Capital gains tax reform set to produce technical boost for AIM

Planned changes to UK Capital Gains Tax, conceived of as a populist response to criticism of the taxation of earnings by private equity executives, could actually result in a surprise technical boost to the Alternative Investment Market (AIM) in early 2008, according to Catherine Stanley, manager of the F&C UK Smaller Companies Fund.

Stanley explained that the UK Chancellor of the Exchequer, Alistair Darling, had previously announced plans in his pre-Budget Report to replace the current system of capital gains tax taper relief and indexation, which are designed to reduce the tax burden on the disposal of an asset the longer the period that it has been held, with a simplified flat rate of 18%.

However, these measures have drawn withering criticism from the business and investment community alike because the abolition of accelerated tapering relief on "business assets" will effectively mean that entrepreneurs and investors in private and AIM–listed companies, who currently may stand to pay as little as 10% tax on share disposals, stand to see a major tax hike.

"The Chancellor has probably been shell-shocked by the scale of the outcry to his reforms and has promised to return with final proposals within a matter of weeks," commented Stanley.

"The existing tax regime has been favourable to entrepreneurs and therefore is one among a number of factors that has made AIM, and the UK in general, a successful base for smaller companies," said Stanley.

"However, while the longer term impact on UK enterprise of these reforms may be less favourable, short term we believe that the introduction could provide a timely fillip to AIM."

Stanley points out that while it has widely been assumed that some owner-shareholders, as well as private investors, may seek to crystallise profits by selling shares ahead of the proposed 18% tax rate next April in order to benefit from the lower 10% rate currently in place, merger and acquisition activity among the larger, more liquid AIM stocks is set to rise in the first quarter of 2008.

"Our sense is that many companies see a short-term opportunity to do deals as entrepreneur-shareholders seek an exit while the tax rate is favourable. This boost in M& A activity, particularly at the larger end of AIM and among quality small cap stocks, should provide a welcome boost to the market," said Stanley.

"We also think that concerns about a wave of general company director selling into the market ahead of the end of the tax year are overdone. Turbulent markets mean that liquidity is currently pretty tight in small cap stocks and likely, in our view, to remain so for sometime yet. Company execs are rational people who will realise that the benefits of trying to publicly dump their stock in this market simply to take advantage of a lower tax rate are, at best, going to be marginal and potentially value destroying."

Stanley concluded that: "While expectations of some form of partial retreat by the Chancellor are growing, a wider run of challenging headlines in recent weeks means that a full-scale U-turn could present a real credibility problem. Mr. Darling is continuing to assert that simplification of CGT as 'the right choice', so some form of face-saving half-way fudge is most likely on the cards."