Employee ownership trusts: rising taxes and economic shifts

Overview

With the expectation that taxes for business owners, and in particular Capital Gains Tax (CGT), will increase at the next Budget, coupled with higher interest rates and a less favourable environment for the PE industry, it is likely that there will be a renewed interest, and increase, in the number of businesses being sold to EOTs, (as opposed to the more traditional trade sale or management buy-out).

Whilst there can be some not insignificant commercial benefits in selling to an EOT, such as less disruption for the business, a smoother and quicker sale process (and therefore lower transaction fees) as well as potential motivational benefits and increased employee engagement, the key benefit is that the sale of the business to the EOT can be tax free. The relief is only available on the sale of companies, but partnerships could potentially avail themselves of the relief by incorporating as a first step.

The tax reliefs

The tax reliefs available in relation to EOTs are:

• the sale by individuals of a controlling interest in a trading company or group to an EOT can, subject to certain conditions, qualify for an exemption from CGT
• provided certain conditions are met, bonus payments of up to £3,600 per employee per tax year can be made by a company that is owned by an EOT, and
• certain transfers into and out of an EOT qualify for inheritance tax reliefs.

CGT exemption

In terms of succession planning, the real attraction for the existing owners is the ability to sell their business, (which can be on deferred payment terms), tax free, representing a tax saving (at CGT rates) of us to 20%. To put this into context, on a sale of the business for £2million (even if the sale would have qualified for Business Asset Disposal Relief) the current tax saving is up to £300,000. If CGT rates increase the tax saving will also be greater.

To qualify for the CGT exemption the five key conditions are:

1. The company must be a trading company or the principal company of a trading group (the “Trading Requirement”);
2. The trustees of the EOT must acquire (and continue) to hold a controlling interest in the company (more than 50% of the ordinary share capital, majority of the voting rights and be entitled to more than 50% of the profits and assets on a winding up) (the “Controlling Interest Requirement”);
3. The trust assets must be held and applied for the benefit of all the “eligible employees” on the “same terms” (the “All Employee Benefit Requirement”);
4. Any distribution from the trust fund or bonus payments must be for the benefit of all eligible employees on the same terms, (although the amount of the bonuses can be variable based on remuneration, length of service or hours worked) (the “Equality Requirement”); and
5. Any employees or directors who have in the last 10 years held 5% or more of the shares in the company, (or any persons connected to them), must be excluded from benefit and must not represent more than 40% of the total employees following the sale of the controlling interest to the EOT (the “Limited Participation Requirement”).

If the conditions cease to be met up to the end of the tax year following the sale, the CGT relief can be clawed back. Any failure to continue to meet the conditions thereafter will result in a tax charge for the EOT/trustees, (essentially, the trust picks up the CGT that would have been payable on the sale to the EOT but for the exemption).

The (non-tax) benefits

As well as the tax benefits, a sale to an EOT can have a number of other advantages, including:

• a ready-made purchaser: there is no need to market the company for sale and a sale to an EOT will generally be a quicker and smoother process than a sale to a competitor or third party, (with less warranties and indemnities, given that the sale is effectively to the employees who are already involved and intimately acquainted with the business). The current owner(s) can also remain as directors and continue to have an active role in the business
• succession planning: a sale of the business to an EOT provides an “exit” route for owners who wish to retire and do not want to sell to a competitor, but where no one within their family or the existing management team are willing or able to take the reins
• increased employee engagement and commitment: as (part) owners of the company the employees feel more invested and have a greater say in the running of the business.

Potential issues

A key consideration is how the EOT will fund the purchase.

Whilst it is possible for the EOT/company to borrow funds, in most cases the purchase price will need to be funded out of the existing (and/or future) post-tax profits of the company. A significant part of the sale proceeds will therefore often be deferred and the impact of this on investment and growth will need to be considered, (and there may also be a conflict between the interests of the selling shareholders, who may also be remaining as directors, and that of the wider business more generally). It does, however, mean that the selling shareholders have a vested interest in ensuring the business remains profitable and successful.

The key for the business, to be sustainable in the long term, is to have in place a good senior management team, and care is required to ensure that the All Employee Benefit Requirement and Equality Requirement once the business is owned by an EOT do not act as a disincentive to them. They can of course be paid market salaries and bonuses without offending these requirements as these requirements relate to the trust assets — the shares and any income from the shares. There are also potential ways in which the senior management team can be given an equity stake alongside the EOT (via an approved EMI or CSOP scheme for example), but how to ensure the management team are fully engaged and motivated is a key consideration.

As noted above, the tax benefits are subject to certain conditions being met (and continuing to be met) and are predicated on the company remaining under ownership of the EOT. An onward sale of the company could therefore trigger a tax charge within the EOT that would need to be factored into consideration by the trustees as to whether any such sale would be in the interest of the beneficiaries, (the employee as a whole). The key point to bear in mind is that the EOT structure is intended to be a long-term structure.

Structure of an EOT and sale process

An EOT is a special form of employee benefit trust (EBT) that holds the shares in the company on trust for all the employees collectively.

Although the trustees of the EBT may be individuals, (including the directors of the employer), it is usually recommended that a company is incorporated to act as the trustee. This can provide a number of advantages with regard to the administration of the trust, as well as providing the trustee with the protection of limited liability. The board of the trustee company will generally include a mixture of the management team and employee representatives.

In terms of the process, the first step is to set up the EOT. The trustees and shareholders then jointly appoint a share valuation expert to value the company to determine the purchase price. This step also helps ensure the trustees are not over-paying for the shares and are properly discharging their fiduciary duties to act in the best interests of the beneficiaries, (the employees). The parties will then enter into a share purchase agreement selling the shares to the EOT. The shareholders may also want to seek a tax clearance from HMRC prior to the sale.

Implementation

The sale of a business to an EOT can, in the right circumstances, deliver significant benefits for all parties, but as ever the devil is in the detail and if not structured or implemented correctly it can have adverse commercial and tax consequences. The owner managed business group at Weightmans comprises a mixture of corporate and commercial as well as tax specialists who can provide comprehensive and integrated guidance and advice on the practical, commercial, legal and tax issues.

If you are interested in further exploring the sale of your business to an EOT, please do not hesitate to get in touch.