How Investing in Small Companies Brings Tax Benefits

Investing in fledgling UK companies, through a number of different vehicles, can help investors to dramatically reduce their tax liabilities

David Brenchley 15 March, 2019 | 1:12PM

AIM ISA, venture capital trust, enterprise investment scheme, tax relief, tax break

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No matter how much you have to invest, consumers up and down the country will be looking to maximise their tax allowances in the coming few weeks before the current tax year ends.

For long-term investors, small companies can prove a fruitful hunting ground. More fledgling enterprises generally have much more scope for growth than larger companies.

For investors that have already maxed out their pension and ISA allowances and are willing to take on an extra level of risk, it may be worth considering investing in up-and-coming UK businesses.

Making subscriptions to venture capital trusts (VCTs), enterprise investment schemes (EIS) or seed enterprise investment schemes (SEIS) provide that opportunity.

The schemes were introduced by the UK Government to encourage investment into fledgling UK companies, says Jason Hollands, managing director at Tilney Group. While they’re higher risk and should only account for a small portion of an investment portfolio, they do offer considerable tax breaks.

“For the right investor – typically a higher or additional rate taxpayer able to take a long-term view – these can be a useful part of their toolkit,” adds Hollands.

Alex Davies, CEO and founder of Wealth Club, notes that each of the three options offers a different mix of tax benefits and which an investor chooses will largely depend on circumstances and how much risk you’re prepared to take. “As a rule of thumb, the greater the tax benefits, the higher the risk,” he cautions.

Tax Benefits of Investing in Small Companies

VCTs provide investors with a diversified, managed portfolio of early stage companies and offer up to 30% income tax relief, with returns paid through tax-free dividends. That said, those tax benefits are repayable if shares are sold within five years.

Up to £200,000 can be invested in VCTs a year, meaning a potential maximum income tax saving of £60,000.

An EIS is a direct investment into the shares of a single unquoted, fledgling company that meets certain criteria. As it is an investment into one company, it is riskier than a VCT and provides less diversification. Income tax relief of up to 30% is again on offer, though tax-free dividends are not.

It does provide capital gains tax relief, though, which will only become payable once you come out of the EIS, unless you re-invest the proceeds into another.

The EIS allowance is £1 million, or £2 million if you invest £1 million into “knowledge-intensive” companies. Knowledge-intensive companies are those committed to creating intellectual property by spending a certain amount of its operating costs on research, development or innovation.

The allowance for a SEIS is a more modest £100,000, and it “is the real winner when it comes to tax savings”, says Davies. You can cut both your income and capital gains tax bills in half when investing in a SEIS.

Both EIS and SEIS also become eligible for business relief after two years, meaning they should be excluded from your estate for inheritance tax (IHT) purposes. They also allow ‘carry back’, which means you can choose to offset the tax relief against the previous tax year and recoup tax that’s already been paid.

Finally, investing in an AIM ISA is another way to access small, fast-growing UK firms. This vehicle, a managed portfolio of stocks listed on the UK’s junior market, gives you all the tax benefits of a normal ISA, with the added advantage of being IHT-free after two years as long as they are held until death.

Again, the reason for this is because some AIM firms become eligible for business relief after being held for two years. It is important to note here, though, that not all AIM stocks qualify for this relief.

“AIM ISAs present a great opportunity for investors and are still vastly underused despite the potential benefits,” says Davies.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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