As part of inheritance tax planning, investors shouldn't overlook the benefits of AIM-listed stocks.
Inheritance tax (IHT), which is levied at 40% on assets over and above the first £325,000 in an estate, is well worth avoiding.
One avoidance strategy is to invest in shares traded on the Alternative Investment Market (AIM), as the value of qualifying AIM shares can be passed on free of IHT once you have held them for two years.
AIM is a subset of the London Stock Exchange that caters for fledgling companies that require a more flexible regulatory system than the main market offers. The exemption from IHT came about primarily to allow entrepreneurs to pass on their businesses intact, as otherwise beneficiaries would often be forced to liquidate assets to pay tax. The tax relief, known as business property relief is therefore only available on direct stakes in a business, which means investors cannot claim it for AIM shares held in a collective fund.
Private investors can create their own portfolio of AIM stocks, which can be lodged in an ISA wrapper. Alternatively, they can pay a specialist fund manager to build a portfolio and buy and sell AIM stocks on their behalf. This will normally be a portfolio of around 20-30 stocks, to provide diversification. Such portfolio management is quite expensive, as can be seen in the table.
These portfolios are higher risk than the average equity portfolio, as AIM-listed companies are typically less well resourced than main market firms. However, AIM has become a lot more mature, having grown in value from £37 billion to £100 billion over the past decade. Moreover, today a greater number of AIM companies are domestically registered – making for greater transparency – yet their revenues are increasingly international.
"The quality of AIM firms has improved enormously," says Richard Power, head of quoted smaller companies at Octopus.
"There were nearly 1,700 AIM firms in 2007 just before the financial crash, but there are now 926. There is not such a long tail of firms with unproven business models."
Prior to ASOS (LSE:ASC) recent profit warning, the firm was the AIM market's obvious poster company. It listed in 2001 at a value of just £14 million, but this recently topped £3 billion. Investing in ASOS would have turned a £1,000 investment at launch into £160,000. Like that other AIM giant, drinks group Fevertree (LSE:FEVR), ASOS comprises around 7% of the index. Booker Group, Domino's Pizza (LSE:DOM), Big Yellow (LSE:BYG), Hiscox (LSE:HSX), Playtech (LSE:PTEC) and Petra Diamonds (LSE:PDL) are other big names that started on AIM but have since graduated to the FTSE 250.
That said, AIM has produced more than its share of colourful flops and failures. For example, Greek tech company Globo, founded by a champion windsurfer, failed after it was found to have holes in its sales data, while insurance conglomerate Quindell was supported by research from strange brokerage houses with comic book place names. In a similar vein, AIM is home to many hit-and-miss oil exploration firms.
Of course, AIM companies can be expected to be riskier propositions, as listing on AIM is relatively cheap and allows companies to access capital under less onerous restrictions than firms in more senior markets. Companies are not required to provide three years of audited statements, for example, and there is no minimum market capitalisation.
Protection is ostensibly provided by nominated advisers, or 'nomads', usually an investment bank or stockbroker. Each company must employ a nomad to shepherd it onto AIM and regulate it once listed. However, nomads are driven by commercial concerns. A particularly dismal chapter in 2015 saw many Chinese companies forced to delist, after nomads withdrew their support despite having enthusiastically promoted the firms a few years earlier.
A more practical difficulty is that not all AIM companies qualify for business property relief, and investors face a challenge in monitoring the market. There’s no definitive business property relief list to check against, and to make matters worse, HMRC only makes a judgment on whether a company is IHT-exempt when tax is due.
It is best to play safe and only buy companies that engage in actual trading rather than passively invest in land or other assets, which entails avoiding investment trusts and their real estate equivalents (REITS) as well as resource exploration companies, which are deemed land companies. You must also tread carefully where profits are derived from joint ventures and subsidiaries rather than from active trading. Companies are also disqualified from relief if they have listings both on AIM and on another market elsewhere.
For investors who want to pick their own stocks, interesting and well-regarded companies include RWS Holdings (LSE:RWS), which specialises in the translation of technical patents; Gamma Communications (LSE:GAMA), a tech comms company that supports businesses; GB Group (LSE:GBG), an identity verification software supplier; Abcam (LSE:ABC), which produces research-grade antibodies; and Gooch & Housego (LSE:GHH), a photonics tech company.
In this context, Investor's Champion could help. This is a service that screens stocks to identify those that qualify, examines company accounts, and meets with management to ensure non-qualifying companies don't slip through (investorschampion.com).
If instead you choose a specialist discretionary manager to manage an AIM portfolio for you, it will conduct due diligence on your behalf.
Simon Radford, head of the tax-advantaged products research team at MJ Hudson Allenbridge, which conducts independent reviews of AIM IHT services, says they can be attractive for certain kinds of investor.
He explains: "Investment in AIM as part of an IHT solution is not for everyone. But it may suit those prepared to put aside money they don't think they'll need, who want some capital growth rather than simply capital preservation, and are prepared to live with the volatility entailed in AIM investing. The market has matured a lot over the past 10 years, but investors should understand that performance should be judged across full market cycles and not simply assume that recent performance can be replicated into the future."
Do your research
"Investors comfortable with AIM should make sure they acquire independent research on the different AIM funds, as these vary in terms of their strategies, fees, teams and the infrastructure supporting investment teams. It is more complicated than selecting a good stockpicker who has been on a strong recent run."
For years AIM pessimists have argued that the prices of many large AIM stocks have been artificially inflated as the big AIM IHT portfolios have bought them up. It is not unusual to find AIM stocks such as boohoo and Fevertree trading on price/earnings ratios of more than 60.
However, not all well-loved qualifying AIM shares are overly expensive, especially in the less glamorous sectors. Wound care specialist Advanced Medical Solutions Group (LSE:AMS), for example, is trading on a PE of 29, flooring specialist James Halstead (LSE:JHD) is on 24, Smart Metering Systems (LSE:SMS) is on 33 and adhesives group Scapa (LSE:SCPA) is on 26.
A big concern is that the AIM investment IHT exemption is an anomaly that could be ended, especially if the Labour Party comes to power. Even the apolitical Association of Accounting Technicians has called for an end to the tax break, arguing it was "not designed as an avoidance measure or to promote AIM-listed shares". The Conservative Party, however, seems to take the view that AIM helps companies requiring funding of £5-25 million and that smaller companies drive employment in the UK.
Ending the IHT exemption would almost certainly damage AIM, as the average investor there is in their mid-70s with IHT planning in mind.
Take AIM: for optimal inheritance tax planning
Mr Williams, age 74, has assets worth more than the current IHT tax-free allowance of £325,000. He also has ISA investments worth £200,000, which alone will incur an IHT bill of around £80,000 on his death.
If Mr Williams transfers his ISA holdings into an AIM ISA, after two years these investments can be left to his beneficiaries free from IHT when he dies. This could save his family or other beneficiaries around £80,000 – or more if the portfolio goes on to generate returns.
Mr Williams can keep adding to his ISA each year to shield more of his estate from IHT. He can make withdrawals whenever he wishes without affecting the IHT relief on the remaining investment. On his death, his beneficiaries will not face a tax bill on the AIM portfolio and can choose whether to retain or sell the shares.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.