Employee ownership trusts: What companies need to know

Contributed by Helen Wood

Whilst employee-owned companies are not a new idea, the specific Employee Ownership Trust (EOT) legislation we have in the UK was brought in via  FA 2014  following the Cass Business School report and the Nuttall Review on employee ownership for the Department of Business, Innovation and Skills (BIS), under the then Conservative–Liberal Democrat coalition Government. It aimed to increase employee-owned businesses as a route to boosting productivity (  FA 2014, Sch. 37 ).

Models of employee ownership fall within one of three categories:

• direct – employees hold the share capital of the company;
• indirect – the business is held on behalf of the employees Pett on Employee-Ownership Trusts 1.3;
• hybrid – a combination of the above Pett on Employee-Ownership Trusts 1.4.

Businesses owned by EOTs fall under the indirect or hybrid approaches. The company is controlled by the EOT, which holds its stake in the company on behalf of the employees. In a hybrid model, some employees hold shares or are granted share options in the company so long as this does not prevent the EOT from retaining control.

Background

The EOT legislation brought in several tax advantages for EOT-owned companies, including a capital gains tax (CGT) exemption for the vendor shareholders, an inheritance tax (IHT) exemption for the transfer of value of the shares to the EOT, and an annual income tax exemption on bonuses to employees (  TCGA 1992, s. 236H–236U ,  IHTA 1984, s. 28A ,  ITEPA 2003, s. 312A–312I (Ch. 10A) ).

After a slow start, EOTs are now better understood and growing in popularity. Employee ownership of companies has grown 90% since the EOT legislation was introduced, mainly to the benefit of SMEs.

While the EOT legislation has been largely successful, there have been instances of perceived misuse. Some vendor shareholders have placed themselves in control of the trustee board, have no plans for increased employee participation or have not considered succession planning. Overseas trustees can be used. The Government is currently considering changes following the 2023 consultation.

What kind of companies consider EOT ownership?

EOTs are sector agnostic, but nevertheless, the structure has been more popular in certain types of business. The Employee Ownership Association (EOA) lists the top employee-owned sectors as professional services, manufacturing, construction, wholesale and retail trade, and information and communications.

Some companies are sold to EOTs following failure to find a trade buyer or private equity (PE) investment, while to others, a sale to employees is their preferred option. EOT ownership can protect jobs where a trade sale would otherwise involve headcount reduction. Typically, the sales proceeds are deferred over several years and paid out of future profits, so it is crucial to the business’s future success (and the vendors’ bank accounts) that the business is a profitable one with growth potential and that management succession has been thoroughly considered before the transaction.

The benefits of EOT ownership for the company

The vendor benefits, such as CGT-free proceeds and not needing to negotiate and compromise with a trade or PE buyer, are apparent but the benefits for the company, whilst more subtle, should be analysed on a case-by-case basis.

For a sale to an EOT to be successful for the business, the directors of the company must conclude that it is the right option for the business at that particular time, stage in its life cycle, within the prevailing market conditions for the sector, and within the wider economic climate.

Tax-free bonuses of up to £3,600 per employee per tax year (but not free of National Insurance contributions (NICs)) are attractive and may help with recruitment and retention. The company should balance the need to pay deferred consideration to the vendor shareholders with the desire to pay tax-free bonuses to employees during the period in which the vendors are still owed sales proceeds.

Where certain employees are critical to the business’s success or have been identified as future leaders, equity awards can be considered beyond their indirect holding as eligible employees. Under general principles, HMRC tax-advantaged share schemes (Company Share Option Plan, Enterprise Management Incentives, Save as you Earn, and Share Incentive Plan) would not be available for an EOT-owned company (where typically the trustee consists of a company) as the company would not be independent. However, the relevant legislation has been amended to allow companies ‘subject to an employee-ownership trust’ to be deemed independent, thus allowing them to access such schemes (  ITEPA 2003 Sch. 2, para. 27(3)–27(6) ,  Sch. 3, para. 19(1)(ba) ,  Sch. 5, para. 17(1)(ba) ,  Sch. 5, para. 9(5)).

Conditions

Trading company

A company whose shares are sold to the EOT must be a trading company, or the parent company of a trading group, at the time of the share sale and for the rest of the tax year (  TCGA 1992, s. 236I ).

As with several other trading tests (such as EMI (  ITEPA 2003, Sch. 5, para. 13–23 )), a trading company is one whose activities are commercial with a view to making a profit and with no substantial non-trading activities. 20% can be used as a rough test to judge ‘substantial’ ( Pett on Employee-Ownership Trusts 2.8).

Controlling interest

The trustees of the EOT cannot have control of the company at the start of the tax year, but by the end of the tax year, they must have obtained more than 50% of the ordinary share capital of the company, have voting control, rights to more than 50% of the profits and assets on a winding up, and no arrangements in place where they could lose that control (  TCGA 1992, s. 236H(4)(c) ,  s. 236M ,  s. 236T ).

Limited participation

In the period from 12 months before the EOT acquires the company’s shares until the end of the tax year in which the transaction takes place, the number of employees and directors who are 5%+ participators cannot be more than 40% of the company’s total employees. Periods of up to six months can be ignored, as can periods where the condition was not met due to events outside the trustees’ control (  TCGA 1992, s. 236N ).

Periods of time before the trust existed can be ignored as they are classed as outside the trustees’ control HMRC (CGT manual  CG67855 ).

All-employee benefit and equality requirement

When the EOT makes payments or transfers, they must be made to all eligible employees on the same terms. Eligible employees are all employees and officeholders of trading companies, or where the company is no longer trading, those who were employees/officeholders in the two years before the company stopped meeting the trading company definition. 5%+ participators and their connected persons are excluded from eligible employees (  TCGA 1992, s. 236J).

‘Same terms’ does not mean equal numerical amounts. Payments can be calculated by reference to employees’ remuneration, length of service or hours worked (  TCGA 1992, s. 236K(4) ).

Structuring factors

Vendors and succession

The selling shareholders can continue in their roles with the company (including as officeholders, where relevant) post-sale. Typically, a plan is put in place to scale back their involvement over time as part of succession planning. It must be clear that control has passed from the vendors to the EOT, or the conditions will not be met ( Pett on Employee-Ownership Trusts 2.14).

Sale price and valuation

The trustees cannot buy the shares from the vendors for more than market value, as this would be a breach of trust ( Pett on Employee-Ownership Trusts 1.17).

It is therefore crucial that the vendors and trustees are both content that the price payable for the shares is demonstrably no more than market value. Where there is little contemporaneous evidence for the price suggested, e.g. recent share transactions or an offer to acquire the shares by a third party, obtaining an independent valuation, while not mandated, is well-advised.

Employee involvement

Setting up an employee council or appointing an employee to the trustee board is not mandatory for EOT-owned companies. However, businesses considering employee ownership should carefully consider both to obtain the widest benefits. An EOT-controlled business without the usual ‘softer’ trappings of employee ownership may be less likely to flourish long-term.

Funding source

Upon the initial creation of the EOT, the trustees have no funds of their own beyond the initial trust contribution to set the trust up (typically a nominal £100 or so). Companies will rarely have sufficient excess cash to entirely fund the sale upfront, so deferred consideration and/or bank loans are common. The company’s directors must be comfortable that either or both can be repaid by using company forecasts and other analyses.

Trustee directors

The EOT legislation does not prescribe the make up of the trustee company’s board. The model employee ownership* documents provided by the government suggest at least one independent trustee director, and two employees voted for by an employee council. In practice, a vendor shareholder is often also a trustee director until deferred consideration is paid off ( Pett on Employee-Ownership Trusts 4.4.3).

* The model trust deed provided is not EOT compliant, but the explanatory notes remain valid on this issue.

Clearances

Currently, market practice is to submit statutory and non-statutory clearances to HMRC ahead of an EOT deal, to disclose its particular structure and mitigate any associated tax risks.

Statutory

Most EOT deals fall within the circumstances set out under the transactions in securities rules (  ITA 2007, s. 682–713 (Pt. 13, Ch. 1) , Pett on Employee-Ownership Trusts 6.3).

A statutory  s. 701 clearance  is advised to seek HMRC’s confirmation that they will not issue a counteraction notice. Such a notice would increase the tax payable by the vendors, due to a tax advantage received from selling their shares to the EOT compared to taking a dividend from the company’s retained profits.

Non-statutory

A point included in the 2023 EOT consultation was whether legislation should be amended to confirm that distributions of profits from a close company to a trustee in order to pay deferred consideration to the vendors, will not be subject to tax on the vendors under  CTA 2010, s. 1020 .

HMRC have historically given clearance on this point to companies being taken into EOT ownership. Amended legislation would do away with the need to submit this non-statutory clearance, making the process easier and less costly for companies and freeing up HMRC time. Until and unless this occurs, a non-statutory clearance is recommended for the company and vendors’ peace of mind.

Timing

An EOT transaction can take place with as little as three months of preparation, where parties agree on all material matters and trustee directors are appointed quickly. For most businesses, however, six months is a more conservative timeframe.

For commentary on EOTs, see Direct Tax In-Depth from ¶473-910.