They tried to bring private equity to heel and kicked AIM in the guts

Jon Mainwaring reports on the tax change that could deal a massive blow to companies and investors on the junior market

The Alternative Investment Market had already suffered some knocks before the Chancellor announced changes to the UK's capital gains tax (CGT) regime in his pre-Budget report earlier this month. But the measures, which will increase the tax on gains made from investing in many AIM shares by 80 per cent, could prove one of the most severe setbacks faced by London's junior market since it was founded 12 years ago.

AIM could have done without the new CGT rules – which come into effect next April – especially as it has already had a tough year. In January, John Thain, the head of the New York Stock Exchange (NYSE), criticised the market for a supposed lack of regulation. Then in March, Roel Campos, a commissioner at the US regulator, the Securities and Exchange Commission, was overheard likening AIM to a casino.

At the time, the London Stock Exchange (LSE) shrugged off these attacks as sour grapes, but it has since tightened some of its rules, issuing a new rulebook for nominated advisers – or "nomads", in AIM parlance. And it has taken the unprecedented step of fining a nomad for failing to make important checks before floating new companies on the market. Nabarro Wells was fined £250,000 after the LSE found "material breaches" of AIM rules in connection with five firms that the nomad advised.

Meanwhile, the LSE has commissioned an independent report from the London School of Economics, due in November, that will examine how the market has developed.

Another problem for AIM has been the fall in the number of flotations of new companies. During the nine months to end-September, only 217 new companies were admitted to AIM, raising £5.2bn – compared with 330 new admissions, raising £6.3bn, in the first nine months of 2006. The emergence of rival small-cap markets such as PLUS and the NYSE-backed Alternext explains at least some of this decline.

Additionally, surveys of institutional investors in AIM have shown dissatisfaction with share price performance after companies have floated on the market.

Despite these problems, the AIM All-Share index has performed respectably since the start of the year, growing by roughly 7.9 per cent compared with an improvement of 5.2 per cent in the FTSE 100 and 4.7 per cent in the FTSE All-Share.

This is a far cry from 2004-05, when the index doubled amid a rush of US and other international companies heading for the market. But AIM has continued to receive plenty of attention from small firms that would previously have floated elsewhere.

"AIM has really picked up the position of supporting growth companies from around the world," says Mike Tomasic, the chief executive officer of CambridgeSoft – a Massachusetts-based technology firm that announced its intention to join AIM this month.

But the news that the Government is to change the rules on business assets taper relief for tax on capital gains is a worrying development for the market

This form of relief for unquoted companies was introduced by the Government in April 1998 to encourage entrepreneurial-ism. Instead of paying 40 per cent tax on capital gains made from holdings in these businesses, investors pay only 10 per cent if they have held their stakes for more than two years. Because AIM companies, unlike their counterparts on the main LSE listing, are viewed as unquoted, most investors on the junior market benefit from the taper relief, and much of AIM's success since it was founded has been attributed to this favourable tax regime.

But the private equity industry has also been using business assets taperrelief to reduce the tax it pays on multi-billion-pound deals to just 10 per cent. The Government's move to an 18 per cent CGT rate was seen as a way to deal with this controversy.

The simplification of CGT has instead meant that investment professionals involved with AIM are now up in arms. John Pierce – the chief executive of the Quoted Companies Alliance, which represents smaller quoted firms, says that, during the private equity controversy in the summer, he was so "horrified" that taper relief might be sacrificed that he contacted the Government.

"It was quite clear that a political head of steam was building up. But the Government told us there wouldn't be a knee-jerk reaction," he says. "Now they've used a sledgehammer to crack a nut and even missed the nut."

This view is echoed by Graham Shore, the managing director of Shore Capital, which advises a number of AIM firms: "18 per cent is still less than the cleaner's rate of marginal tax."

The question now is how the changes to CGT taper relief will affect AIM in the run-up to April.

"Our view is that it is not a good step for the market," says Philip Secrett, a partner at Grant Thornton Corporate Finance and an AIM specialist. He accepts there has been a lot of speculation about whether there will be a run on AIM shares ahead of the deadline, but he says this depends on how much money is directed towards AIM for tax reasons. "No one can say what will happen for sure."

Mr Shore is more pessimistic. "If you've £40,000 in a particular AIM share that you'd bought for £20,000 [more than two years before], then you'd be a fool not to sell," he says. Even assuming such an investor used his entire £9,200 yearly capital gains allowance for this one transaction, selling his shares before the April deadline would save him around £900.

However, the LSE itself appears philosophical about the changes. It takes the view that the scrapping of CGT taper relief might have the unintended consequence of improving share liquidity on the market, at least in the short term, as directors will have less incentive to retain their shares. "One of the persistent criticisms of AIM is its lack of liquidity. But company founders may be tempted, before the tax change comes in, to offload more of their stakes," says an LSE spokesman.

The exchange intends to look at the issue over the next few weeks and give its feedback to the Government by the end of the year.

But given that the Government has already ignored the pleas of the Quoted Companies Alliance to leave taper relief for AIM firms alone, it seems unlikely there will be a U-turn in policy. Instead, Mr Pierce is hoping that some other concession can be gained for investors in the junior market – an exemption on stamp duty for trading in AIM shares, for instance.

However, AIM still looks like it is here to stay. As Mr Secrett at Grant Thornton says: "Companies on AIM and those on the main market are different. And not all investors make investment decisions based solely on tax considerations."