The funds most at risk of AIM stocks losing IHT relief

On the 30 October, there could be some significant changes to the tax system in Britain.

Sir Keir Starmer’s Labour government will set out its Autumn Budget, which will set the tone for the next four to five years in office.

Already, Chancellor Rachel Reeves has said that there is a £22 billion “black hole” in the public finances that needs to be filled.

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However, Reeves has pledged not to touch income tax, national insurance or VAT. This means that pensions, inheritance tax (IHT) and capital gains tax are very likely to be in the firing line in an attempt to fill that black hole.  

Consequently, the tax rules around AIM shares – those quoted on London’s “junior” Alternative Investment Market - may be changed.  

Currently, most AIM shares are not part of an estate for IHT purposes. They qualify for this Business Property Relief (BPR) break if they have been held for more than two years at the time of death.

BPR is generally not available through funds, so to qualify you must be invested directly in shares, although there are exceptions.

The Institute for Fiscal Studies (IFS), a think tank, says the removal of special treatment for AIM shares could raise £1.1 billion this tax year, rising to £1.6 billion in 2029-30. But it adds that this could be an underestimate.

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Although the IFS does say that those currently using AIM shares to avoid inheritance tax could respond by using other avoidance strategies, leading to a lower amount raised for the Treasury.

The IFS argues that there is no rationale for this relief as AIM shares are held at arm’s length in a similar way to regular shares. If the tax break is removed, this may lead to lower demand for AIM shares.

It is, of course, unknown exactly what impact scrapping the IHT relief on AIM shares would have, but it would clearly not be a positive for the group of companies.

Simon French, head of research at stockbroker Panmure Liberum, says that in isolation, the removal of the IHT break would be an “systematic risk” for AIM. While Nicholas Hyett, investment manager at Wealth Club, says it could cause “severe disruption” to the market.

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This could lead to even more pain for AIM investors: even accounting for IHT tax breaks and the extra investors this may have drawn in since 2012 when the rules were introduced, returns from AIM-quoted shares have been disappointing.

Data going back to 1998 shows that the FTSE AIM All Share index is flat, including dividend reinvestment, while the FTSE All-Share has risen 325%. Since the start of 2012, the AIM index is up just 26%.

Which funds could be affected by a tax change?

Lots of popular UK smaller companies funds have big allocations to AIM shares, which puts their portfolios at risk if there is a widespread hit to AIM company share prices.

For example, the £129 million Liontrust UK Microcap has 88.7% invested in AIM shares and Gresham House UK Micro Cap has 73.5% invested there. Schroder UK Smaller Companies has 38% in AIM shares.

Meanwhile, Stonehage Flemming AIM mainly” invests in companies quoted on AIM and Marlborough Nan Cap Growth has “significant” exposure to AIM, according to the fund group.

Most funds do not disclose how much they have invested in AIM, but data on how much of a portfolio is considered “micro-cap”, which data group Morningstar defines as the smallest 3% of UK companies by market capitalisation, is a useful proxy.

The table below shows the funds with the highest allocations to micro-cap shares.

Source: Morningstar 18 September 2024. *Defined by Morningstar as the smaller 3% of UK-listed companies

Some interactive investor Super 60 funds have investments in AIM shares. These include Amati UK Listed Smaller Companies, which has 45% in the junior market, and Henderson Smaller Companies investment trust, which has around 20% there and about 70% in the FTSE 250.

Alex Watts, an investment data analsyt at ii, says: “Given the Henderson Smaller Companies’ exposure to AIM-listed stocks, and high level of gearing (now 14%) to take advantage of lowly valuations, HSL is an option for patient and adventurous investors with sufficient risk appetite.”

While there is a risk that AIM valuations will be hit by IHT changes, Watts says that there are clear advantages to owning funds that can buy shares quoted on AIM.

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He says: “The draw of having some AIM exposure is that it may offer an early entry point to under-researched, small but fast-growing businesses, delivering earnings and share price growth beyond those well-covered, established large caps.” 

While AIM stocks represent some of the smallest listed UK businesses, there’s still a wide spread of companies comprising the index. In fact, the AIM index, with over 600 constituents, totals slightly more companies than the FTSE All-Share (560).

It spans from a small number of recognisable multi-billion-pound household names, such as Fevertree Drinks (LSE:FEVR) and YouGov (LSE:YOU), right down to micro-cap names with market caps under £1 million.

However, Watts does acknowledge some risks, such as volatility, which has been 50% higher than the FTSE 100 over the past three years and elevated corporate activity: delisting, and a dearth of IPOs has meant the number of AIM stocks has declined by around 1,000 pre-2008 to the current 614 today.

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Further, he says that the last three years of outflows from UK equities put downwards pressure on valuations and performance across the board.

Watts says: “AIM weathered the storm badly, losing over 30% in 2022 vs a flat FTSE All-Share and falling a further 6.4% in 2023, as the rest of the UK market recovered.”

But he adds that there has since been improved performance and sentiment towards smaller companies, thanks to improving economic data and consumer confidence, among other factors.

“However, AIM businesses still face obstacles, in the form of the delayed effects of rising borrowing costs, and unknown trajectory of government fiscal policy ahead of the October Budget,” Watts concludes.