We are specialist, experienced lawyers who know our way around all the technical, practical, legal and tax considerations associated with Employee Ownership Trusts.
Employee Ownership Trusts (EOTs)
Employee ownership trusts (EOTs) were introduced in 2014 and offer business owners of trading companies an alternative to a trade sale or other third party exit. They also offer attractive tax benefits for business owners (who need not be the founders of the business).
If you are thinking about putting your business up for sale or succession planning, you should consider if employee ownership (EO), via an EOT, may offer you a different and tax efficient pathway. You should investigate if an EOT may be the right choice for your business and employees.
If you operate your business via a partnership structure it should be possible to take advantage of an EOT – by first incorporating your business (relying upon tax relief at that stage), with the shareholders of the new company selling shares to the EOT.
What is an EOT?
An EOT is a type of employee benefit trust established for all employees of the company.
It is the ‘vehicle’ used to acquire a controlling interest (of more than 50%) in a trading company from its business owners (the trustee must acquire a minimum of more than 50% of the ordinary share capital).
Legal requirements for an Employee Ownership Trust
There are a number of conditions to establish an EOT that will require careful consideration by business owners in consultation with their staff. These include:
- who to appoint as a trustee of the EOT; (typically, a UK resident company is used to avoid the risk of personal liability on individual trustees and for administrative reasons);
- the governance structure between the company and the trustee of an EOT;
- the market value of the controlling interest sold to the trustee; (which will require an independent valuation); and
- how the trustee will fund the purchase of a controlling interest; (typically, the majority of the purchase price will be left outstanding, as a loan owed to the business owners who are selling shares, which will be repaid over time out of the profits of the trading company (this is known as vendor loan financing).
Business owners have a fair degree of flexibility in structuring a move to Employee Ownership under an EOT. For example, they could sell the minimum shareholding (of more than 50%), to meet the controlling interest requirement, and continue to retain a substantial minority interest. Alternatively, they could sell up to 100%. In the latter case this would represent a complete move to a 100% EO model.
In addition, EOTs may if they wish pay income tax-free bonuses of up to £3,600 per employee each year, although there is no exemption for national insurance contributions, if tax free bonuses are paid.
Tax on Employee Ownership Trust
A key advantage for business owners of selling to an EOT is tax. This is because if certain conditions are satisfied, the sale of a controlling interest in shares by the business owners to a qualifying EOT should be free of capital gains tax (CGT).
This would represent a significant tax saving, given that chargeable gains realised on shares sales are currently taxed at 20% (or, 10% on the first £1m of gains, if an individual is eligible for Business Asset Disposal Relief).
X and Y each held a 50% stake in a trading company (XYZ Limited) for many years. They jointly sold a 51% stake in tax year 2020/21 to the trustee of an EOT, retaining 49%.
The 51% stake was valued independently on sale at £4million. Subject to no disqualifying event occurring later (see Example (2) below), X and Y claimed CGT relief on the entire gain realised on sale of the 51% stake in tax year 2020/21. This resulted in a nil CGT liability on the sale of the 51% stake in XYZ Limited.
If CGT relief was not claimed and assuming their base cost was a nominal sum, X and Y would each have paid:
- CGT of £300,000 each (assuming Business Asset Disposal Relief (BADR) was available on the first £1 million of gains; and CGT at 20% paid on gains above £1 million), or
- CGT of £400,000 each if BADR was not available, (ignoring the tax-free allowance for CGT).
To take advantage of this generous tax relief does require compliance with certain conditions. In summary:
- if business owner(s) sell a controlling interest to an EOT during a tax year, and
- provided a disqualifying event (see below) has not occurred in the period expiring at the end of the tax year following the tax year in which the EOT acquires its controlling interest,
the business owners should be eligible for CGT relief.
(This should enable more than one business owner to sell shares during the tax year in which the EOT acquires a controlling interest, and benefit from CGT relief on their sale of shares.)
Tax clearance of an Employee Ownership Trust
A tax clearance should be sought by the company/selling shareholders in advance of sale to an EOT. This would be to ensure that HM Revenue & Customs would not counteract the CGT relief; and treat the business owners as receiving an income tax advantage by selling their shares to the EOT.
This clearance (relating to transactions in securities) should be applied for early in the process of transitioning to EOT status.
Stamp duty will be payable on the consideration payable for the shares. This will usually be an expense met by the trustee.
If a disqualifying event occurs in the tax year of the EOT’s acquisition of shares or the tax year following, the selling business owners would not be eligible to claim CGT relief (or relief would be ‘clawed back’ if the business owner had already claimed relief).
Disqualifying events encompass the company ceasing to be a trading company, or the EOT ceasing to meet the controlling interest requirement (see further below on change of control), or any of the other EOT conditions that the EOT is required to meet, including those relating to the all employee benefit and equality requirements.
If a disqualifying event occurs after the business owners received CGT relief (i.e. from the start of the second tax year after the EOT acquired its controlling interest), the trustee of the EOT (if it is UK resident) will be liable to CGT at the time of the disqualifying event.
In this event, CGT will be due on a deemed acquisition and disposal of the shares held by the EOT. This is calculated on the market value of the shares at the date of the disqualifying event less the base cost of the shares originally sold to the EOT by the former business owners.
Using the same facts in the Example above, the trustee of the EOT sells its 51% stake in XYZ Limited to a third party purchaser in tax year 2022/23 for £6 million. In this event (assuming no changes to CGT legislation), the following will apply:
The sale of a 51% stake is a change of control (see below) and a disqualifying event. With the sale occurring in the second tax year after the trustee of the EOT acquired its controlling interest, the trustee of the EOT (a UK resident trustee) will be subject to CGT on the sale of its 51% stake.
CGT will be due at the applicable rate in tax year 2022/23. This will be due on the £6 million received from the purchaser less the trustee’s inherited base cost (which was nominal).
Change of control – what happens if the company is sold to a third party?
If there is a sale of the company before the end of the tax year following the sale of shares by the business owners, the CGT that would otherwise have been due on sale by the business owners will come back into charge. In contrast if there is a sale after this period has expired, it will be the trustees of the EOT that will bear CGT on a disqualifying event.
For the business owners, it is expected that they would want to have some protection against CGT becoming payable in relation to their own sale of shares to the EOT. Equally, insofar the EOT’s acquisition was funded by vendor loan finance, the trustee’s cost of funding its own CGT would in turn limit their ability to fund the business owners’ outstanding deferred consideration.
Care would need to be exercised at both board and trustee level as to acceptance of a third party offer, aside from tax considerations (as above), including if a sale would be in the interests of the EOT beneficiaries.
Direct share incentives
While collectively the beneficiaries of the EOT (the employees) would, via the EOT, together beneficially own the EOT’s shares, it is nevertheless sensible to consider the award of direct share incentives to staff after an EOT is established.
Further, there is no bar on a company controlled by a corporate trustee of an EOT from granting options/awards under a tax advantaged arrangements (such as Enterprise Management Incentives or Company Share Option Plans). However, care would need to be taken if grants of discretionary awards were made to selective employees because that would breach the EOT equality requirement.
Selective options or awards
One alternative would be for the company to grant selective options or awards over new shares, always ensuring that any future share issues do not breach the controlling interest requirement. In addition the trustee would be expected to purchase shares acquired under such incentives from employees.
EOTs represent a distinct way to change a business’s ownership, but without the uncertainties inherent on a trade sale or other third party exit (where a new owner may want to quickly integrate the acquired business and staff into its own business and culture).
In fact business owners who sell to an EOT can (and often do want to) remain fully engaged in the business after transition to EO status. It is also widely viewed that businesses and their employees do collectively benefit from EO, in terms of engagement and performance.
Advice on setting up an EOT
We specialise in all types of employee incentives. Not only do we have yeras of legal experience, we are also experts on the tax aspects. We provide bespoke advice for both employers and employees, always focusing on your objectives and circumstances in a highly practical and cost effective way. Please do get in contact to discuss.
Manages to explain difficult concepts in easy to understand language. In tune with her clients.