What happens if AIM stocks lose IHT tax break status?

Up to a third of AIM stocks are held for tax planning reasons, but Government plans could end this and spark widespread sell-offs. Our award-winning AIM writer discusses what the consequences of scrapping it might be. 

Chancellor of the Exchequer Rishi Sunak did not make any changes to the inheritance tax (IHT) regime in his recent budget statement, but there are still concerns he will make changes that could affect the tax benefits of these shares. 

There are calls for the tax relief on AIM shares to be assessed to see if it is value for money for taxpayers.

IHT-related investments and portfolios represent an important component of the cash invested in AIM companies, and these investments can be passed on free of IHT. Most AIM companies are eligible for business property relief. 

This means that if an investment in a qualifying AIM company is held for at least two years, it will not be subject to IHT. This is also known to investors as ‘IHT relief’.

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AIM qualifies for IHT relief because it is not deemed to be a designated recognised stock exchange, such as the Official List of the London Stock Exchange, and the shares are deemed to be unlisted. 

Not all AIM companies qualify, though, and there is not a specific list of qualifiers – so investors need to be careful. Generally, they have to be trading businesses and not investment companies. 

Individuals can buy AIM shares themselves or invest in an IHT portfolio managed by a fund manager. Some of the managed portfolio investments are held in ISAs. 

There are suggestions that between one-fifth and one-third of money invested in AIM is for tax planning reasons.

It is unclear what these estimates are based on. They could be based on the total value of deals in AIM shares or the percentage of shareholdings. Founders will gain the benefits of IHT relief – they are the ones it is meant to benefit – but all or most of their stake would probably be held prior to coming to AIM.

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Whatever the figure, it is certain that there is a significant amount of money invested for IHT relief purposes. Octopus Investments’ AIM IHT portfolio is worth £1.7 billion. While the Octopus portfolio is much bigger than rivals, the total in managed AIM IHT portfolios is substantial, and then there are IHT relief-based investments made by individuals on top of that.

Of course, it is possible that if the wrong shares are chosen that an investor could lose more on the investments than they would have paid in tax. It is still risky. 

This has to be a long-term investment strategy. It is no good investing in a company where the share price is soaring for short-term reasons. A resources company with a risky exploration project is not ideal. 

The company needs to have solid long-term growth prospects. Cash generative and dividend paying companies are best for this type of investment.

In January 2018, when he was Chancellor of the Exchequer, Philip Hammond asked the Office of Tax Simplification to carry out a review of all the aspects of inheritance tax, and provide recommendations on how it can be made more effective and simple.

The July 2019 report by the Office of Tax Simplification suggested a review on the tax relief offered by AIM shares.

The Office of Tax Simplification review can be downloaded here. 

At the beginning of this year, the All-Party Parliamentary Group on Inheritance and Intergenerational Fairness published a paper called Reform of inheritance tax. This cross-party group of MPs want to reduce the headline rate of IHT from 40% to 10% for estates worth less than £2 million, and above that threshold the rate would be 20%. 

They also want to bring in a flat-rate tax paid on lifetime gifts. The idea is to simplify the IHT regime and remove the complex reliefs, so there would be no IHT relief on AIM shares. The Treasury said that it will consider the findings but has not given a formal response. 

IHT portfolios

There are around 30 major fund managers offering AIM IHT portfolios. The portfolios tend to go for larger, dividend paying companies. The major stakes tend to be in FTSE AIM 100 constituents. 

This means that in the boom times, the portfolios may underperform the market as the more fashionable and frothy investments soar, but the strong asset and earning backing means that they can do better in tougher markets and over the long-term. 

The average market cap of investments in a managed portfolio ranges from around £100 million for Downing to more than £700 million for Octopus. Many of the fund managers have a policy of not investing in companies with a market capitalisation of less than £50 million.

There are just over 300 companies on AIM that are valued at more than £50 million. Not all those are eligible for IHT relief. The portfolios tend to invest in between 20 and 40 companies.

There are a number of AIM companies that tend to pop up in many of the portfolios, such as James Halstead (LSE:JHD) and Nichols (LSE:NICL), that do have high ratings that might be difficult to obtain as a Main Market company without tax perks. Both these companies were Main Market companies that moved to AIM, and their price-to-earnings ratios do appear to be lower before they moved to AIM.

There are other reasons, such as the attitude to the sectors or even changes in accounting regulations, that will affect the historic multiples. Undoubtedly, demand from the portfolios has helped to push up the share price of some companies and maintain it at high levels, but that does not mean the share prices do not move. 

Also, increasingly the fund managers are seeking other investments because it is getting more difficult to gain a stake in the old favourites. Kettle components supplier Strix (LSE:KETL), cloud computing and hosting services provider Iomart (LSE:IOM) and student accommodation developer Watkin Jones (LSE:WJG) are becoming more significant in portfolios.

An example of a company that has been a major part of some of the portfolios is Jet2 airline operator Dart Group (LSE:DTG). This was a positive for many years, but this year it has been a drag on some of them. There have been differing approaches to Dart. 

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Dart remains the top holding of the Thornton AIM IHT portfolio, but Hawksmoor Investment Management sold its entire Dart shareholding when the share price bounced back from its low. 

The overall long-term performances of the AIM IHT portfolios tend to be impressive. The ones that started earlier have probably done better because they bought some of the standard investments before demand pushed the share prices up. The Octopus portfolio rose in value by 252.5% over ten years, while the Fundamental Asset AIM portfolio has risen by 315.4% over the same period.

This year the performance has been less impressive, with declines in value and most of the portfolios underperforming AIM and the Numis Smaller Companies Index. However, most are outperforming the FTSE All-Share index, where total return fell by 17.5% in the first half. 

IHT relief is not the only reason why some companies have high valuations. For example, ASOS (LSE:ASC) and Boohoo (LSE:BOO) are highly rated, but they do not tend to figure in the top 10 investments in the main portfolios. That is despite the fact that they account for more than 7% of AIM’s market value. They may be held by individuals for IHT relief purposes, though.

The investment styles of individuals are likely to differ from the more cautious approach of professional fund managers for this type of investment. 

What happens if IHT relief goes?

Taking away the IHT relief from AIM shares is likely to affect demand for them, and potentially the ratings of some companies. This will be particularly true if there is a sell-off and investors seek to transfer their money to other investments. 

The professionals generally invest in the most liquid AIM investments, but even these share prices can be affected by even relatively limited disposals. 

The short-term share price movements would depend on whether investors in portfolios tried to get out of them immediately and shares have to be sold by fund managers to repay investments. Uncertainty about whether the portfolios will be liquidated could hold back some share prices. 

It is different to Woodford, though, where the funds owned large stakes in highly illiquid companies. 

However, the AIM shares in the managed portfolios are predominantly good investments that would still be in demand by investors without any tax relief. Many have attractive yields and a decline in the share price would make them even more attractive to investors seeking income. 

The money invested in AIM IHT portfolios would still have to be invested somewhere and the type of individual investors taking advantage of a tax perk like IHT relief are not going to dump their investments if they have proved to be successful and still have good prospects.

How it will affect the flow of new money into AIM is another question. Undoubtedly, some of the money invested in AIM may be there purely due to the IHT relief. There would still be AIM eligibility for ISAs as an attraction for investors. 

Andrew Hore is a freelance contributor and not a direct employee of interactive investor.