Whilst Employee Ownership Trusts (EOTs) are not particularly novel as an exit solution, it seems to have taken a while for the idea to catch on within the mainstream. Our Corporate Finance team have seen this growth ourselves this year, and have completed two EOTs recently, with several more in progress.
As with any growing trend, it’s also perhaps not surprising that EOTs have caught the attention of HMRC, who are now seeking to refine their EOT guidance through a consultation period. This strategy is partly driven by those who have sought to exploit the EOT route as a tax efficient exit plan, whilst still seemingly retaining control post-exit of their business.
So, what are the proposed HMRC changes and how might these affect EOTs moving forward?
The consultation topics can largely be broken down into three key areas:
A fundamental concept of an EOT exit plan is for existing shareholders to dispose of a majority stake of their holding to the trust, allowing the trustees to gain control of the business and therefore be “owned” by the employees, albeit via a trust. It is, however, common practice for former owners to continue to be involved in the operations of the business, after all, there are benefits in doing so, not least the levels of knowledge and experience that are then retained.
Control of the EOT can be further complicated when the former owner(s) are appointed as sole or majority trustees of the EOT. This is deemed to be the former owners retaining control and it becomes more difficult to substantially argue the statement that the company is being run for the benefit of the employees.
Current guidance from HMRC does not stipulate rules for appointing trustees of an EOT, however, there is guidance for “best practice”, something that the Scrutton Bland Corporate Finance team have followed when working on EOT transactions for our clients. HMRC are proposing to follow the best practice guidance by preventing former owners and connected persons from acting as trustees of an EOT if they represent the majority of trustees. In reality, achieving this specific point is simple. By ensuring that an odd number of trustees are appointed, with the majority being either employee representative trustees or independent trustees, you can ensure that former owners do not retain control via a numerical majority. It’s interesting to note that the focus here is on control gained via the numbers of trustees representing a majority, however, it is likely that some detail will have to be added to account for instances where control is gained via various legal clauses in the trust deed, be it voting rights or additional powers, for example.
Under the HMRC proposals, any breaches of these conditions would be a disqualifying event and would lead to an immediate Capital Gains Tax charge to the trustees (or to the former owner, if within the first year of disposal). This is by far the biggest consideration and area of review for existing or proposed EOTs going forward, as the tax consequences could be significant.
Funding an EOT
A core factor in the financing of an EOT transaction is that the consideration (or part of it) is typically deferred over several years and paid out through distributions of future profits. Whilst this arrangement saves the employees the burden of funding the share purchase upfront, it typically requires the exiting shareholders to gain HMRC advance clearance to ensure that any future distributions are treated as Capital Gains as opposed to being liable for Income Tax.
HMRC has acknowledged that this process of seeking advance clearance can be onerous and that it can add an element of uncertainty to the transaction. Under their proposals, the government is suggesting changing legislation so that any contributions made by the company to the EOT trustees in order to repay the former owners for the acquisition cost of the company shares will not be treated as distributions liable for Income Tax charges. It should be noted, this treatment would only apply if the consideration paid for the shares does not exceed the open market value for those shares.
Tax on EOT bonus arrangements
The last area sees a proposed simplification to the existing HMRC rules surrounding tax-free bonuses paid to employees of EOTs.
Under current EOT incentives, an employee-owned company may pay up to £3,600 annually to its employees by way of a tax-free bonus. As with any tax-advantageous route of remuneration, there are strict rules governing these qualifying bonus payments, mostly based around the concept of equality and participation. These rules are designed to protect employees against bonuses being paid favourably to directors and the highest paid individual in an EOT, and failure to comply with the rules will result in no employee being eligible for a tax-free bonus.
Under the proposals set out by HMRC, amendments would be made to the rules to enable bonuses to be awarded to employees without directors necessarily having to be included. It is hoped that these changes will ensure that bonuses are easier to administer and improve the image of what is already a very attractive benefit of an EOT.
Overall, I think the proposals are a great move for solidifying EOTs as an attractive exit option for the right companies. It will certainly be interesting to review the findings of the consultation once they are released later this year. What is does highlight, however, is the need for these arrangements to be well thought through and executed correctly to avoid falling foul of the potential pitfalls. These types of tax-beneficial schemes are under constant review and are open to changes to respond to any unintended exploitation, so getting the right advice from an independent professional adviser is key.
The Corporate Finance team at Scrutton Bland are knowledgeable and experienced in advising businesses wishing to explore the option of an Employee Ownership Trust as a means of exiting a business. For more information or an initial discussion please contact James by emailing firstname.lastname@example.org or calling 0330 058 6559.