The new UK Government has made it perfectly clear that the Budget on 30 October is going to involve some tough decisions that will affect people’s finances. While much of the media speculation has focused on how capital gains tax might evolve, inheritance tax (IHT) is also a potential target for big changes such as abolishing tax relief on owning certain AIM-quoted shares.

The Institute for Fiscal Studies said in April that abolishing IHT relief on AIM stocks would raise £1.1 billion in the 2024-25 tax year, rising to £1.6 billion in 2029-30. With public finances in a crisis, every extra penny matters to the government and this seems like one of the most vulnerable places for change.

Scrapping the tax relief on AIM stocks could backfire. Principally, it goes against the Government’s efforts to support growth of UK businesses.

COULD DAMPEN INVESTOR INTEREST IN SMALL CAPS

Companies typically admit their shares for public trading so they can access capital markets. AIM has a good reputation of being a vibrant marketplace where companies can tap investors for more cash through placing new shares. Many of these companies will have joined AIM in the knowledge that the tax relief benefits are a key attraction for investors. Take the benefits away and there is a danger that fewer investors would be willing to back the type of stocks you find on AIM, principally small companies.

Just look at a company like document management specialist Restore (RST:AIM). It has regularly tapped investors for more cash over the years and used the proceeds to increase market share, expand its skillset through acquisitions and become a much bigger business. Investors who funded this growth plan included fund managers running portfolios specifically to invest in AIM stocks that qualify for the IHT relief.

COULD DERAIL REVIVAL IN UK MARKET INTEREST

Scrapping AIM IHT relief could trigger a sell-off in small caps just at the point where investors are starting to show more interest in the UK market.

Concerns about an economic slowdown in the US has led certain investors to look for ways to diversify their portfolio beyond the popular fast-growth tech stocks that have delivered big gains in recent years.

The UK market might have what they need as it is full of cheap stocks offering slow but steady growth, often with defensive qualities that could see them prosper in good or bad economic conditions. While such names are typically members of the FTSE 350 index, any sell-off in AIM could still hurt the reputation of the broader market.

AIM’s biggest companies by market value often feature in AIM IHT portfolios including telecoms provider Gamma Communications (GAMA:AIM), veterinary specialist CVS (CVSG:AIM) and engineering services group Renew Holdings (RNWH).

COULD DEPRESS COMPANY VALUATIONS

Abolishing the tax relief could result in fewer people wanting to hold such stocks, causing share prices to fall and these types of companies to trade on lower valuations. The knock-on effect could be an acceleration of UK takeovers if more companies are trading cheaply.

There aren’t enough companies joining the stock market to replace those leaving through takeovers, meaning we’ve got a shrinking pot of opportunities. It’s no wonder that fund managers are starting to moan about a lack of choice on the UK market.

TAKING A DIFFERENT VIEW

Despite there being reasons to keep the tax relief, it’s important to take a balanced look at the situation and consider why the Government could take it away. In addition to the financial benefits to the Treasury, there is an argument to say the system is outdated and hard to defend.

The rules state an investor’s estate won’t have to pay the 40% inheritance tax charge upon their death for any investments in AIM stocks that qualify for business property relief, subject to certain conditions.

Business property relief legislation came into power in 1976 for family firms passed down through generations so that inheritance tax bills wouldn’t put a privately-owned business into liquidation.

It was subsequently expanded to include holdings in businesses quoted on London’s AIM stock market following concerns that such investments were harder to sell quickly than shares on London’s Main Market.

While AIM stocks are typically remain smaller in size versus ones in the FTSE 350 index, it’s fair to say that liquidity has improved since the junior market launched in 1995.

HOW THE SYSTEM WORKS

An individual would need to invest in qualifying AIM companies for at least two years in order to get the inheritance tax relief. The clock starts ticking from the point at which they invest in qualifying stocks. If they make a second (or more) deposit of funds, a new clock starts for that amount of money.

If they sell the stocks after the two-year qualifying period ends, there are three years to use that cash, but the investor must reinvest in qualifying stocks by the time that three-year period ends and at the point of death.

The rules are complicated and HMRC refuses to publish a list of qualifying stocks. An investor unsure of which stocks qualify for the relief could instead use one of the AIM IHT portfolio services run by various asset managers but charges can be expensive, often between 1.5% and 2% a year.

CHASING THE TAX BENEFIT COULD LEAD TO POOR OUTCOMES

For those managing their own investments, there is an argument to suggest the tax relief encourages DIY investors to pick AIM stocks purely because of the IHT benefits, not because they are good companies or good investments. That poses the risk of having inferior stocks in a portfolio simply to avoid tax, which is a poor approach to investing.

Fundamentally, this is a tax benefit for the wealthy and that puts it directly in the line of sight for the Keir Starmer’s administration. If you had to rank the list of tax benefits to disappear in the next tax year, this has to be near the top.

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