FTSE-only ISA allowances could boost the AIM market sharply; scrapping Inheritance Tax could have the opposite effect. Read why below.
Cast your mind back to November 2022 — centuries in investing, and yet less than a year ago. After the Truss-Kwarteng mini-budget adventure, Chancellor Jeremy Hunt is telling the nation that even though we are already the most taxed we have ever been since WWII, and inflation remained in double-digits, he’s not done.
Income tax personal bands are staying frozen until 2028, corporation tax s rising to 25%, and the capital gains tax free allowance is reducing from £12,300 to £6,000 in the new tax year, and then to just £3,000 from April 2024. Meanwhile, the dividend allowance is being sliced from £2,000 to £1,000 to just £500, with the rate paid rising as well.
There’s been better days at the Treasury.
Then after an adventure in windfall taxes (collapsing investment in the North Sea), Hunt decided to make it easier for pension funds to invest up to £75 billion in private companies, including those listed on AIM.
As an investor in AIM shares, I’d argue this might not be the safest place for cash — ironically, I avoid the small cap market for my pension precisely because it’s too risky.
But apparently, the Chancellor — after calling dividends ‘unearned income’ — has had a change of heart. Let’s look at what this all means for small cap investors.
Inheritance Tax non-planning
As investors have no wish to conduct estate planning, the Chancellor has decided that tinkering with pensions and inheritance tax every other Friday might be a good idea. I’ve gone into how encouraging pension funds to invest billions into the AIM market could be great for investors before, but this new idea could have the exact opposite effect.
Essentially, the Chancellor is considering throwing meat to the sharks by abolishing inheritance tax. This tax hits less than 4% of estates given the exemptions, and the fact that the wealthiest can easily avoid it through careful tax planning. Arguably reform would make more sense than scrapping it entirely.
I won’t go into the ethics though — but simply state the facts. The entire AIM market is worth circa £90 billion, and at present, most AIM shares are completely exempt for inheritance tax purposes once held for two years. They’re exempt for the same reason they’re considered private companies for the purposes of Hunt’s pension fund shenanigans — they’re admitted to trading on AIM and are not technically publicly listed.
This means that a common strategy for married couples (who have a combined £1 million IHT-free allowance in most cases), is to give away excess cash and assets seven years before death to avoid the charge, and then invest the remainder in EIS-qualifying shares and AIM shares.
As noted above, AIM shares become exempt from inheritance tax after you’ve held them for two years — and even taking the usual volatility into account, it’s worth noting that the typical IHT charge is 40%.
Therefore, if a couple had £5 million to their name, inheritors would pay 40% of £4 million, or £1.6 million in inheritance tax. That’s a huge incentive to invest in AIM — though also contributes significantly to volatility as inheritors sell shares for cash.
By some estimates, one third — or £30 billion — of all AIM shares are held to legally avoid inheritance tax. Therefore, if inheritance tax were to be scrapped, arguably there could be a huge sell-off in AIM shares. For context, Octopus Investments has an AIM IHT portfolio worth £1.7 billion — the largest dedicated portfolio in the sector.
I did consider that the government would consider scaling the tax back over time, and perhaps replace it with a flat-rate tax on lifetime gifts as suggested by the All-Party Parliamentary Group on Inheritance and Intergenerational Fairness. However, their move to scrap the Lifetime Allowance for SIPPs entirely earlier this year has me reconsidering.
This lot don’t do gradual, considered moves.
It probably makes sense to scrap the AIM inheritance exception anyway (and replace it with EIS style income tax rebates), but I’m not so sure that it would be a disaster. The AIM market has fallen by a third over the past five years, and the types of investors taking advantage of the IHT tax perk perhaps won’t be scared off regardless.
And there’s a bigger problem. Labour has promised to bring the SIPP Lifetime Allowance back once elected, and therefore will almost certainly bring Inheritance Tax back. While this ruse to get people to vote Conservative after a pretty dismal decade might work on some, the reality is that AIM investors will be unlikely to sell until they have clarity from the next government on what they would do.
Ironically, this lack of certainty is just more evidence of how uninvestible the UK is becoming for those needing certainty.
ISA changes
Hunt is also planning to shake up ISA rules, having engaged in meetings with industry executives on how to simplify the tax-free wrapper. To be fair, ISAs are relatively complex — even if there is nothing so generous anywhere else in the world.
You have:
- Cash ISAs
- Stocks and Shares ISAs
- Innovative Finance ISAs
- Lifetime ISAs
and can invest a maximum of £20,000 per annum from your net income, with all returns tax free. I’ve gone into detail on how these ISA products work elsewhere, but it does make sense to amalgamate these into a single product.
But the idea is to encourage investors to pile into UK stocks, much like Hunt wants pension funds to do the same. I suspect that the underutilized Innovative Finance ISA will be scrapped, the cash ISA and Stocks and Shares ISA combined into one product, and the Lifetime ISA bonus incorporated into this single account, but without the current penalties and complexities.
But most importantly for the AIM market, one option Hunt is considering is an additional ISA allowance that can only be used to invest in FTSE-listed companies. However, the Financial Times notes that this would ‘add complexity and require an overhaul of how transactions are reported to HM Revenue and Customs.’
Reading between the lines, there’s a good chance that ISA investing will be completely limited to FTSE-listed shares. Again, there is nothing like an ISA anywhere else in the world — and arguably, it’s not unreasonable to ask investors to back Britain in exchange for some ridiculously good tax efficiency.
Investors could still invest in the US through their SIPP or bite the bullet and pay some taxes. But this change could:
- see much greater liquidity
- a more active IPO market
- greater stakeholder capitalism within society
- a more attractive UK market to pension funds
- faster UK growth
For context, ever since Lawson and Brown started meddling with pensions — including taxing dividends held by pension investments — UK pension funds and retail investors have deserted the London market. Private share ownership has declined in the UK from circa 55% in the 1960s to just 12% today.
It’s not hard to see why — capital gains are much higher across the Atlantic, while FTSE 100 dividend stocks are taxed so much, they might as well not bother.
Meanwhile, UK pension funds have opted for the safety of bonds rather than the ever riskier UK shares and will continue to do so given the volatility of the political environment. Again, pension funds need to guarantee they can pay out, and even if bonds don’t pay as much as shares (even though they have improved significantly in 2023 given rising rates), pensions will always take the lower risk option.
The country subscribed to 12 million ISA accounts in 2020-21, though most opted for cash ISAs — with 4.2 million citizens holding assets of more than £10,000 in cash. The government would like that cash to be invested, though it’s worth noting many retain this cash as emergency funds rather than to be invested.
The bottom line
Every multi-billion titan starts somewhere — and in the UK, they start on AIM. Changing taxation rules every five minutes is in nobody’s interest, and especially company directors considering whether or not to list within an already fragile IPO market.
Here’s what’s changed in a year (for better or worse): income tax, national insurance, dividend tax, corporation tax, student loans, SIPPs, windfall tax & pension allocations. The Chancellor now wants to mess with ISAs — literally robbing Peter to pay Paul.
Worse than this, it seems that Hunt — having declared war on unearned income — is now planning to make even more dividends from share investing tax-free, while dividends earned by directors of limited companies are still taxed at the increased rate.
This isn’t a political point, other than to say that reducing the capital gains and dividend allowances, and then reversing this action by increasing ISA allowances, is equivalent to rearranging the deckchairs on the titanic. This kind of nonsense keeps happening.
And AIM will suffer for it. Or not.
Who knows?
Not Jeremy, that’s for sure.
This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.
Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.
