Setting up an Employee Benefit Trust

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Our client

Our client was a mobile virtual network operator (MVNO) with an IoT platform from which customers are able to deploy, manage and scale IoT applications. It wanted to let its employees know that funds had been earmarked for them which would be paid out if when the company was sold. The question was – how do they go about formalising that? We answered the question by setting up an employee benefit trust (EBT) to hold shares which would be turned into cash on sale for the employees.

Background

The company had more than 20 years of experience in IoT connectivity. It was committed to 100% employee satisfaction. Its directors had engaged in conversations with employees over several months as part of a process to bring about cultural and organisational change across the company. The objective of the process was to facilitate further engagement by employees in the business by providing them with a tangible stake in it so that they might feel more engaged in their contribution and their link to the company would become more tangible.

So it was decided that employees with over nine months’ service and who remained employed by the company at the time of the sale of the business should benefit from the proceeds of sale depending on their length of service and seniority.

Ethos

Since the company was multinational with a large number of eligible employees in many different jurisdictions, the problem with granting share options was ascertaining the types of arrangements that can be operated in those different jurisdictions. There may be legal and/or tax reasons why arrangements need to be adopted in a particular way. Finding out about and implementing share option plans would have been costly and time consuming.

An EBT on the other hand was a useful and more cost efficient vehicle for coping with incentivising overseas employees, providing a neutral basis for dealing with employees both in the UK and around the world and also making it easier to deal with employees that move from one jurisdiction to another.

To further its ethos and objectives our client decided to establish an EBT which would acquire approximately 15% of the company’s total issued share capital from its two founder members for a sum considered to be the market value of the shares by reference to recent sales of shares by departing employees.

These shares would then be held be the trustee of the EBT. When the company is sold, the proceeds of sale of the shares held by the trustee will be paid to the discretionary beneficiaries of the EBT – namely the eligible employees.

Selecting the Trustee for the EBT

Often a significant factor in choosing where to establish an EBT is the fact that a UK-resident EBT is within the scope of UK capital gains tax (CGT). It will be subject to CGT on all trust fund gains and since that the trustee would have to pay the tax liability the employee would get a smaller profit.

A non-UK resident EBT is outside the scope of UK CGT altogether.

Benefits received by employees from the trust are generally taxed as employment income. Our client chose to use a professional trustee company located in Jersey with whom we liaised at all times to set up the trust.

Funding the EBT – loan or gift?

Loan

A loan by the company to the trustee was considered. However, since our client as the settlor of the trust was a “close” company (many private companies are close companies) tax implications had to be considered.
Where a close company makes a loan to an EBT that already holds shares in the company, or the EBT intends to acquire shares with the loan, a corporation tax charge of 32.5% may arise on the value of the loan under section 455 of the Corporation Tax Act 2010.
These are anti-avoidance provisions that broadly apply where a close company lends money to a participator or enters into a similar debtor-creditor arrangement – the “loans to participators” rules.

The mischief that the loans to participators rules are aimed at is where a participator in a close company attempts to extract profit from the company without paying the income tax that would have been due if the company had distributed that profit in the form of a dividend.

Where the rules apply, the company is liable to pay a corporation tax charge nine months and one day after the end of the accounting period in which the loan is made, unless the loan is repaid before that time ( section 455 CTA 2010). The corporation tax charge is refundable, and will be repaid by HMRC nine months and one day after the end of the accounting period in which the loan is repaid or written off. If it is written off, the participator is treated as having received a dividend of the amount written off for tax purposes.

There are certain exclusions but none of these apply to EBTs.

Gift

It was decided that the EBT would be funded by a gift from the company under the terms of a contribution agreement.

Documents to establish and fund the EBT

Trust Deed

By this document the company creates (or “settles”) the EBT and appoints the trustee company.

An EBT and the company that creates it are two separate legal entities; this means that once the company has transferred property into the trust, it will be run by trustees who have ultimate control over trust property. It is the job of the trustees to distribute the trust, although they will often be guided by recommendations from the company as to how they should do so.

Many provisions of an EBT trust deed are fairly standard but some provisions may need to be amended or added to reflect what the EBT will be used for, including the scope of the class of beneficiaries.

Operating Agreement

An operating agreement will be necessary where certain practical matters must be agreed with the trustee, such as which share plan awards the EBT will be asked to satisfy and how the EBT will be put in funds to meet any obligations it assumes.

This agreement will:

  • Set out the terms on which the trustee agrees to satisfy existing and/or future awards under a company’s employee benefit scheme or schemes using shares held in the EBT.
  • Safeguard the ability of the company and the trustee to deliver shares to employees on the exercise or vesting of share awards.
  • Set out the procedure to ensure that the trustee can deliver shares at the relevant time.

Our client’s EBT would be holding all shares transferred to it until sold to a buyer of the company after which the sale proceeds received by the trustee would be paid out to the discretionary beneficiaries (employees).

Since the trustee would not be transferring shares to employees to satisfy awards and would not be acquiring shares from departing employees, an Operating Agreement was considered not to be required. Instead, Letters of Recommendation (below) were considered sufficient to achieve our client’s objectives.

Share Purchase agreement

A Share Purchase Agreement was required to document the agreement by the founders to sell shares to the trustee and the trustee’s obligation to pat, contingent on receiving the contribution by way of gift from the company under the Contribution Agreement.

Contribution agreement

Since EBT was to be funded by a gift from the company, a simple contribution agreement was drafted setting out the terms on which the contribution was to be made.

Letters of Recommendation

A letter of recommendation was sent to the trustee detailing the objective of our client’s cultural and organisational change and the objective that employees with over nine months’ service and who are employed by the company at the time of a sale of the business should benefit from proceeds of sale of the business depending on their length of service and seniority, and stating that the EBT was being established to achieve this.

When the company eventually wants the trustee to consider exercising its discretion in a certain way (by transferring proceeds of sale of shares to particular employees) it will send a further letter of recommendation to the trustee setting out how it would like the trustee to act, and inviting the trustee to exercise its discretion under the trust deed to do so.

Board minutes

Board minutes to set up the EBT were prepared, approving the trustee’s terms of business including the trustee’s fees and what services are included in these fees, and approving the trust deed, the letter of recommendation and the transfer of shares.

Shareholder approval

Shareholder approval for setting up the EBT and transferring the shares to the trustee was not required under our client’s articles of association or shareholders’ agreement. However, consistent with the company’s ethos and objectives of facilitating further engagement by employees and aligning the interests of employees with those of shareholders, shareholders were consulted in any event and shareholder consent was obtained for the provision of funds to the EBT by the company by way of gift.

Notification to HMRC

HMRC do have to be notified of the creation of the EBT and we took care of the formalities.

We are specialist commercial solicitors who can also handle the tax aspects for you. We run transactions and understand how the process fits together. . Please do give us a call on 0207 438 1060 to discuss.