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Guest Article: Enterprise Investment Schemes And HNW Individuals - You Cannot Keep A Good Idea Down

Kieran O’Gorman

Deepbridge Capital

1 February 2013

Editor’s note: This publication has written a number of recent articles concerning the growing use of UK-based structures called Enterprise Investment Schemes. The EIS model has been around for over a decade and in the light of recent government tightening of pension reliefs for high earners, and a widening of EIS tax reliefs, the model looks more alluring than ever. But as ever there are risks to watch; with all tax-deductible investments of course, what governments give, governments can withdraw. To cast some light on the state of the EIS market, amid a number of recent launches, Kieran O’Gorman, partner at Deepbridge Capital, gives his views. Feedback is welcome.

In a bid to persuade banks to increase lending to households and small businesses, the Bank of England and the Treasury launched the £80 billon Funding for Lending scheme in August 2012, offering discounted funds on the condition that lenders passed them on to borrowers in the form of cheaper loans. Early evidence from the Bank of England would suggest that despite these measures, net lending to businesses fell by £2.1 billion in December, exacerbating a £2.5 billon contraction in the previous month.

It’s an undeniable truth that the recovery of the UK economy from the current recession will be heavily dependent upon the success or otherwise of UK small businesses, the engine for UK job creation. These are the very same firms that currently face a severe funding gap due to traditional lenders’ apathy and reticent to lend development capital to small companies in the UK.

For these reasons, the Enterprise Investment Scheme offers a vital source of development and expansion capital to many of these companies. For the period 1993/94 to 2010/11, over £8.6 billion of funds has been raised, invested in over 18,500 companies. In the most recent tax year for which data is available, 2010/11, £525 million was invested in over 1,900 companies.

Since the introduction of EIS model, three successive Governments have improved the terms of the Scheme thus delivering what is now arguably the most generous tax-efficient investment opportunity available to the UK tax-payer.

Since 6 April 2011, companies no longer have to spend EIS funds solely in the UK, provided the company has a UK permanent establishment. Therefore UK companies can now expand internationally using EIS funds.

In April 2012, the amount an investor could invest in EIS doubled to £1 million per annum, and the amount an EIS qualifying company could raise in a year also rose to £5 millon. The size limit of an EIS-qualifying company also increased, widening the range of investment opportunities. Also, the 2013 Finance Bill removed the threat to cap the amount of income tax relief that a taxpayer could receive , this proposal threatened to severely limit relief on losses on EIS investments. In April 2012, the introduction of the Seed Enterprise Investment Scheme recognised the particular difficulties that very early stage companies face in attracting investment.

These favourable developments are set against a rising tax burden for investors, particularly high net worth investors, who have seen pension tax reliefs dramatically eroded in recent years. While the rationale for EIS is sound, the EIS market faces several fundamental challenges at the current time, including the Retail Distribution Review and the FSA proposals to potentially ban the retail distribution and marketing of unregulated collective investment schemes .

Furthermore, there is a suggestion that investor interest in legitimate tax-efficient investing has been unduly clouded by the adverse media coverage of several dubious tax avoidance schemes that do not subscribe to the ethos of EIS.

It is undeniable that while EIS offers a range of compelling tax advantages, as part of a well-balanced, diversified portfolio, such investment is higher-risk than more traditional investment opportunities. A spectrum of EIS offerings is available, ranging from sector-specific and generalist EIS, to more specific opportunities. Some suffer an absence of diversification, whilst others have a core reliance on the Government’s energy policies , whilst others are too specific . Therefore, it is imperative that  investors understand what they are investing in, and appraise the investment manager of the EIS. Indeed, a capable manager will take an active role in building the value of the investee companies to reinforce the chances of success and plan for an eventual exit.

The team at Deepbridge recommends that the EIS structure is suitable for sophisticated investors, given the illiquid nature of the investment, and the level of due diligence required to fully understand the risk/reward profile involved in EIS. They represent a higher-risk but extremely tax-efficient investment for suitable investors, and also offers the chance for these investors to actively take part in the UK recovery.

Ultimately, investors shouldn’t let tax advantages drive their investment decision – investors should explore the underlying investment proposition and the EIS management team, and demand more transparency in terms of manager remuneration and investor reporting.

In recent months, there has been an interesting development in the EIS space. A recently-launched multi-manager platform can now enable advisers to compare and contrast differing EIS in a low-cost and time-efficient manner: this is, in Deepbridge’s view, a vital evolutionary step in the EIS space.

At the present time, clarity is urgently needed from the Financial Services Authority, the UK regulator, as to whether EIS structures will be included in the proposed UCIS retail distribution ban . The EIS provider community also needs to get its house in order and declare a common consensus on how it accommodates the Retail Distribution Review - without it many advisors are reticent to recommend EIS to suitable investors. Resolution to these issues is however expected imminently: given the apparent failure of a number of government initiatives to kick-start lending to UK small businesses, a wider adoption of EIS investing is needed now more than ever before.