TAX NEWS - June 2010

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British Tax: Venture Capital Trusts (VCT) and Enterprise Investment Scheme (EIS) Tax Benefits

Venture Capital Trust (VCT) and Enterprise Investment Scheme (EIS) funds offer a good route into enterprise investing and have the added attraction of offering tax relief, writes Julian Hickman, partner, Longbow Capital LLP.

Investing in early stage, dynamic, innovative British companies is something all investors should give serious consideration to. The life science, well being and healthcare sectors are typical examples of the British investment opportunities available.

However, not all openings are equal, and investors need to consider carefully how they can access such opportunities. One such way is to invest through Venture Capital Trusts (VCT) and Enterprise Investment Scheme (EIS) funds, both of which offer a range of tax reliefs for investing in innovation and reflect the risk and rewards available.

British success story

Dynamic, innovative British companies represent an exciting part of the investment landscape. This is typified by the UK healthcare sector which is world-class. In life science investment, the UK leads in Europe; globally it is second only to the US. The UK is a leader in developing cutting-edge healthcare products for a world market, exporting healthcare goods and services in 2009 with a value of over £14bn.

Scientific research funding hit £3.4bn in 2008-09, and all signs point towards the UK Government continuing to be committed to the sector. With a £120bn healthcare market, the UK is home to many of the world's leading clinicians, scientists and researchers, attracted by its world-class research capabilities and track record of breakthroughs.

The UK is Europe's top R&D location and a global hub for scientific research. It has eight of the world's top universities (in Europe, four out of the top five), and a cluster of world-class research centres.

Growing demand

Continuing further support for investment in the sector has come from broad changes in healthcare provision, driven by shifting demographics and technology improvements. Key drivers of change, and opportunities for investment, include:

- Baby boomers: the ageing population will increase demands on the healthcare system.
- Chronic diseases such as diabetes and dementia are ever more prevalent and affect all sections of society. Diseases like these require long-term management as well as long-term treatment of symptoms and side effects.
- Access to specialist information through the internet is empowering people to take control of their health and increasing demand for products and services that can be used at home. Technological advances are making these low cost home-use products a reality.

For those interested in investing in exciting opportunities generated by a sector like  healthcare, there tend to be two fundamental choices - either investment into early stage, unquoted companies, or into later stage, more mature businesses quoted on the main markets.

In the first of these, unquoted companies, investment in start up and seed funding usually involves angel investors. Investment into slightly more developed, faster growing companies, however, is generally known as venture investment and in many cases is done through Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs).

Investment is not without risk, however. Cancer specialist Antisoma recently highlighted the risks associated with investing in early stage companies. The company's lung cancer drug, which was being developed with Novartis, failed in Phase III clinical trials, resulting in a sharp decline in its share price. This highlights investors should not invest in just one company, but through a portfolio to achieve some measure of protection through diversification.

Tax benefits

Both VCTs and EIS funds offer exposure to companies at an early stage of their development through a portfolio approach. In recognition that investment in innovation is of key importance within the British economy, Venture Capital Trusts (VCTs) and EISs have been granted a range of tax reliefs that investors can take advantage of.

EISs were launched by the Government in 1994 to encourage private individuals to invest in UK companies focused on enterprise and innovation. The scheme has been classed the "the last great tax break" because of the depth of its tax benefits. EISs can offer opportunities for investors to mitigate across several different brackets including income tax, inheritance tax, as well as providing generous Capital Gains Tax (CGT) deferral relief which permit qualifying investors to carry forward tax liabilities.

Following enhancements to the scheme announced in 2009, investors can also carry back their income tax relief to the previous tax year, to a maximum of £500,000, effectively giving the investor £1,000,000 of relief across two years.

By investing in EIS funds, an investor can benefit from:

- 20% income tax relief on up to £500,000 invested in a single year or £1,000,000 of relief across two years.

- Tax-free gains on any profits with no limit on sum attracting 100% CGT relief.

- Capital gains tax deferral relief on gains generated up to three years before or one year after the EIS investment

- 100% inheritance tax exemption through 100% business property relief (BPR) subject to a minimum holding or qualifying period of two years.

Investment spread

So where does holding an Enterprise Investment Scheme (EIS) or Venture Capital Trust (VCT) investment sit within an investor's portfolio? Any consideration of portfolio construction encourages diversifying investment across different asset classes. This serves the dual purpose of reducing exposure to a volatile market, while also offering the opportunity of enhanced returns.

The process of achieving this is strategic asset allocation; essentially identifying the optimum balance between risk and return. Although this approach has come in for some criticism over the last two years, as investors discovered many of their investments were more correlated than previously thought, the concept is still good.

With each asset class having its own risk and return characteristics, combining them in the right proportion should reduce the impact of market volatility on the portfolio. This proven approach advocates holding a proportion of higher risk investments alongside more traditional classes. More commonly referred to as alternative asset allocation, this includes property, absolute return funds, and venture capital.

The more traditional approach to controlling risk in a portfolio is, for capital growth to have a high percentage of equity based investments with a lower percentage of fixed interest and, conversely, a higher fixed interest and lower equity exposure for a lower risk, income generating portfolio.

Surprisingly, it has been shown that by holding around 20% of any portfolio in alternative investments, volatility is reduced, and return increased. This is because alternative investments are affected by different factors to equities and fixed interest, often being less sensitive to swings in the stock market, yet still rising strongly in a bull market. Holding all else constant, the addition of an alternative asset such as an EIS fund to a portfolio will reduce volatility and increase returns.

Investing in British enterprise and innovation can be an exciting and rewarding experience. Prospective investors should consider whether they prefer to invest in a single sector, or whether they would prefer to invest across a range of sectors.

Investment should always be done through funds to gain the protections afforded by diversification and the best way to do this is through a Venture Capital Trust (VCT) or EIS fund.  These offer a good route into enterprise investing, and they have the added attraction of offering the investor some measure of tax relief to lower the risk of the investment they have made.

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