Employee Ownership TrustsDownload PDF version
In 2014 the Government introduced new tax laws designed to encourage employee ownership of businesses in order to stimulate growth by aligning the interests of employees with founders.
Typically, upon a disposal of shares in a trading company, the owner will pay capital gains tax (“CGT”) at a rate of 20% or 10% if they qualify for Entrepreneurs’ Relief. However, you can now sell some, or all, of your shares to an employee ownership trust (“EOT”) (subject to satisfying certain conditions) for full market value without incurring any capital gains tax liability in a way which also benefits your employees. The primary requirement for the relief is that a controlling stake (or more) in a trading company is offered to all employees.
This statutory relief has been somewhat overlooked for several years but has recently come into more focus as many business owners look to retain talent and realise value.
How does it work?
Shareholders sell a controlling stake in a trading company to an EOT. The consideration due to shareholders is partly funded by cash reserves of the trading company which are contributed to the EOT and/or bank borrowing. The remaining consideration may be left outstanding to be settled using future profits of the trading company or proceeds realised upon a future disposal. Interest may be charged on the vendor loan notes to incentivise their quick settlement by the trustees of the EOT.
The gain realised by shareholders will be exempt from CGT, provided certain conditions are met.
To further incentivise, companies controlled by EOTs are also able to award annual bonuses of up to £3,600 which will be exempt from income tax.
What are the qualifying conditions?
There are a number of conditions that need to be met before and after the sale to the EOT, including:
- The shares being sold to the EOT must be of a trading company or the principal company of a trading group (Trading Requirement).
- The trustee of the EOT must restrict the application of any settled property for the benefit of all eligible employees on the “same terms” (All Employee Benefit Requirement).
- A controlling interest (more than 50%) in the company must be transferred to, and maintained by, the EOT (Controlling Interest Requirement).
- The settled property of the EOT must be applied for the benefit of all “eligible employees” and this must be explicitly stated in the trust deed (Equality Requirement). However, it is possible to differentiate between employees on the basis of remuneration, length of service and hours worked.
- The number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% of the total number of employees of the company or group (Limited Participation Requirement).
The legislation sets out specific disqualifying events which include breaching any of the above conditions.
Depending on the timing of the disqualifying event, it can result in a withdrawal of the CGT exemption for shareholders or the deemed disposal of the shares in the trading company by the EOT. It is therefore important that certain restrictions are built into the sale to protect the seller’s position.
- A sale to an EOT can be beneficial where a management buy-out is being considered but perhaps management are not ready or are yet to be identified.
- The sale to the EOT allows shareholders to have certainty in the meantime and realise current value. The shareholder can stay fully involved with the business, allowing them to retain control over the timing and nature of the succession of the business, and continue to receive market-competitive remuneration packages.
- The transaction should not cause any disruption to the day to day running of the business and should allow for lower professional fees than in a typical third-party deal.
- The EOT will be a passive investor, with the decision-making power remaining with the board of the trading company. An “Operation Agreement” should be put in place to clearly define the roles and responsibilities of the trustees, original shareholders and the board.
- In some instances, shareholders may be wary of selling a significant stake in the business for fear of missing out on future value. This risk may be mitigated by structuring the terms of the sale to include an earn-out element, although care needs to be taken with regards its terms from a tax perspective.
The rules governing EOTs are complex and shareholders considering selling their interest to an EOT should be aware of the advantages and disadvantages. For help and advice please contact Richard Perry on [email protected].
This paper is intended to be a brief note for clients and other interested parties. The information is believed to be correct at the date of publication but should not be relied upon as a substitute for professional advice. Please speak to a member of our team.