We regularly provide education and information around topics such as tax efficient investing and property investing here at GrowthFunders, but we don't give financial advice. We don't make recommendations on investment products or advise on where you should invest your money.
And speaking to a professional advisor is always recommended before making any form of investment. Each will have their own advice to give and they'll all offer something different, ideally suited to your specific needs as an investor.
However, if there's one piece of advice that is offered across the board it's diversification. It's about spreading risk and not keeping all of your eggs in the one basket.
We've talked about this previously in relation to property investing and how property can be particularly beneficial for portfolio diversification, but having been talking about tax efficient investing a lot recently, I wanted to take some time to explore the role tax efficient investments can play when you're looking to achieve a diverse portfolio.
Diversification is about variety
On the highest of levels, to achieve diversification you need to have variety. Therefore any new asset classes or investment types you're bringing into your portfolio is going to mean you're diversifying your portfolio to some degree.
But a lot of investors want - or are advised - to look at greater levels of variety, therefore building a portfolio that doesn't just include one or two different asset classes or a handful of investments that differ in risk, but one that is as varied as it can possibly be.
And given tax efficient investing is very much focused on early-stage businesses, the vast array of startups available mean you can achieve a level of variety with this asset class that's particularly considerable.
Look at it on a high level. Investors into some of our EIS-eligible investment opportunities over the past couple of months have invested into a data intelligence platform aimed at security professionals right around the world through to a food tech company that delivers self-service ordering solutions. Add into this an employee engagement software company, a travel-based business and with a clothing company on the horizon, and it's easy to see how diversification can be achieved.
If we take those five companies, you could have spread a £5,000 investment allocation equally as five £1,000 investments and have an investment into five completely different sectors. Not only would these investments add diversification in terms of general risk levels (investments into early stage businesses are generally seen as a higher risk/higher return strategy), but it spreads your investment across a variety of sectors, adding even greater levels of diversification.
You can extend your return period
Now with these investments, the general exit strategy is a trade sale or acquisition of some type. It's not a definitive rule, but as most early-stage startups are disrupting existing markets, such an exit strategy is common - you make enough noise by doing some brilliant work and you're undoubtedly going to prick up the ears of the larger companies in the arena (or larger companies who want to enter into the arena).
But for a trade sale or acquisition to happen, you're generally looking at needing to hold your shares for at least four or five years. Again, this isn't a definitive rule, but aside from the fact the Enterprise Investment Scheme (EIS) requires investors to hold their shares for a minimum of three years to be able to access the majority of tax reliefs and incentives available, startups at this level are looking for money to grow and expand. As such, it could very easily take at least the minimum share holding period alone for their initial plans to be implemented and the results realised.
Therefore, if you're invested into assets that are targeting a return in one or two years - our residential property development projects are a perfect example - adding investments into early stage startups can be a brilliant way to add diversity in terms of longer return periods.
Furthermore, early stage startups very often go on to raise multiple rounds of funding. For example, a company could begin with an official raise under the Seed Enterprise Investment Scheme (SEIS), progress to an Enterprise Investment Scheme round after a year or two, and then move forward to several seed rounds. As such, you could quite easily be invested into a company for in excess of five years - or longer - all the while seeing the value of your investment continue to grow.
Mitigating tax on other investment returns
Looking at the tax reliefs in more detail, given early-stage startup investing is a higher risk/higher return strategy, the UK government provides tax reliefs to help mitigate the level of risk involved.
The most notable of the tax reliefs under the EIS is 30% income tax relief, based on the value of your investment. Increasing to 50% for earlier stage SEIS investments, it's clear how beneficial these can be - at the point of investment you can reduce your capital at risk by between a third and a half. That's a hugely attractive point.
But when we're looking at diversification, it's actually the Capital Gains Tax (CGT) benefits that can be most appealing.
Looking at the EIS as an example, investors are able to benefit with regards to CGT in two separate ways:
- Any returns on your EIS investments are not liable to CGT. If you invested £1,000 and your shares increased in value to £10,000, your £9,000 return would be able to be realised without any form of tax needing to be paid.
- Investors can effectively defer the payment of a CGT bill from any other source until an indefinite time in the future.
With the former self-explanatory (although you can read more about EIS and Capital Gains Tax here), the latter takes a bit more discussing, but the benefits can be particularly beneficial.
Let's imagine you had sold a commercial property and had a £10,000 capital gain. Assuming you have already used your tax free allowance elsewhere, you'd be liable for at least 18% in capital gains tax. That's £1,800 that needs to be paid to the HMRC.
However, the EIS gives you the ability to defer this amount by investing the £10,000 capital gain into an EIS opportunity - and the amount is continually deferred up until the point that you dispose of your EIS shares.
If your £10,000 investment increases in value, it could very easily mean the amount of CGT owed is able to be covered by your gain (which itself is not liable to CGT). And of course, should the investment decrease in value, you'll have deferred that gain for what could very easily be several years.
Undoubtedly beneficial, if we swap to the SEIS, things become even more favourable - not only are any gains you achieve on your investments also not liable for CGT, but if you invest a capital gain from elsewhere into the scheme, the liability that has arose on the gain is effectively halved. 50% isn't deferred until a point in the future, but completely written off.
Using the £10,000 example above and the £1,800 CGT liability it would incur, investing that £10,000 into an SEIS opportunity would allow you to reduce the liability to £900.
These types of tax reliefs and incentives simply aren't achievable in other asset classes. Lower risks and shorter return periods can undoubtedly be achieved elsewhere, but the tax reliefs are very much synonymous with early-stage startup investing, making them an attractive proposition for investors looking for diversification who are seeing capital gains.
Planning for the future
On the same tax relief level, if you're planning for the future - and most importantly, for future generations - tax efficient investments can prove to be particularly attractive.
And the main reason behind this is the returns realised on investments aren't liable to Inheritance Tax (IHT).
Not one of the more well-known tax reliefs/incentives available under the EIS and SEIS, but it's easily one of the most beneficial for those who are focused on the impact their financial situation could have on their future generations.
At present, the Inheritance Tax threshold is £325,000. There are a whole host of stipulations and criteria to take into account, but on the most basic of levels anything within your estate above this will be liable for IHT at a rate of 40%.
So if we said your primary, personal possessions - your home, vehicles, cash in the bank, etc - were worth £325,000, and you had non-EIS or SEIS shares in a company that were deemed to be worth £100,000, the recipients of your estate would need to pay £40,000.
However, if these shares were EIS or SEIS shares, there would be zero IHT that needed to be paid and the shares would simply be inherited by the beneficiaries of your will.
IHT is one of the least favourable taxes in the UK, but it's also one that's dubbed 'the voluntary tax' as with some planning, the amount you are liable for can be greatly reduced - and EIS and SEIS investments can be a perfect example of such planning.
Achieving portfolio diversification with tax efficient investing
One of the most common traits of a successful investment portfolio is diversification. Keeping your eggs in one basket is rarely a recommendation in any scenario, and it's never more apparent than in investing.
With any investment you incur risk. Sometimes it's minimal, other times it's considerable, but the primary risk level of a portfolio is dependent on your requirements and expectations as an investor. Yet regardless of what end of the risk scale you generally sit at, diversification should always be a key consideration - and adding tax efficient investments into your portfolio can be a brilliant way to achieve it.