How to pay less income tax: investing into the Enterprise Investment Scheme
We're quickly approaching the 2017/2018 financial year end. Thursday 5th April marks the closing of the current financial year; the 12 month period used to calculate how much income we made and how much tax we're liable to pay on it.
By income, we're generally talking about anything that you receive on a regular basis. The most common example of this is PAYE salary from an employer, but it also covers things such as the money you receive from income-focused property investments or the money you make from any work you charge for on a self-employed basis.
Now one of the most common phrases in relation to taxes is from Benjamin Franklin:
In this world nothing can be said to be certain, except death and taxes.
And for the most part, it's perfect. If you're making an income that's above the tax free allowance (currently £11,500), you're going to be liable to income tax at some percentage of your earnings - anywhere between 20 and 45% as of today.
But whilst there is a legal requirement to pay income tax on any income above the tax free allowance, it is completely and utterly possible to reduce the amount of tax you pay.
Tax efficient investing and benefiting from EIS
I'm not talking about tax avoidance or tax evasion here. I'm talking about legal schemes, offered by the UK government, that provide a range of tax reliefs to investors into early stage startup companies.
And the most notable of these is the Enterprise Investment Scheme (EIS).
In a nutshell, by making an investment into a startup that's raising investment through the Enterprise Investment Scheme you can legally reduce your income tax bill - or in some instances, dependent on the sum of money invested, actually remove the amount of money you pay in income tax.
The primary reason behind this is because an investment into an EIS opportunity is one into an early stage company, when compared to other asset classes, it can bring with it more risk. This isn't a surprise - early stage companies are full of ambition, focus and determination, but there's no guarantee they'll go on to be a multi-billion pound company.
The EIS tax reliefs
For this reason, the UK government provides tax reliefs on EIS investments in a variety of capacities. We go into a little more depth about the tax reliefs here, but on the highest of levels an investment into EIS brings with it:
- Income tax relief
- No capital gains tax liabilities
- Capital gains tax deferral relief
- Income and capital gains tax loss relief
- Inheritance tax and business property relief tax relief
Looking at the income tax-based reliefs (we're going to talk about the capital gains tax reliefs with regard to EIS investments separately), let's use an example of how you could reduce your tax bill this year.
Imagine you're an employee with a full time contract on a salary of £40,000 for the financial year 6th April 2017 to 5th April 2018 (and for this illustration, you haven't received any additional income). Over the course of the year you'd pay a total of £5,700 in income tax - this is 20% of £28,500, which is your taxable income as a basic rate tax payer after you've removed your tax free allowance of £11,500 for the year.
As an employee, you'd pay this tax in 12 instalments when you receive your monthly salary. It happens automatically and you have no need to complete a tax return.
However, let's now say you had invested £10,000 into our Intelligence Fusion EIS investment opportunity that closed out last year. With EIS, you can receive income tax relief at 30% of your investment amount - so in this case, £3,000.
Because the money you're liable to pay in tax has already been paid at the point of being earned, you could fill out a tax return for the financial 2017/18 financial year (which would generally need to be filed before 31st January 2019) and effectively claim back that £3,000.
The same principle applies if you aren't an employee but are self-employed, the main difference being you wouldn't claim back the money but it would be reduced from the tax you owe before your final calculation is made.
Therefore, if you earned £40,000 on a self-employed basis, you would still be liable for £5,700 in tax. Assuming you didn't have any expenses, your investment into the EIS opportunity would reduce this tax bill from £5,700 to £2,700.
And if you did have expenses? Well this is where it can get interesting.
Using the same calculation above, let's say you had £2,700 of allowable expenses. That would take your income tax liability down to £3,000 - and so with your £3,000 in income tax relief from your EIS investment, you would pay a grand total of £0 in income tax for this financial year.
Making an EIS investment
One of the most interesting points of EIS opportunities are that they're easier to make an investment into than most first believe.
Making any investment brings with it a need to fully research the opportunity, understand the risk and return profile and take professional advice to ensure it fits within your requirements as an investor.
However, on the assumption you've done this, the investment process can be one that takes just a couple of minutes; a few clicks to enter your investment amount, agree to the investment details and finalise the process. As soon as the investment round closes, one of our investment team will be in touch to request for the transfer of funds. Once the process has been completed in its entirety and the HMRC have all of the documentation required from the company facilitating the raise, you'll then receive the relevant documentation to be able to claim your tax relief (known as a 'EIS3' form).
An important point to note here is, theoretically, you could invest, finalise and receive your EIS3 form (and therefore claim your tax relief) in the same year. However, it's not always the case, often because the investment round stretches over several months or it closes towards the end of the tax year.
Should this be the case, your tax relief can be either carried back to the previous tax year or kept and used in the coming year, flexibility that can be particularly beneficial when you're looking at tax planning and making the most from your investments.
Paying less income tax each and every year
The Enterprise Investment Scheme has been in operation since 1994, and it's showing no signs of being restricted (in fact, the 2017 Autumn Budget actually made it more attractive to investors and therefore more beneficial to startups).
Giving investors the ability to back the next generation of British businesses every year, it's a genuine possibility that through tax efficient investing you can reduce - if not completely remove - your income tax liabilities for the year.
Plus, with investments made with the intention of generating a profit, you could very easily reduce tax and increase your income at the same time (and remember, with any income from EIS investments being free of capital gains tax liabilities, you'll pay no tax on any profits achieved).