Tax-free sale to an Employee Ownership Trust

Wider employee ownership can bring benefits to business as well as to employees, with enhanced motivation and productivity. In 2014 the government introduced a significant tax incentive to encourage businesses to adopt an employee ownership model, with an exemption from Capital Gains Tax (CGT) on the sale of shares to an Employee Ownership Trust (EOT).

An EOT is a special form of employee benefit Trust which is set up to hold shares on behalf of all eligible employees of the company (usually employees who hold less than 5% of the company’s shares).

Tax exemption on disposal of shares to an EOT

A disposal of shares to an EOT is exempt from CGT if all the qualifying conditions are met. This is particularly beneficial for shareholders who do not qualify for the 10% CGT rate with Business Asset Disposal Relief (BADR) or where the amount at stake exceeds the £1 million lifetime limit for BADR.

Qualifying conditions for this tax exemption

• The EOT must acquire and retain a controlling shareholding in the company (ie. more than 50%).
• The company must be a trading company or the holding company of a trading group.
• The EOT must be set up for the benefit of all eligible employees on the same terms although there is some flexibility in that this can be by reference to remuneration, length of service or hours worked. 
• Following the disposal the number of people who are directors or employees and who continue to hold at least 5% of the company’s shares must not exceed 40% of the total number of employees.

How does the disposal to the EOT work?

The shares can be sold to the EOT for up to full market value. There is no legal requirement for a full commercial valuation but Trustees of the EOT should seek an independent valuation of the business to be satisfied that they are not paying more than market value for the shares. Alternatively, the vendors and the EOT can jointly appoint a valuation expert to determine the value.

Often there is insufficient cash in the company to fund 100% of the sale proceeds on completion but the balance of the consideration can be left outstanding as a debt owed by the EOT to the vendors or it may be possible for the EOT to obtain funding via external borrowings. 

We often see the sale proceeds funded out of future post-tax profits of the company which are paid up to the EOT as additional contributions and then out to the vendors over a number of years. If the company funds the disposal price via contributions to the EOT; such cash contributions will not be tax deductible for the company or taxable receipts for the EOT.

In this scenario it is important that the trading company remains profitable and generates sufficient cash after the disposal as this is how the deferred consideration is financed.

Does the EOT have to acquire all of the company’s shares?

The EOT does not have to acquire 100% of the shares but must acquire and continue to hold a controlling interest. This means that not all shareholders need to sell their shares to the EOT and shareholders do not have to dispose of their entire shareholding if they wish to retain some share ownership.

In practice it is unusual to see minorities not participating in the sale. The CGT exemption only applies for disposals in the tax year in which the EOT acquires a controlling interest. If not all shareholders sell their shares to the EOT then a later disposal of shares to the EOT will not be tax-free, although BADR  may be available to give a 10% CGT rate.

How do the employees benefit from the EOT?

Employees can benefit via bonuses. The EOT must be for the benefit of all eligible employees on the same terms but there is some flexibility in that bonuses can be paid by reference to remuneration, length of service or hours worked.

Another tax incentive for EOTs is that companies that are controlled by EOTs are able to pay tax-free bonuses of up to £3,600 per year to each employee (although this is still subject to NIC).

Other advantages of selling to an EOT

In addition to the CGT exemption on the disposal of shares to an EOT and the tax-free bonuses, there are other advantages:

• the EOT allows the employees to indirectly hold the shares, motivating the workforce without the employees having to personally fund the purchase price
• the EOT creates a ‘friendly’ purchaser for the shares which will be particularly attractive for those businesses with succession issues and who may not want to sell to a third party
• the vendors can remain as directors or employees post-disposal and can continue to receive market remuneration and bonuses from the employing company after the disposal. This may be more difficult if they were selling to a third party
• the vendors do not have to sell all of their shares to the EOT and not all shareholders need to participate in the sale to the EOT; the EOT just needs to acquire a controlling interest
• a disposal to an EOT may be an easier sales process than to a third party.

How is senior management incentivised?

It is possible to have a structure whereby the EOT holds a controlling interest in the company for the benefit of all its employees but with tax-efficient share incentive plans in place for senior management.

Senior management may be looking to personally acquire shares in the business going forward. If they have reservations about an indirect shareholding via an EOT because of its requirement to benefit all employees on the same terms, the company can remunerate its employees via bonuses and other incentives outside the EOT, including the adoption of tax efficient share schemes.

For example, there are special rules that ensure that an EOT-controlled company is regarded as “independent” for the purpose of tax-approved share option schemes such as Enterprise Management Incentives (EMI) or Company Share Option Plan (CSOP), allowing those companies to potentially adopt such schemes.

What happens if the EOT subsequently sells its shares?

EOTs hold shares for the long-term so there are tax consequences if the EOT subsequently sells its shares. If the EOT no longer has a controlling interest at the end of the tax year in which the original disposal takes place or in the following tax year then the CGT exemption on the original disposal to the EOT is withdrawn. A loss of controlling interest by the EOT thereafter will trigger a CGT liability for the EOT.

If the EOT makes a distribution of net proceeds then it will need to distribute to all eligible employees on the same terms (this can be by reference to remuneration, length of service or hours worked) with PAYE and NIC applying.

A consultation on potential EOT scheme changes ran until 25 September 2023.

The focus of that consultation seems to be to ensure that the acquiring Trusts themselves are UK tax-resident (rather than overseas) Trusts. There were also questions which seemed aimed at ensuring the composition of the Board of Trustees gave greater weight to those who might ensure the Trust acts for the benefit of all employees rather than merely groups related to previous owners.  We will have to wait and see but expect to know more as draft Finance Bill clauses are released – perhaps with the Budget papers on 6 March.

Any changes are likely to take effect in the new tax year, but it is encouraging to note that HMRC seems to recognise the wider benefits of the EOT model as a mechanism for securing employee engagement and business ownership. 

Summary

A disposal of shares to an EOT provides both an extremely tax-efficient exit solution for shareholders and a mechanism that encourages and motivates the workforce going forward. The rules are complex with various qualifying conditions so it is important that professional advice is sought.