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  • Employee Ownership Trust

    28 February 2022

    Zeeshan Khilji

    Following legislation introduced in September 2014 (FA 2014, s 290 and Sch 37) to promote employee-owned corporate structures, the concept of an employee ownership trust (EOT) was born.

    This employee ownership trust model provides entrepreneurs with an alternative exit route and an opportunity for succession planning which involves transferring control of the business for the long-term benefit of employees in a tax-efficient manner. The former owners receive value for the shares they transfer, normally with an element of deferred consideration, while preserving the independence of the business after their departure. This can protect the employees who helped build the business from some of the challenges that so often follow a change of ownership.

    This type of exit may not suit business owners looking for a quick sale to an external investor in exchange for consideration payable on completion or shortly after the disposal date; rather, it is aimed at entrepreneurs who want the business they created to remain independent and are content to be patient in realising the full value of their shares on an exit.

    As well as preserving the internal culture and independence of the company, the sale of an eligible business to an Employee Ownership Trust can achieve significant tax benefits for the vendor shareholders, as explained below.

    Advantages of a sale to an Employee Ownership Trusts

    Although not a requirement, an independent valuation undertaken before the sale will allow the owners to demonstrate that the sale is at full market value. It allows the employees to become participators in the future profits and growth of the business without having to use their own funds and therefore eliminates typical succession issues such as finding the right buyer for the business. With a captive sale process, the transaction could also result in lower professional fees and less time consumed by the parties involved because the sale of the company to a trust for the benefit of its own employees is more likely to complete.

    From a tax perspective, assuming that the necessary qualifying conditions (see below) are met, no capital gains would be realised by the vendor shareholder(s) on the sale of their shares, which would take place on a ‘no gain, no loss’ basis for capital gains tax purposes. Without this benefit, each respective disposal of shares would probably have been subject to the lower rates of 10% on the first £1m of the gain realised on the transaction (assuming that business asset disposal relief (BADR) is available), with the excess gain being subject to the standard 20% rate. In light of the recent reduction in the lifetime allowance for BADR purposes, and considering the recent speculation that the capital gains tax rates may be increased I would expect that the capital gains tax benefits will make this exit route even more important and valuable.

    Because the Employee Ownership Trust needs to acquire a controlling (in other words 50.1% or more) interest in the business, not all of a company’s owners need to dispose of their ownership to the Employee Ownership Trust. Shareholders who wish to retain minority shareholdings can choose to do so. Note, however, that if a minority stake is retained a subsequent disposal of that retained shareholding to the EOT in a later tax year would not qualify for the Employee Ownership Trust exemption and would be subject to the standard rates of capital gains tax described above.

    Following the disposal, the original owners who also held directorship positions in the business could retain these roles and continue to be appropriately remunerated.

    Once a company is under the control of an Employee Ownership Trust, it can pay bonuses to eligible employees of up to £3,600 a year, which would be exempt from income tax but subject to the standard National Insurance contributions regime. To qualify for the above income tax saving, all eligible employees must receive the bonus on a ‘same terms’ basis, although the amount received can be determined by reference to one or more permitted differentiation factors (such as remuneration level, length of service or hours worked) as long as each factor is applied separately and all eligible employees receive at least some bonus.

    Because this form of remuneration is a cash bonus rather than a dividend, the company does not need to have distributable reserves in advance of making these payments. There is no obligation to pay the bonus and the selling shareholders may wish to ensure that they are paid consideration for their vendor loan notes (VLNs) before such bonuses are paid out. Ultimately, this is a commercial decision that needs to be agreed by the various parties.However, to achieve the above benefits and tax savings the transaction must be structured correctly ensuring that the qualifying conditions are met, as explained in the Employee Ownership Trust (EOT) sale diagram and the sections below.

    How does a sale to an Employee Ownership Trust work?

    The diagram above represents the typical structure of a transfer of shares to an EOT where the consideration payable remains outstanding at the completion date, being settled over time from future profits generated by the company once it is under the EOT’s control.

    The outline of expected transaction steps is as follows:

    1) A qualifying EOT (as explained below) is established.

    2) The EOT acquires more than 50% of the current issued share capital from the existing shareholders in exchange for consideration which typically will be a mixture of excess cash on the company’s balance sheet, third-party debt and vendor loan notes.

    3) Assuming that the company remains profitable following the transaction, the business will typically use some or all of these profits to fund the EOT which in turn will use these funds to repay the outstanding debt to the shareholder(s).

    Note that there are different commercial and tax implications depending upon whether the company gifts or lends, or a bank lends, the necessary funds to the EOT.

    Qualifying Conditions

    The following key requirements must all be met for the commercial and tax benefits described above to be achieved:

    • trading requirement;
    • equality requirement;
    • controlling interest requirement; and
    • limited participation requirement.

    Trading requirement

    The company whose shares are subject to the disposal transaction needs to be a trading business or, the holding company of a trading group. A ‘trading company’ means a company carrying on trading activities which do not include to a ‘substantial extent’ activities other than trading activities (e.g. holding and making investments).

    Equality requirement

    The equality requirement is also called the ‘all-employee benefit requirement’. This means that all employees must be entitled to be beneficiaries of the EOT, subject to a qualifying period of employment of up to one year. The application of any settled property from the EOT must be provided on the same terms to all beneficiaries of the trust. However, the actual amounts received can be determined by reference to one or more permitted differentiation factors (in other words, remuneration, length of service and hours worked) as long as each factor is applied separately and all beneficiaries receive at least something.

    Specific individuals are excluded from the class of beneficiaries. These are, namely, anyone who is, or has in the previous ten years, held or been entitled to acquire 5% or more of any class of shares in the company and who would, on a winding-up, be entitled to 5% or more of the assets on a winding-up, or any person connected with them.

    Controlling interest requirement

    Before the tax year in which the EOT acquires the shares, it must not hold a controlling interest in the company.

    The EOT must acquire a controlling interest in the company and, once it has acquired this, must continue to hold it throughout the remainder of the tax year.

    The EOT will hold a controlling interest if:

    • the trustees hold more than 50% of the ordinary share capital and more than 50% of the voting rights;
    • the trustees are entitled to more than 50% of the profits available for equity holders of the company;
    • the trustees would be entitled on a winding up to more than 50% of the profits available for distribution; and
    • there are no provisions in any agreement and the like which could cause the above conditions to cease to be met without the consent of the trustee.

    The controlling interest needs to be retained by the EOT on an ongoing basis to avoid a disqualifying event from arising, as described below. Therefore, any arrangements which could possibly dilute the EOT’s shareholding (such as share options being granted) should be reviewed carefully to ensure ongoing compliance.

    Limited participation requirement

    For a time both before and after the sale to the EOT, the number of individuals who are both participators in the company (other than participators who do not hold, or are not entitled to hold, 5% or more of any class of share in the company and on a winding up are not entitled to 5% or more of the assets of the company) and employees or office holders of the company (plus the number of people who are employees or office holders who are connected with them) must not exceed 40% of the total number of the company’s, or respectively the group’s, employees. This is intended to prevent very closely held companies from benefiting from the EOT tax reliefs, but this can also catch out companies with multiple share classes because the 5% participation is measured on a share class by share class basis rather than relative to the overall enterprise.

    Tax considerations

    The capital gains tax relief can only be claimed for one tax year and is not available if the relief has been claimed for the company, or a company in the same group, in a previous tax year by the same taxpayer or persons connected with them.

    Some of the key tax considerations that the involved parties would need to consider, both at the point of sale as well as on an ongoing basis following the disposal, are discussed below. 

    These are:

    • disqualifying events;
    • sale of shares at more than market value;
    • transaction in securities rules;
    • share incentive arrangements; and
    • inheritance tax.

    Disqualifying events

    Following the completion of the sale of shares to the EOT, it important to ensure that a disqualifying event (such as a breach in any of the qualifying conditions as described in the section above) does not occur in either of the first tax year following the end of the tax year in which the disposal transaction occurs or in any of the subsequent tax years.

    Should the EOT cease to meet any of the qualifying conditions described above before the end of the first tax year following the end of the tax year in which the disposal to the trust occurs, then the capital gains tax treatment available on the original disposal of the shares will be withdrawn with a capital gains tax liability arising to the initial vendors.

    For example, if the disposal to the EOT occurs in 2021-22, the vendors’ capital gains tax relief will be withdrawn if there is a disqualifying event on or before 5 April 2023.

    On the other hand, if the disqualifying event occurs in any of the subsequent tax years (in the above example, on or after 6 April 2023), there will be a deemed disposal and reacquisition of all the shares held by the EOT which could trigger a dry capital tax charge on the trustees, assuming that the trust is resident in the UK for tax purposes. As the EOT will have inherited the vendors’ original base cost, the trust will be subject to capital gains tax on the full amount of the growth in value of the shares since they were originally acquired by the vendors.

    Sale of shares in excess of market value

    Careful thought should be given when determining the consideration value at which the shares in the company will exchange hands.

    If the original shareholders and the trustees of the EOT agree a price for the shares which exceeds their market value, it is likely that the excess proceeds will be subject to income tax at a rate of up to 45%, assuming that the original shares in the company were employment related securities. It is therefore advisable that an independent tax valuation is obtained to evidence the market value of the shares.

    Transaction in securities 

    Further, when the transfer of the shares to the EOT takes place, it is also important to consider whether the transaction will be caught by the transactions in securities legislation. This is particularly important in cases where the company whose shares are being transferred also provides the funding which the EOT then uses to pay the consideration due to the vendor shareholders.

    Control

    Following the takeover of the company by the EOT, the company can continue to incentivise key management through bonuses and discretionary share option schemes and may also operate all-employee incentive arrangements. However, care will need to be taken to ensure that any share incentive arrangements do not dilute the EOT in such a way that ceases to meet the controlling interest requirement.

    In practice, this means that shares that will be the subject of an employee share incentive plan will be newly issued shares or, if issuing new shares would result in the EOT’s shareholding being diluted below 51%, be sourced from the remaining minority shareholders (assuming that the EOT does not have full ownership of the company), rather than being sourced from the EOT’s holding.

    Specific provisions in the tax legislation provide that companies controlled by an EOT can offer tax advantaged share plans to their employees. These might be enterprise management incentives (EMI), company share option plans (CSOP), share incentive plans (SIPs) and save-as-you-earn (SAYE) as long as the other qualifying conditions for such plans are satisfied.

    Inheritance tax

    As part of the transaction, it is likely that the vendor shareholder(s) will exchange shares in the company that are probably exempt from inheritance tax (assuming that business property relief is available) for a mixture of cash and/or vendor loan notes which would be chargeable assets from an inheritance tax perspective. Consideration should also be given by each vendor shareholder to the potential inheritance tax consequences arising on the transaction.

    Commercial and practical considerations

    Particular attention also needs to be given to various practical and commercial considerations at both the implementation stage and the running stage of the EOT-backed structure – in particular, corporate governance and cashflow modelling.

    Corporate governance considerations

    Having decided that the disposal of the shares to an EOT is a viable route forward because of the wider commercial and business benefits, various corporate governance matters must be addressed at the implementation stage. These include the nature and composition of the board of trustees of the EOT, the extent to which the employees should have any input with regards to the key commercial and executive decisions and the mechanism of doing so and such like.

    Because the consideration due to the vendor shareholders will, at least partly, be likely to remain outstanding at the date of sale in the form of vendor loan notes, consideration also needs to be given to the composition of the board of directors as well as the nature and extent of any vendor loan note holder and minority shareholder safeguards, particularly on issues for which the consent of the various parties is required. Consideration of these factors is important to safeguard both the repayment of the outstanding proceeds to the outgoing shareholders as well as to achieve an appropriate balance with regards to the interests of the various stakeholders involved in the structure following the sale, such as trustees, employees, vendor loan holders and any remaining minority shareholders.

    Cashflow modelling

    The expected cashflows should be modelled carefully and prudently to ensure that the structure can meet its goals of building value for the benefit of the employees, while ensuring that the company has enough funding capacity to repay any outstanding consideration and potential interest due to the outgoing shareholders.

    Conclusion

    Many advisers are ‘encouraging’ businesses towards implementing employee ownership trusts (EOTs). I have no problem with their use for their intended purpose of spreading ownership among a large group of employees, but not where EOTs are being promoted as a profit extraction scheme for owners. 

    In order to decide If the EOT is a viable option one must consider all relevant factors. It is vital that adequate consideration is given the commercial operation of the business going forward and is not purely driven by the tax savings generated as a result of the transaction. This point is particularly important considering that the selling shareholders could, in any event, also qualify for other capital gains tax reliefs such as business asset disposal relief and because unwinding an EOT-backed structure can be complex and expensive.

    As with all tax planning, there is no substitute for taking professional advice tailored to specific personal and business circumstances. Get in touch today to discuss your options.