in recent years (JustGiving, Crowdfunder, Seedrs. Crowdcube, SyndicateRoom, Zopa, Funding Circle) there are lots of opportunities to invest small amounts into impact startups (whilst in many instances also taking advantages of generous tax reliefs).

8. Investments for Inheritance Tax Relief through Business Property Relief (BPR) Scheme

Business Property Relief (BPR) has been an established part of inheritance tax legislation since 1976. And as an investment incentive, it’s relatively straightforward. Once BPR-qualifying shares have been owned for at least 2 years, they can be passed on free from inheritance tax on the death of the shareholder. Not every interest in a business will qualify for BPR. Broadly speaking, investments in the following kinds of businesses that carry on a trade rather that investment activities could qualify for BPR, including:

• Shares in qualifying companies that are not listed on any stock exchange
• Shares in qualifying companies listed on the Alternative Investment Market (AIM)
• An interest in a qualifying business, such as a partnership

Most recently, since 2013 investors can hold AIM-listed shares within Individual Savings Accounts (ISAs). This means an ISA that invests specifically in AIM-listed companies expected to qualify for BPR can offer inheritance tax exemption as well as the traditional ISA benefits of tax-free income and capital growth.

9. Limited Partnerships, Private Equity and Hedge Funds

PE and hedge funds are often able to operate free of taxation. Instead, when funds are distributed to the partners, those gains (and losses) are taxed at the individual level.

Thus you end up paying taxes for your PE or hedge funds gains, however those are taxed as capital gains and not income, which is much more favourable. Most importantly, if as a limited partner you lose money you can easily use those losses to offset gains elsewhere. The manipulation requires the services of a professional tax accountant, but for most limited partners it’s well worth the trouble.

Sources:

1. GrowthFunders
2. Investopedia
3. Thomson Reuters Practical Law

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