Don’t allow the tax tail to wag the investment dog

There are plenty of considerations to make when looking at the multitude of investment opportunities for clients.

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Andrew Aldridge | Deepbridge Capital
25th October 2018
Andrew Aldridge Deepbridge Capital
"With so many investment types and opportunities available to advisers and investors, it is possible to get waylaid by misconceptions and misperceptions"

In recent times in our sector – tax-efficient investing – we’ve noticed increasing levels of adviser interest in how such investments work, what are the benefits and the potential pros and cons of such a recommendation, depending on the client. We are the first to say that these investments are clearly not for every client and the higher-risk that accompanies them will often mean a consideration is not even necessary.

With so many investment types and opportunities available to advisers and investors, it is possible to get waylaid by misconceptions and misperceptions which could lead an adviser in a direction which is not necessarily the appropriate route one for the client.

The important thing for advisers is to not dismiss this sector out of hand, but also to ensure they are fully aware of what the sector looks like today, not what it might have been just a couple of years ago, and to make sure that advice and recommendations are based on those facts.

Here are just three potential mistakes that could be made by advisers when considering a tax-efficient investment for their clients:

Firstly, don’t allow the ‘tax tail to wag the investment dog’. Of course, when it comes to investment decisions, tax reliefs might be the initial driver for a consideration of tax-efficient opportunities, but ultimately the recommendation should be based on the right investment reasons and what is ‘under the bonnet’ of the tax-efficient investment proposition.

The Government provides tax reliefs in order to reduce some of the investment risks and to therefore incentivise investors to support UK businesses. For example, if utilising an Enterprise Investment Scheme proposition, if income tax relief and loss relief are available and utilised then the investor could be risking less than 40p in the pound. While such an investment is only likely to be a small percentage of a portfolio and applicable to a minority of clients, advisers should undertake thorough research and invest in propositions which are right for the client. Due diligence that simply defines whether a tax-efficient investment is appropriate is no longer acceptable, it has to look, analyse and consider why the specific recommended products are appropriate.

Secondly, advisers should not fall into the trap of only considering one tax need of a client, especially when many more may be relevant. There are plenty of tax-need examples to consider, including but not limited to;

• Growth – if the investor is looking for growth then EIS offers tax-free growth.
• Income – if the investor needs income going forward then a Venture Capital Trust proposition may be more appropriate than an EIS as dividends are tax-free – in our experience, a majority of EIS companies are unlikely to be yet in a position to be paying dividends anyway.
• Inheritance tax – if the investor is more ‘mature’ then a consideration of an EIS investment (which will qualify for business relief and therefore IHT exemption) could be relevant.
• Downside protection – if the client is usually of a lower-risk tolerance but has specific reason for a tax-efficient investment then perhaps the loss relief potentially available under EIS may be a reassurance.
• Capital gains – EIS investments also provide investors with the potential to defer capital gains tax, in addition to mitigating income tax. Seed EIS propositions also offer 50% CGT mitigation.

Thirdly, it’s important to ask the right questions, especially given the changing nature of EIS and the modern world. Advisers should understand exactly what the investment manager does, the investments it makes and its experience within the sector its investee companies operate. Does the investment manager have the experience of working with growth-focused companies – in that regard, sector experience is vital.

After the quality of the manager has been assessed, how quickly does it deploy its funds? If you are utilising carry back, this is particularly important - with a number of EIS managers currently not able to offer deployments in this tax year this can be a big issue. Even if you’re not requiring carry back, the longer it takes to deploy funds, the longer it takes to claim any tax reliefs and, ultimately, the longer it will take to complete the three-year EIS qualification window. At the end of the day, this will also likely mean it will take longer for any exit from the investment to be achieved.

Overall, therefore, it’s important for advisers to fully understand client needs, particularly from a tax perspective, when it comes to tax-efficient investment opportunities. Marrying this up with a specialist investment manager that understands the new world and is an expert in its chosen field, should give you every chance of delivering real value to those clients that are suitable for such investments.

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