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Portfolio services: A safe route through Aim

Created:
1 September 2006

Following the chancellor's crackdown on trust schemes in the last Budget, one of the few remaining ways to avoid paying inheritance tax (IHT) is to invest in qualifying 'unquoted' companies. But investing in unquoted companies can be highly risky and the tax rules are complicated, so using a managed portfolio service might be safer than attempting to do it yourself.

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If you invest in qualifying unquoted companies and hold the shares for at least two years, your investments will then avoid IHT on your death. Her Majesty's Revenue & Customs (HMRC) defines unquoted companies as those that are completely unlisted, as well as those that are only listed on the Alternative Investment Market (Aim).

And, as well as receiving IHT relief after being held for two years, qualifying unquoted companies also benefit from accelerated taper relief on capital gains, reducing the effective rate of capital gains tax (CGT) for a higher-rate taxpayer from 40 per cent to 10 per cent after two years. By contrast, taper relief on standard investments only reduces the effective rate of CGT for higher-rate taxpayers to a minimum of 24 per cent after a 10-year holding period.

Unfortunately, though, investing in unquoteds is not a simple matter. For one thing, smaller companies can be extremely volatile and are much higher-risk than large companies, as they have little fat to help them survive recessions. Over the past 10 years, the junior FTSE Aim index has fallen by 4 per cent, compared with a 56 per cent rise in the main FTSE All-Share index.

What's more, the issue of whether or not an unquoted company is regarded as qualifying for IHT and CGT relief can be a very tricky one for private investors to work out. To be classed as a qualifying asset for business property relief (BPR - the regime granting tax relief after two years of ownership), a company must not be involved in certain excluded trades - primarily, investing in shares, land or property. But even if the company itself appears to qualify for BPR, activities by subsidiaries could result in a partial loss of tax relief.

To make matters worse, these tax reliefs do not apply to companies that have full dual listings on certain international markets (which can be difficult to check). BPR eligibility will also be lost if a company is taken over or moves from Aim to the main market.

Worse still, it may be impossible to know if a company will qualify for BPR, as HMRC does not produce a list of eligible companies and only makes a judgement once claims have been submitted on death. Therefore, the safest approach is to entrust your investment in unquoteds to a professionally managed portfolio service.

A number of portfolio services have now sprung up to cope with demand from private investors. Fund managers and brokers offer investors managed spreads of Aim-listed companies in order to receive BPR. You can also opt for a portfolio or fund that invests in shares issued under the Enterprise Investment Scheme (EIS), which provide additional tax breaks in return for taking on a higher degree of risk.

Aim portfoliosAlthough Aim-listed companies tend to be riskier than those listed on the main market, Aim portfolios are actually a lower-risk route to IHT relief.

Justin Modray, of independent financial adviser (IFA) Bestinvest, explains: "EISs can be attractive but, for most people, an Aim portfolio is better because you can get a wider choice of companies to invest in."

That's because an Aim portfolio can invest in any qualifying shares listed on Aim, which hosts more than 1,550 companies, including large, mature businesses. Aim shares should be relatively easy to trade, too, whereas many EIS companies are completely unlisted and may be impossible to sell. Another advantage of using an Aim portfolio over other IHT avoidance methods is that you retain access to, and control over, your investments.

Aim portfolio managers also tend to focus more on capital preservation than growth, as the potential IHT saving could be undermined by having your investments wiped out entirely. Stephen Williams, manager of the Brewin Dolphin Aim portfolio service, says: "I'm not trying to shoot the lights out - what I'm paid to do is deliver steady performance for our clients."

Similarly, Sean O'Flanagan, manager of the Collins Stewart Aim portfolio service, says that it is possible to take a low-risk approach to Aim. He says of his holdings: "All of them are profitable, all of them pay a dividend and the vast majority have net cash. I'm not going for relatively new issues because there isn't a track record." In the four months since his service launched, the average portfolio has risen by 2 per cent, compared with a 13 per cent fall across Aim generally.

Managers tend to pick from model portfolios and screened lists to build tailored portfolios to suit each client. The number of holdings tends to depend on the size of the initial investment, given cost and administration issues. Smaller investments will tend to be spread across 10 to 15 companies, while larger investments will be diversified via 30 or more holdings.

But Adrian Quin, of portfolio manager Christows, emphasises the importance of having specialist lawyers or accountants to screen companies for BPR eligibility - many portfolio managers outsource the job, leaving them to focus on investment management. Mr Quin explains: "You've got to do the due diligence. We feel that up to half the companies on Aim will not qualify for BPR."

Portfolio managers tend to run different portfolios for different investors, depending on their investment needs and any ethical considerations. Andrew Banks, manager of the Singer & Friedlander Aim portfolio service, says that many of his clients wish to avoid drinks companies, while some seek an income from their holdings, rather than growth. So, to provide an income, he often holds unquoted preference shares, which can yield up to 6 per cent.

BPR applies provided you have been invested in eligible assets for at least two of the last five years before death, so managers can buy and sell to take profits or to replace companies that have lost their eligibility. However, managers must reinvest straight away to avoid a situation where an investor dies while the portfolio is holding cash or ineligible shares (which would not receive BPR, regardless of how long eligible assets had been held beforehand).

It is impossible to obtain comparable information on performance, so you need to look at other factors when deciding on what service to pick. Richard Allen, of IFA Allenbridge, suggests you should ask whether a manager's investment style is driven by sectors or valuation, and whether they buy and hold, or sell to take profits.

Mr Allen also points out the importance of checking how flexible a manager will be in managing a portfolio to meet your individual requirements. On top of your investment goals and moral issues, you might want a manager to realise losses to wipe out any capital gains. Mr Allen notes: "If they're not prepared to speak to you, do you want to invest money with them?"

Charges are another important factor to consider. Most services have an initial charge - which tends to be reduced, if you buy direct or through a discount-broking IFA - and an annual charge plus dealing charges. And dealing charges could make quite an impact - Noble includes all trading costs in its annual fee, whereas Rensburg charges a flat rate of £10 per deal and Pilling & Co charges up to 1.65 per cent on top of each trade.

Mr Modray recommends the Collins Stewart service, as Mr O'Flanagan used to work alongside star smaller companies fund manager Peter Webb at boutique Unicorn. However, he warns that Aim portfolios are risky and should only be considered once simpler forms of IHT planning have been established (such as using wills to pass on the exempt allowance, currently £285,000).

Click here to download a table giving details of Aim portfolio services

EIS portfolios and fundsEIS investments avoid IHT after two years and are also free from CGT after the minimum three-year holding period. You can shelter unlimited capital gains by investing in EIS companies, too, and there is 20 per cent income tax relief on investments of up to £400,000 a year.

The downside is that, to be eligible for EIS, shares must be newly issued (by unlisted or Aim-listed companies) and companies must be no larger than £7m in gross assets at the time of investment. In other words, the supply of investment opportunities is fairly limited and the companies involved are tiny, hence very risky.

Another problem is that it can be very hard to exit at a time of your choosing, as it is often impossible to sell unlisted shares. The normal exit routes are through flotations or trade sales.

The level of deal flow is crucial, too, enabling managers to find gems and avoid dross. Rupert Yeoward, of portfolio manager Rathbones, points out that he often sees companies progressing from being holdings in its venture capital trusts to its EIS portfolios and then on to Aim. You can either invest through a managed portfolio service or a fund. But EIS portfolio services tend to have higher annual charges than Aim portfolios, due to the difficulty of researching completely unlisted companies.

Alternatively, you could use an EIS fund. Tax relief is instant for approved funds, but they must invest 90 per cent of their assets within six months. Ted Mott, manager of Oxford Gateway Fund 3, thinks such a rate of investment is unwise, as deals can take up to eight months to research properly, and prefers to run an unapproved fund, where tax relief depends on the timing of each underlying investment. You have up to three years to shelter a capital gain in EIS holdings and gains can also be sheltered if they are made up to a year after buying EIS shares.

EIS funds and some EIS portfolios also charge performance fees on top of their annual charges.

Click here to download a table giving details of EIS funds and EIS portfolio services

More information on EIS funds and portfolios is available at www.tax-shelter-report.co.uk.

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