A beginner’s guide to tax efficient investments

15th March 2018
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Tax efficient investment schemes are some of the most effective ways for contemporary UK investors to save their funds, or re-invest them to generate greater returns or diversify their investment portfolios.

a guide to tax efficient investments

The term ‘tax efficient investments’ refers to investment opportunities through which investors will receive tax benefits. More specifically, these type of investments use government approved programs to give investors tax relief on the investments they make into pre-qualified companies or investment vehicles. The type of tax relief investors receive in return range from capital gains relief through to loss relief and inheritance tax relief.

Notable examples of tax efficient investments include ISAs (individual savings accounts) and the Enterprise Investment Scheme (EIS).

The Individual Savings Account (and its sisters, Flexible ISA and Junior ISA) can be used by investors to simply save cash-or later re-invest the funds saved. Under this type of tax efficient investment scheme, the investor pays no income tax on any dividends earned from the ISA. Moreover, investments are free from capital gains. UK citizens can start open an ISA and start saving as soon as age 16—and investing in stocks at 18. Similarly, Junior ISAs allow adults to open ISAs for their children and put cash, stocks, and shares away until their child comes of age.

In 2016, the government rolled out a new iteration of tax efficient investments: the Flexible Individual Savings Account (Flexible ISA). Similar to the cash ISA, the Flexible ISA allows the investor to withdraw money from their account and return it in the same tax year without reducing his or her tax free allowance.

The latter, the Enterprise Investment Scheme founded in 1994, is government implemented and aimed at securing investments for high-risk businesses, such as newly incorporated start-ups. This securing of funds is achieved by offering tax efficient investments to any investor that buys shares in a high-risk company that has been approved by the scheme. The investors invest their money, the high-risk business achieves funding that they otherwise may not have secured and the investor in turn receives benefits for having taken such a risk.

Being a tax efficient investment scheme, the EIS naturally offers investors tax related benefits. Perhaps the primary benefit is that the EIS investor will receive income tax relief of up to 30% on the investment, saving them a significant amount of money that would have otherwise been spent on tax. This means that should an investor put up £1 million into an enterprise, he or she may claim tax relief for 30 percent of shares purchased, resulting in a maximum tax reduction of £300,000.

A secondary benefit of tax efficient investment is that there is no capital gains tax applied to the sale of any shares that the tax efficient investor sells for the high-risk business. Under specified conditions, investors can defer their capital gains until a tax year when they retire or may be paying lower tax rates anyway.

A third benefit of this tax efficient investment is that the investor won’t have to pay any inheritance tax on profit made from the investment, as long as the investor remains as such for a two-year period.

Of course, there are a few stipulations to this tax efficient investment. In order to achieve the benefits offered by the Enterprise Investment Scheme, the tax efficient investor must hold on to their shares for three years. If the investor pulls out at an earlier date, he or she will lose the benefits offered by the EIS. This stipulation is in place precisely to ensure that the scheme provides a mutual benefit to the companies for which it has been set up-securing a symbiotic relationship between investor and enterprise.

Tax efficient investments are so highly rewarded because they often imply a considerable degree of risk to the investor.  Seed EIS allow investors to put up to £100,000 into a fledgling start-up enterprise and experience up to 50 percent in tax relief, compared to the 30 percent in the typical EIS. Qualifying firms in the SEIS tend to be very small and newly formed, making this type of tax efficient investment a strategic option for the seasoned investor.

Tax efficient investments may present a certain amount of risk, but they are simultaneously a highly misunderstood category of investment. The most notorious complaint against tax efficient investments is that they are targeted exclusively to high-net-worth investors alone. This is largely the fault of the legal rhetoric around tax efficient investments like the EIS, which promise investors of a £300,000 relief on a £1million investment. This leads people to believe the EIS is only for multi-million pound investors. In practice, the average investment ranges from £2000 to £18000 across different London-based investment groups—a far cry from one million.

Indeed, tax efficient investments are designed with smaller investors in mind, with the hope that tax reliefs will incentivize smaller or more risk-averse investors to put funds into small or fledgling companies. Indeed, tax efficient investment schemes are less attractive to high level investors, as they put a strict limit on the amount of tax free money investors can take out of their pension accounts. While investment within these tax efficient schemes still requires a certain net worth of the individual investor, these programs are altogether designed to empower investors that would be otherwise excluded—and foster a strong culture of entrepreneurship within the UK.

This is particularly noteworthy in the post-Brexit context, as the UK navigates its position domestically and within Europe. On a more macro scale, this structure of tax efficient investments helps to support investors and enterprises alike, empowering both parties to fuel the UK economy.