Employee Ownership Trusts

Tax Bite - Employee Ownership Trusts

The Employee Ownership Trust (“EOT”) legislation was introduced in 2014. Since the news of a possible rise in CGT rates at some point in the relatively near future, more business owners have been looking to achieve an exit and as a result EOTs are currently on a lot of people’s radars.

As a headline, the CGT relief afforded to shareholders is hard to ignore – a complete exemption from CGT on the sale of a controlling interest in a company to the trustees of an EOT. Despite this, we often find that clients who are interested in hearing about an EOT sale as a possibility for their company ultimately don’t proceed with it once the full tax, legal and practical picture is properly understood.

A sale to an EOT may be more straightforward than a third party trade or private equity sale in some respects (e.g. due diligence), but does come with its own complexities. There are a number of detailed requirements in the EOT tax legislation itself, but also a number of wider tax and legal risks and considerations.

For owners who are looking to make a complete exit and pass the business on to the employees, it should be possible to fit not only within all the technical requirements of the EOT tax relief legislation but also within the wider legal and practical implications of moving to employee trust ownership. Even then, however, shareholders selling to an EOT take on certain risks, such as the risk of clawback of the CGT relief if certain disqualifying events occur after the sale, and typically the risk of business failure - EOT transactions are ultimately funded through the business and so typically with a significant amount of deferred consideration, which depends on the ability of the business to fund it.

The tax and other risks are even more significant where only, say, a 51% shareholding is being transferred to an EOT, particularly if an onward sale of 100% to a third party is the ultimate goal. In those sorts of cases, as well as all the usual EOT considerations, a number of other issues require careful consideration, including for example:

• The risk of HMRC attacking the deal under the transactions in securities legislation, turning what the client expected to be 0% CGT into (up to) 38.1% income tax. Advance clearance can be sought from HMRC on this point, but all relevant facts need to be fully disclosed and there will be a material a risk of clearance being denied if the transaction is perceived to be motivated by extracting cash tax-free rather than being a commercially-motivated decision to move to genuine employee-ownership;

• The employment-related securities income tax legislation, particularly the “sale at an overvalue” rules, bearing in mind that a 51% shareholding may very well not, for tax purposes, have a market value equal to 51% of the whole company valuation. Any excess paid over market value would be taxable at income tax rates (up to 45% with national insurance too); and

• Whether the EOT trustees would, legally, be acting in accordance with their obligations to benefit and protect the employees (excluding the owner) in agreeing to on onward sale particularly if the bulk of the consideration would be needed to fund the deferred consideration owing to the former controlling shareholders. Note also that where a sale to an EOT qualifies for CGT exemption for the seller, it is a “nil gain nil loss” transaction meaning the EOT trustees inherit the seller’s original base cost and so suffer the tax on the “day one” gain as well as any future gain in value of the shares on a later sale. Depending on the facts it could quite easily be the case that all of the proceeds are swallowed up in paying the deferred consideration and the tax bill with nothing at all left to benefit employees.

For any seller contemplating an exit, a sale to an EOT is certainly worthy of consideration and should always be on the menu of options. However it must be appreciated that it is a hugely significant strategic decision for the business and must be the right cultural fit, and if the main driver is simply looking to achieve a tax-free sale, an EOT is unlikely to be appropriate.

If you have clients who are interested in finding out more about the requirements and implications of an EOT sale, please do get in contact.

Posted on 31/01/2022 in Tax News


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