EIS law change puts AIM in focus

And two profound legislative changes in 2012 are bringing the London Stock Exchange’s junior market – called the Alternative Investment Market (AIM) – squarely into their sights in 2013.

The purchase of newly issued shares of AIM quoted companies has long qualified for enterprise investment scheme (EIS) tax relief. But in 2012, the rules changed significantly in favour of private investors.

Firstly, regulation introduced in April 2012 doubled the annual allowable

EIS investment per investor – from £500,000 to £1m – while at the same time increasing the amount of funds an EIS qualifying company could raise in a year from £2m to £5m.

The size limit of an EIS qualifying company’s balance sheet and employee numbers were also increased. A whole new class of larger, more mature businesses suddenly came within the scope of EIS investment – and a prime hunting ground for those is AIM.

The second key change was announced on publication of the 2013 Finance Bill. A general rule had previously been proposed to cap the amount of income tax relief that a taxpayer could receive (from the 2013/14 tax year onwards), which threatened to severely limit relief on losses on EIS investments. But the Finance Bill announced a carve-out for shares in EIS qualifying businesses.

The significance of these two developments is profound and independent advisers can no longer afford to ignore what this means for their clients.

But before discussing that further, it’s worth making two more important observations.

The first is about AIM itself. According to London Stock Exchange data, the average bid premium – the extra a bidder is prepared to pay over the market price before the bid is announced – in the 10 months between January and October 2012 (for companies trading in EIS qualifying sectors) was 47 per cent.

This compares, for example, to a historical range for main market equities of 10-20 per cent and clearly points to outstanding value opportunities on AIM.

The second important observation relates to how powerfully EIS reliefs can affect the performance of a portfolio.

This can be seen in the table (right) which shows what happens in three hypothetical portfolios containing just two shares each. In ‘scenario A’ both shares double in value; in ‘scenario B’ one share doubles and one loses 100 per cent of its value; and in ‘scenario C’ both shares lose all their value. In each case, an EIS fund dramatically outperforms a fund with no relief. All three scenarios are looked at in the context of both EIS qualifying and non-EIS qualifying investments. The difference in outcomes is striking.

The lowest row in the table shows the percentage returns on net investment – 100p in a non-EIS fund, and 70p (100p less 30p tax relief) in an EIS fund. In ‘scenario A’ (both shares double), the return on net investment is 186 per cent (because there is no CGT), compared with just 82 per cent in a non-EIS fund.

In ‘scenario B’, where one share doubles and one loses all its value, the return is 68 per cent in an EIS fund, compared with zero in the non-EIS fund.

Finally, in ‘scenario C’, where both shares fall to zero, and investor’s loss is limited to only half of the net 70p outlay, compared with 72 per cent of their net outlay in a non-EIS fund.

This suggests that an EIS portfolio of AIM quoted investments could play an important role within a balanced portfolio seeking performance that might not be found from traditional asset classes, while limiting potential losses through EIS loss relief.

Of course, it’s important to keep in mind that EIS investments may not be suitable for all investors. On paper they should appeal across a broad spectrum of individuals, they’re not mass-market products. Ideally, they’re intended for wealthy investors who have already used their annual ISA and pension allowances, and who are willing to accept the risks involved. EIS funds should form part of a balanced portfolio, typically not making up more than 5 or 10 per cent of investments held.

In the expanding sphere of alternative investments, EIS investment activity will grow significantly in the next three years, from roughly between £700-£800m in 2010-11 to as much as £2.5bn by 2014-15. And on that stage, AIM is set to play an ever more important role. That means that for some independent advisers to remain relevant, they are going to have to rethink AIM all over again.

Brett Williams is managing partner at Old Burlington Investments