What are tax efficient investments?

Tax efficient investments give investors tax relief on investments into qualifying companies or investment vehicles.

There are a number of UK government-approved schemes to invest in, and many types of tax relief an investor may receive from their investment. These reliefs range from capital gains tax relief through to loss relief and inheritance tax relief.

As with all investments, there are trade-offs to be made when weighing up the pros and cons of each type of investment. Two rules to keep in mind when considering these, or any type of investment:

First, if it sounds too good to be true, it probably is. We’ll only be looking at government-approved schemes in our review.

Second, the more tax relief on offer, the riskier the investment class is likely to be. We’ll get into this later when we talk about the alternative investments that offer tax relief.

Below we’ll take you through the HMRC-approved tax efficient vehicles and the various reliefs they offer. While you can’t avoid paying tax entirely, you certainly can reduce the amount you pay while diversifying your portfolio and having an impact too.

Forms of relief investments may offer

Income tax relief

Some investments, including EIS, SEIS, and VCT, allow you to reduce the income tax owed to the government by a percentage of the amount you invest through the scheme.

Capital gains tax relief

Some investments, including some ISAs, EIS and SEIS, do not incur taxes on the gains made by those investments when held for a defined period of time.

Capital gains tax deferral

EIS and SEIS schemes allow investors to defer existing capital gains taxes if they invest those capital gains through them.

Loss relief

Some of the investments allow for investors to offset part of their income tax bill or capital gains tax bill against any losses on their investment into the scheme.

Inheritance tax relief

Many of the alternative investments allow investors to take advantage of some form of inheritance tax relief, so if the investment is held for a certain number of years it will fall outside of the estate and not face inheritance tax.

Comparison of tax efficient investments

The table below gives an overview of how different tax efficient investments compare on the benefits they offer.


tax efficient investments

Alternative tax efficient investments

Alternative tax efficient investment vehicles are often more generous with the tax reliefs they offer investors than other types of investment. This comes at the trade-off of an increased level of risk associated with the underlying investments.

While the mainstream vehicles can invest in large liquid stocks, funds, bonds and even be held in cash, the alternatives are primarily focused on early-stage unlisted companies, or, in some cases, listed companies with smaller market caps. Below we outline a few of the alternatives available.


Investing in startups with EIS and SEIS

Early-stage investing is risky by nature: these businesses are small, fledgling ventures with limited resources in a changeable world of public opinion, market shifts and competing incumbents. Nine out of ten startups fail within the first four years.

Despite the odds – or perhaps because of the thrill – many individual investors continue to support the small, enterprising companies seeking to change the world, and in so doing take advantage of the EIS and SEIS – two of the most generous tax incentives in the world.

The Enterprise Investment Scheme (EIS)

The Enterprise Investment Scheme (EIS) was launched in 1994 to encourage investments in small, high-risk companies in the UK – i.e. to encourage people to invest in startups.

Eligible EIS investments allow you to take advantage of the following reliefs on up to a cap of £1m per tax year (or £2m per tax year as long as at least £1m of this is invested in knowledge-intensive businesses).

Read more about the Enterprise Investment scheme by downloading our EIS Guide.

  • Income tax relief of 30% of your investment. This can be used in the year of investment or carried back one year.
  • Capital gains exemption on profits earned on shares held for a minimum of three years.
  • Loss relief, should the company you’ve invested in fail, equivalent to your tax bracket multiplied by your ‘at risk capital’ (the total loss on the shares once income tax relief has been accounted for).
  • Capital gains deferral on gains realised on the disposal of any asset which is reinvested in an EIS qualifying company.
  • Inheritance tax exemption on shares held for a minimum of two years.

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The Seed Enterprise Investment Scheme (SEIS)

The Seed Enterprise Investment Scheme (SEIS) is a tax efficient investment designed to complement the EIS by helping small, early-stage companies. Like EIS, investments can be made directly into companies, or via an SEIS fund. It does this by offering tax reliefs to individual investors who purchase new shares in those companies. The main tax reliefs are:

  • Income tax relief of 50%.
  • Capital gains tax relief on profits realised on shares held for a minimum of three years.
  • Loss relief on investments that are realised at a loss.
  • The ability to defer capital gains from other investments.
  • Inheritance tax relief.

Shares sold before the three year holding period are subject to clawback of some of the tax reliefs.


Venture Capital Trusts

VCTs are closed-end listed funds created by the UK government in the 1990s to help direct investment into earlier-stage private and listed (on the AIM market) businesses. VCTs offer investors the following tax reliefs:

-Income tax relief of 30%. -Tax free income. -Tax free dividends.

Shares sold before the five year holding period are subject to clawback of some of the tax reliefs.

Compare EIS and VCT


Mainstream Tax Efficient Investments

ISAs and pension contributions are the two most searched for financial related terms during the tax year, and for good reason. These investment vehicles not only offer an assortment of tax reliefs, they allow for investment into underlying investments that are safer, relative to alternative investments. Of course, the trade-off is that lower risk means lower reward, and on the whole they provide steady growth rather than sizeable returns.

ISAs

An ISA, or individual savings account, is a tax-free savings or investment account that allows the investor to maximise the potential of their investment returns by shielding the gains from income tax, capital gains tax, and tax on dividends. There are several types of ISA:

  • Stocks and Shares ISA: Allows investors to invest into listed stocks or funds.
  • Cash ISA: allow users to earn interest on their savings and not pay tax on the earnings.
  • Junior ISA: Savings parents make for children who can start managing the account at age 16.
  • Lifetime ISA: an ISA specifically targeting first time buyers and must be used for the purchase of a home. Here the government will contribute 25% on up to £4000 invested into the ISA each year.

Pension Contributions

We’ve all heard of pensions, your long term savings plan that you can hopefully fall back on when you retire. With pensions, you can choose to have your pension managed by a fund manager, or you can choose to make more of the decisions yourself through a SIPP (self-invested personal pension).

When it comes to tax relief, you can claim additional tax relief on your Self Assessment tax return for money you put into a private pension of:

  • 20% up to the amount of any income you have paid 40% tax on.
  • 25% up to the amount of any income you have paid 45% tax on.

What’s right for you?

As with everything there are pros and cons to all of the tax efficient invesment available, so decide what level of risk you are comfortable with before making any investment decision and, if you are still unsure, it can be beneficial to speak to a financial advisor.

Alternative investments are often preferred by experienced investors who have built a portfolio of mainstream investments, maxed out their pension allowance, and are looking for opportunities to make sure they are as tax-efficient as possible. On the other hand, many investors seek out opportunities to invest in startups, via EIS, SEIS, or VCTs, so that their investment has an impact on the environment, and because they are eager to help the next generation of entrepreneurs. It's a very personal choice, so do keep an open mind.

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