The Finance Act passed in November 2015 contained a number of changes relating to Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EISs).

These are aimed at ensuring investment continues to be targeted at those sectors and companies needing it most. In addition, the proposals will bring the investment rules for both VCTs and EIS in line with the new European Union rules on State Aid. The important thing is that these changes will ensure innovative businesses at the smaller end of the spectrum continue to benefit from EIS and VCT investment.

Here is a breakdown of the changes to VCTs and EIS:

• The maximum amount of funding that a company can receive from a VCT or EIS over the course of its lifetime has been reduced to £12m, unless it is a company that is considered to be ‘knowledge-intensive’ which can receive up to £20m.
• The timeframe in which companies remain eligible for VCT or EIS funding has been reduced. Firms have to have made their first commercial sale in the past seven years, or ten years for knowledge-intensive businesses.

• With the EU keen to ensure that ‘state aided’ money – such as investments that qualify for tax relief – is used to fund new growth rather than to acquire existing shares or businesses, VCT money can no longer be used to fund management buyouts and acquisitions.

• Investments made in reserve power companies no longer qualify for the EIS or VCT tax relief. Companies in the business of any energy generation activities will be excluded from VCTs and EIS funding as of 6 April 2016.

Importantly however, there have been no  changes made to the tax relief available to investors through EIS or VCTs. The above changes impact the way that fund managers deploy VCT and EIS investments, but for advisers and investors the tax features of the products remain the same.

How much impact are these changes going to have for the sector?Investors and advisers should note that investments already made are not affected by the changes, and a specific VCT or EIS will not look any different to the shareholder after the change. It will still be a portfolio invested in hopefully well-performing businesses that will continue to do what they have been doing. Also, the changes do not materially affect the way in which VCTs or EIS work. Indeed they will only help to ensure that high growth and innovative businesses can continue to benefit from investment.

There is, however, an impact on the likely availability of VCTs to invest into. For VCTs, a number of major providers are either not fundraising this tax year or have reined their fundraising limits back, as the changes may have impacted their investment strategies, restricting how they deploy cash already raised.

For EIS, demand is set to be significant before the end of this tax year, as it is the final opportunity for investors to access the energy generation sector through the product before it is removed from the qualifying list on 6 April. It is, therefore, vital that investors with the appropriate risk appetite act now and do not wait until the end of the tax year, by which point many VCTs and EIS are expected to be closed for investment.

Can we expect more changes in the Budget coming in March?Last year, there was greater opportunity for the government to set out financial legislative changes, given that there were two Budgets and an Autumn Statement. Some people might look at the subsequent legislative changes made to VCT and EIS legislation and surmise that there is increasingly heavy scrutiny from the government.

But successive governments, including the current one, have been very supportive of VCTs and EISs since they were introduced over 20 years ago, demonstrated by the increases in the amounts that individuals can invest. Successive governments have also made legislative tweaks designed to ensure tax incentives are focused where needed, namely to help compensate for the higher risks involved in smaller company investment. While the latest new rules will inevitably reduce the number of smaller companies eligible for VCT and EIS funding, they are not unreasonable and do not come as a shock.

At present, the industry is waiting for HMRC to issue guidelines on many of the changes that were announced in 2015. For example, there is seemingly a lack of clarity on what exactly constitutes a 'knowledge-intensive company', and indeed what would represent a ‘first commercial sale’ when looking at the reduced timeframe for VCT and EIS funding. In the absence of such guidelines, the industry is somewhat working under unclear constraints, and we would be hopeful of getting some clarification soon.

One change, which would be welcomed in 2016, although we are unlikely to receive details until the summer, is that the government has announced plans to introduce increased flexibility for replacement capital within VCTs and EIS, subject to the EU agreeing. Using replacement capital involves purchasing the shares of existing shareholders, something which is often necessary as part of a restructure that often accompanies an injection of new capital from a VCT.

If further constraints are announced, it is worth remembering that rule changes to VCTs and EISs to date have never been applied retrospectively. This is clearly of benefit to investors in these areas, although there is no guarantee that this will always be the case. In addition, tax-efficient investment vehicles aimed at supporting smaller companies have never been able to ‘follow their money’ indefinitely. There comes a point at which every successful VCT or EIS qualifying company should be able to raise funds from other sources, at which point it should no longer find such funding necessary. We are supportive of changes that ensure funding is directed at those small companies, and sectors, most in need of support.

A financial planning opportunity

Both VCTs and EISs are well-established government-approved initiatives and in addition, both are recognised as being a vital source of funding for many UK smaller companies.

These companies can often have strong growth potential, and can make a significant contribution to our economy as well as generate thousands of jobs annually. As a result, they can be a compelling investment opportunity, and investor demand for such products shows no signs of abating. According to the Association of Investment Companies, the 2014/2015 tax year raised the fourth highest level of funds ever, with £429m invested in new VCT shares, according to the AIC. For EISs, a record £1.53bn was raised during the 2013/2014 tax year, according to HMRC, and I expect the statistics for the most recent tax year will be equally positive.

Pension changes are playing their part. Last year, changes were announced which allowed individuals to draw down more capital from their pensions, effectively giving investors the freedom to invest that capital elsewhere. In addition, as of April 2016, the annual and lifetime pension allowances are being restricted. These changes mean that some investors may wish to consider alternative tax efficient ways to invest their money, if they want to take advantage of the pension flexibilities and/or are likely to hit one of the pension allowance limits. One possible option available is VCTs and EISs, as with their attractive tax benefits – and, in the case of VCTs, the possibility for tax free dividends – they have the potential to complement existing retirement portfolios. However, investors should understand that VCTs and EIS products are higher risk investments because they invest in smaller companies and, for the same reason, they are not to be considered as a replacement for pension investments.

By way of example, an investor whose pension fund is approaching the new £1m lifetime allowance limit could consider diverting a portion of their income into a VCT instead. This will offer them up to 30% upfront income tax relief which they can retain as long as they remain invested in the VCT for a minimum of five years. There will be no capital gains tax applied to growth in the value of their shares, and any dividends from their VCT investment would be tax free (and do not even have to be declared on their tax return). Many VCTs target tax-free dividend returns around the 5% mark (according to Mark Dampier in The Independent, September 2014).

A reminder about EIS and VCT risksBoth VCTs and EISs are regarded as high risk products that place investors’ capital at risk. Those that do well achieve their objectives and have the potential for significant returns but not all succeed, as such clients could end up with less than they originally invested. If your clients are not comfortable with these risks or with the idea of investing in smaller companies then such investments are not right for them. As planners and paraplanners know, although there are some well-established VCTs with generally stable portfolios, the performance of such investments can be volatile and past performance is no indicator of future success. There are also charges with these investments which may be different to typical pensions and ISAs, and higher charges would impact rates of return.

Where is the market heading?

The market for VCTs and EISs is now mature and the type of opportunities available today are vastly different to when these schemes were first introduced. If you need a reminder of just how much has changed over two decades, the internet was still considered primarily a government rather than a commercial project when EISs were introduced in 1994. The Octopus high growth small business report in October identified some 22,000 fast growing UK smaller companies with an annual turnover between £1m and £20m – firms that make up less than 1% of UK companies but created one in every three jobs last year. Yet almost one in every four companies surveyed said they found it difficult to access the funding they needed to grow. Clearly, there is still a huge opportunity for VCTs and EISs to help support these underfunded firms. We believe there will continue to be a good pipeline of potential investment opportunities.

But while the range of companies that now qualify for tax relief might be slightly smaller, there is still a thriving and fertile market full of the type of fast growing smaller companies, many of whom are desperate to access funding, that VCT and EIS managers like us look out for. Having managed VCT and EIS portfolios for over a decade, we are used to governments making changes to the rules to ensure investment is being targeted to sectors most in need of finance. We are therefore very much anticipating business as usual.