London: Minimising taxation is part and parcel of successful investing. But when do the risks outweigh the benefits? At what point does the tail begin to wag the dog?

At the lower end of the scale, things such as premium bonds and Isas (Individual Savings Account — a tax-efficient way to save or invest) are unlikely to add much risk, but anything that involves investment in small or start-up companies certainly does.

“The cornerstones of most people’s financial planning are individual savings accounts and pensions,” says Patrick Connolly, a financial adviser at Chase de Vere.

For taxpayers pushing up against these thresholds, there are tax incentives to invest their money in government-approved vehicles such as venture capital trusts or enterprise investment schemes.

Then, there are schemes specifically engineered to deliver significant tax advantages, many of which have come under scrutiny from HM Revenue & Customs (HMRC).

With opportunities to save tax come potential pitfalls for unwary investors. “There’s always a trade-off with tax efficiency and risk; the challenge is to strike the right balance for the right person,” says Connolly.

Here, FT Money considers a range of investments that offer tax breaks and assesses the risk trade-off.

Premium bonds

Perhaps the safest form of tax-efficient saving is government-backed premium bonds, offered by National Savings & Investment. They do not pay interest, but offer tax-free prizes instead. Savers can withdraw their deposits without notice or penalty.

For every £1 invested, a number is entered in a monthly prize draw. Each month, 1.8m prizes are awarded, with one top prize of £1m. A second monthly £1m jackpot will be added in August.

“Given the low interest rates on cash held in the open market ... when you take into account tax payable on interest, you’re not giving up a lot for the chance of winning a jackpot,” says Tony Mudd, divisional director of tax at St James’s Place Wealth Management.

There are £45.7bn of premium bonds outstanding, owned by more than 21m savers. Only 2.6 per cent of investors hold the maximum £30,000, according to NS & I. The maximum amount that can be invested in premium bonds increased to £40,000 from June 1, and to £50,000 in 2015-16.

All capital saved in NS & I is backed by the Treasury, so it is a very safe form of investment. However, premium bonds cannot be transferred; if the holder dies, they must be cashed in within a year.

Isas and pensions

Since their introduction in 1999, Individual savings accounts have become a mainstay of tax-efficient saving. By April 2013, HMRC estimated that the market value of Isas stood at £443bn.

Income from an Isa — whether interest or dividends from shares — is tax-free, and any capital growth is exempt from capital gains tax. “Realistically, if you can’t afford to lose your savings, cash Isas are the perfect place to put it,” says Mudd.

From July 1, annual Isa allowances will increase to £15,000, from £11,880, allowing couples to save up to £30,000 tax-free in Isas each year.

Isa holders will also have flexibility to switch their money freely between stocks and shares Isas and cash Isas.

The main problem with cash Isas is that rates are very low, meaning that your capital will probably not even keep pace with inflation.

The risks of investing through a stocks and shares Isa reflect the risks associated with the shares or funds in a given portfolio. Unlike cash Isas, whose deposits are protected by the Financial Services Compensation Scheme up to £85,000 per provider, savings held in stocks and shares Isas are not covered.

The forthcoming inclusion of peer-to-peer lending through Isa wrappers may, however, introduce risks for investors. Although peer-to-peer firms have been subject to regulatory oversight since April, there are inherently higher risks.

Assets held within Isas do not retain their tax-exempt status upon death. As such, they are not an effective tool for inheritance tax planning for estates valued at greater than the qualifying threshold of £325,000.

Pensions are an attractive shelter during the accumulation phase, when contributions attract tax relief and investments can grow free of tax to a lifetime limit. However, once a pension pot is crystallised, any income drawn from it is taxable. New rules from April 2015 will make it easier to take benefits from a pension without incurring very high tax charges.

Aside from the risks of the underlying investments, wealthier savers could also fall foul of the annual and lifetime allowances, and pensions are a multi-decade commitment — withdrawals before age 55 will be subject to hefty tax charges.

Business property relief

Various investments can be used to qualify for business property relief, which offers a way to avoid inheritance tax. One of the most mainstream is shares traded on the Alternative Investment Market, which since August can be included in stocks and shares Isas.

There are two risks in doing this. One is that not all Aim stocks qualify; a company must be a trading business, rather than a holding company.

The other is performance. Although there have been stunning individual performances, Aim shares generally have a poor record. They tend to be smaller and prices can be very volatile; even Asos, Aim’s largest company, saw its value fall by up to 40 per cent recently after a profit warning.

“There is a touch of the flavour of the month about Aim shares,” says Paul Taylor, managing director at McCarthy Taylor. “The relief from IHT has got to be weighed against the [investment] risks — you’ve got to be quite sure that your shares won’t lose more than 40 per cent.”

Rob Burgeman, a director of investment management at Brewin Dolphin, says the tax breaks are in place only because of the inherent risks of investing. As well as the risk to investment capital, he points to the possibility for BPR to be lost if an Aim company moves to the Official List.

BPR extends to the inheritance of a business, or interest in a business, and any land, buildings or equipment. Agricultural property relief applies to working farms, including land and buildings, but there are caveats. Where the value of a farmhouse that has a market value above its agricultural worth, or where any farm property is rented to nonfarm workers, APR will not apply.

“Tax is not necessarily the main reason why people invest in farms, but it’s certainly an advantage,” says Christopher Miles, a director at Savills.

Agricultural land values have risen significantly in the UK, with prime arable farmland rising by an average of 273 per cent over the past decade, according to Savills. However, land and other forms of property investment are illiquid; buying or selling can take months and incur significant transaction costs.

VCT and EIS

Further along the risk spectrum lie venture capital trusts and enterprise investment schemes, government-approved vehicles for investing in small companies. To encourage investment, the Treasury offers 30 per cent income tax relief upfront on VCT investments, capital gains are exempt from CGT and dividends are tax-free.

The trade-off for the financial relief is high investment risk. “VCTs are typically best-suited for investors who have used up their Isa and pension allowances and are willing to take risks,” says Connolly.

Ian Sayers, director-general of the Association of Investment Companies, says that reductions to tax-free pension allowances are proving a “fillip to the sector” by providing an incentive for more investors to look at alternative outlets for their savings. The VCT industry reported its strongest fundraising for eight years in 2013-14.

VCTs are also illiquid; the secondary market is limited for many smaller VCTs and investors’ ability to exit such investments hinges largely on respective managers’ policy on share buybacks, says Matthew Woodbridge, vice-president at Barclays Wealth and Investment Management. The largest VCTs offer to buy back shares at a discount to net asset value of about 5 per cent, much less than historical rates, he says.

VCT investors may also be vulnerable to the loss of tax relief, as illustrated by the removal — and later provisional reinstatement — of Oxford Technology’s VCT status this year. Loss of VCT status could expose investors to large tax liabilities.

EIS allow direct investment in businesses. Investors receive 30 per cent income tax relief and investments qualify for BPR after two years. Capital gains are tax-free after three years and CGT can be deferred for up to three years. Seed EIS, which was extended this year, provides even more generous tax reliefs.

“A lot of people are being advised to invest in EIS to get the tax breaks,” says Alastair Kilgour, chief investment officer at Parkwalk Advisors. “It is not an investment strategy for people who do not understand the risks.”

Investment risks are inherently lower for schemes that invest in operational projects, rather than those still in the embryonic phase. EIS investments are illiquid and money often is tied in for lengthy terms.

Costs can be very high. “The only common feature among EIS and VCTs is their eye-watering charges,” says Burgeman.

Sun sets on solar subsidy

If you have passed a field newly planted with solar panels, the chances are that it was financed through an enterprise investment scheme. More than 60 per cent of retail EIS fundraising in 2013-14 went to low-risk renewable projects, according to industry publication Tax Efficient Review.

Investors benefit from a public subsidy — renewables obligation certificates — that guarantee inflation-linked income for solar generation, but once the finance bill receives royal assent this month, new solar investments will no longer qualify for EIS status.

The rule change did not come as a surprise, says Guy Miles, managing director at Octopus Investments. “The exclusion of solar will not do meaningful damage to the EIS market,” he says.

For EIS managers, the challenge is to find a replacement that replicates solar’s growth prospects and low-risk profile.

“We like the renewables sector because returns are index-linked,” says Oliver Hughes, infrastructure investment director at Oxford Capital. “There are a number of asset classes that are exciting.”

Anaerobic digestion, which produces energy from organic waste, is a leading candidate for greater EIS investment.

— Financial Times