Will my Aim portfolio beat inheritance tax?

When an individual dies, provided qualifying Aim shares were held for a cumulative period of two years or more within the five years before death, that money is deemed to fall outside the individual's estate. This is due to the shares qualifying for 'business property relief' and represents one of the most efficient ways to avoid inheritance tax. By contrast, when making a gift an individual has to wait seven years for the monies to fall fully outside of their estate.

However, while this can be a useful strategy for some, it is high risk so is not suitable for everyone, plus it is tricky to get right.

HAROLD BEARD'S PORTFOLIO

Investors Chronicle's economist Chris Dillow says:

Imagine there were two shares with identical risk and returns. Call them A and B. Imagine now that the government were to impose an extra tax only upon share A. What would happen?

Clearly, investors would sell share A and buy B, so the price of B would rise relative to A. When will this stop? The answer is: when A's price has fallen so far, and B's risen so far, that prospective post-tax returns are equal. A will offer higher pre-tax returns than B, simply to compensate for the higher tax on it.

The moral of this tale is simple. There's no point, in a free market, buying an asset merely because it has a tax advantage. This advantage should be offset by lower pre-tax returns. In other words, there's no point holding Alternative Investment Market (Aim) shares simply to avoid inheritance tax (IHT). You pay for this tax break in the form of lower pre-tax returns.

That's the prediction of common sense - you don't get something for nothing.

And guess what? History bears this out. Aim shares have indeed underperformed the main market. Since May 1997, the All-Share has given a total return of 4.7 per cent a year, while the FTSE Aim index has lost 1.6 per cent a year, even including dividends.

There might be something else behind this poor show - the growth illusion. Over time, on average, investors tend to overestimate the growth potential of speculative stocks, with the result that they pay too much for them and they subsequently underperform. And Aim, and your portfolio, have higher proportions of speculative shares than the main market.

There's a third issue with this portfolio. Aim stocks tend to be more volatile than stocks on the main market. This means that even a nicely diversified portfolio of them, such as yours, will be more volatile than a similar portfolio of larger, more mature stocks.

This, in turn, means that even if Aim shares were to buck the trend of the last few years and have the same average performance as the main market, there's more chance of them losing money over the longer term.

Now, it doesn't follow from all this that you should sell this portfolio and buy other stocks. Theory says you should be indifferent between tax-advantaged and tax-disadvantaged stocks, not that you should actively favour the latter. And it's possible that - especially now - the speculative froth in Aim shares is unusually small and so they won't underperform the All-Share from now on.

What it does mean is that you shouldn't confine your investing to Aim, unless you have specific expertise in researching its stocks, which I find unlikely for such a disparate bunch. There's only one distinction that matters in the stock market - the one between good and bad stocks. Where they are listed is not so important.

Danny Cox, head of advice at Hargreaves Lansdown, says:

The principle is sound: invest in the right Aim shares that qualify for business property relief and after two years they are free of inheritance tax. You need to hold qualifying shares for a two-year qualification period out of five years - this allows trading in and out of qualifying shares or to cover the eventuality that a share no longer becomes qualifying.

The definition of what doesn't qualify is as follows:

■ A business or company is engaged wholly or mainly in dealing in securities, stocks or shares, land or buildings, or in making or holding investments;

■ A business is not carried on for gain;

■ A business is subject to a contract for sale, unless that sale is to a company that will carry on the business, and the sale is made wholly or mainly in consideration of shares in the company buying the business

■ Shares in the company are subject to a contract for sale or the company is being wound up, unless the sale or winding up is part of a reconstruction or amalgamation to enable the business of the company to be carried on

So I think (but I am not 100 per cent sure) that currently some of your holdings don't qualify. For example:

Jelf Group is in the investment business, Colliers International is a property company, Randall & Quilter is in the investment business to name just three.

So you need to keep a close eye on this; otherwise your fundamental objective of IHT relief will be lost.

I also don't know of a 'list' of qualifying stocks. This is because a stock may not always qualify, or may only partially qualify. For example, if a business holds too much cash for an extended period this may be deemed an investment and the stock may then only qualify for 85 per cent rather than 100 per cent tax relief.