By Mary Tierney BSC ARCS ACA CTA Tax Director
HMRC open consultation : Taxation of Employee Ownership Trusts and Employee Benefit Trusts Taxation of Employee Ownership Trusts and Employee Benefit Trusts – GOV.UK (www.gov.uk)
Background
EOTs were introduced to encourage employee ownership of the businesses they work in and enables indirect ownership of the company where shares are held collectively by a trust on behalf of the employees. Wider employee ownership is seen as desirable based on evidence that employee-owned companies perform better, are more resilient and open to change, and have more committed and engaged employees.
Whilst introduced in 2014, it is only in the last couple of years that EOTs have really gained traction and are now a popular and widely accepted option for owners looking to exit their business in a way that preserves it for the existing workforce.
The consultation of 18 July considers certain targeted reform to ensure the tax reliefs granted by Employee Ownership Trusts (“EOTs”) are in line with government policy and will run for 10 weeks from 18 July 2023 to 25 September 2023.
Whilst this is a consultation – and there is a long way to go before the responses are collated and proposals for changes in legislation are made, the two most important take-aways from the consultation in our view are:
- EOTs are here to stay – under the existing government at least and
- The key point discussed below for existing EOTS to think about is the structure of the board of the EOT company
What is an EOT
An EOT is a trust where the trustees are bound by the terms of the trust to apply their control of the company for the benefit of all the employees of the company.
For a company operating under an EOT structure, the company is owned and controlled not by individual shareholders, but by the trustees of the EOT.
Providing a number of detailed provisions are met, the exiting shareholder may benefit from a 100% capital gains relief on the disposal of their shares as long as the trustees obtain a controlling shareholding as a result of that disposal, and this is a tax benefit that is clearly attractive to exiting shareholders.
The consultation
The purpose of this summary is not to go through the conditions, rules and benefits arising from ownership by an EOT – but rather to highlight to points raised in the consultation and what that might mean to companies who are currently, or who are considering ownership within an EOT structure.
The trust and the trustees
Typically, the exiting shareholder is relying on the future performance of the company to fund an element, and often a substantial element, of the payment for their shares, and so is reluctant to entirely relinquish involvement in the company. They also have years of valuable experience and expertise that it still needed by the company. As such they are often appointed as one of the directors of the company that acts as the trustee of the EOT.
At present there are no legislative restrictions regarding trustee appointments, and whilst it is not something we have encouraged where we have been involved in EOTs, to date, it has been possible for the former owners to be the sole director of the company which acts as the trustee of the EOT.
The proposal in the consultation is therefore that former owners (or those connected with them) should form less than half of the board of the trustee company – in other words if there is one former owner who is to be a director of the trustee company, they will need two unconnected directors of this trustee company -either employees of the trading company or a suitable professional to act alongside them. If this condition is not met, the EOT will fail and an immediate tax charge would arise. One of the consultation questions also considers whether it should be a requirement that the board of the EOT company includes employees of the trading company.
As this is a consultation we do not know if this will become legislated or when it would take effect, but we would suggest that any existing EOT considers, if it does not already comply with this condition, whether and who appropriate additional directors of the trustee company could be.
Residence of the EOT
This provision is unsurprising. At present an EOT established offshore will pay no capital gains tax on the sale of the company shares whereas a UK resident EOT would pay capital gains tax if the underlying company shares are sold.
The proposal is not that offshore trustees will be banned, but that the majority of the trustees should be UK residents which will ensure that capital gains arising on any eventual sale of shares remains within the UK tax net.
How a transition for an EOT that has been set up with offshore trustees is to be managed is not commented on in the consultation document.
Contributions from the company to the EOT
The proposal here confirms a point derived from a weakness in the original legislation.
It is common that the EOT is funded out of distributions of profits paid by the trading company to the EOT, both at the time of the disposal and to fund deferred consideration and interest.
Logic dictated that the contribution to the EOT should not be taxed as a dividend, otherwise any tax benefit of an EOT would be lost, and the understanding was that these contributions to the EOT would be neither deductible in the underlying trading company or taxable in the EOT. The legislation around this was unclear however, and so this resulted in the need, in each case to write to HMRC to obtain a non statutory clearance that the contributions to EOTS would not be taxed as dividends, a clearance that was inevitably given.
Sensibly therefore, this position is to be confirmed in legislation. Similarly HMRC has also confirmed that they propose to cease giving clearances around a specific targeted anti-avoidance rule that could treat a contribution to an EOT as a loan resulting in a corporation tax charge on the basis that if there is no tax avoidance purpose, this anti- avoidance legislation cannot apply.
The important point that is made in the consultation is that the consideration paid by the trustees for the shares must not exceed the open market value for the shares.
Tax Free Bonuses
One of the benefits of being owned by an EOT is the ability of the company to make tax free bonus payments to employees of up to £3,600 per year – and there are detailed rules around how these bonuses are allocated. Some difficulties arise due to the rules around directors and the ability to pay bonuses and bonus entitlement and so consideration is being given to enable tax free bonuses to be paid without having to include directors of companies within the group in this. We would welcome this as we have seen the existing rules causing practical issues when considering how to operate the tax-free bonus plans.
Conclusion
EOTs have been and continue to be an effective and useful tool when considering exit and succession planning. The consultation addresses some of the obvious and common issues that have arisen over the past 10 years, and many of these have been highlighted already by the professional accountancy and tax bodies. Experience shows that every EOT is different and there are practical and legislative hurdles to understand and overcome, but experience is also showing us that this form of indirect employee ownership is delivering an effective new model of ownership that does achieve the aims of the regime and engages the next generation of business managers and employees in a positive way.
If you have any questions about EOT’s please get in touch.
