There has been a recent surge in demand for business owners wanting to sell their companies to their own staff through tax-efficient Employee Ownership Trusts (EOT). In this article, we provide a recap of the benefits of EOTs, the conditions that must be met and considerations for funding an EOT, before explaining both the importance of and the things business owners need to consider when applying for HMRC clearance for their EOT.
Benefits of an EOT
Firstly, a recap of EOT benefits and conditions. EOTs have strong tax benefits to offer:
- Capital Gains Tax (CGT) - the most substantial tax benefit of an EOT is a complete exemption from CGT for the owner selling shares to the EOT. To put that into perspective, at today's tax rates (February 2021) if the owner sold the business to a third party then the owner would be charged 10% on the first million of capital gain and 20% on anything above that. Thus, with an EOT, the shareholder could be saving up to 20% capital gains tax.
- Income-tax-free bonuses - where the EOT is in place, employees can be paid up to £3,600 income-tax-free bonuses per annum (National Insurance would still apply).
However, as with any tax relief, the EOT rules set out specific conditions that must be met for the tax benefits covered above to be available. Here are some of the main conditions:
- Shareholders must sell at least 50.1% of the company's issued share capital to the EOT - that is, the controlling interest must be transferred to the EOT. They must be ordinary shares, i.e., they have to have rights to dividends which are not at a fixed rate and assets on a winding up in proportion to the shareholding transferred to the EOT. The EOT must also hold the majority of the voting rights.
- The business must be a trading company - i.e., it must carry on a trade that is not investment activity. Thus, it applies to a variety of companies, including professional service companies. In fact, quite a few professional firms such as lawyers, accountants, architects find an EOT a suitable option for employee engagement. Although, please note it has to be a limited company, not a partnership.
- Beneficiaries of the EOT needs to include all employees and ensure equal treatment. The income tax-free £3,600 bonus has to be distributed on an equal basis. Some conditions are allowed if, for example, an employee works on a part-time bases or hasn't been with the company for a specific period of time.
- A shareholder with >5% cannot be a beneficiary of the EOT. Anyone who in the last 12 months, or is connected to the person, in the last 12 months had >5% would not be able to be a beneficiary.
- 2/5th rule - this states that an EOT cannot be set up where the shareholders/directors exceed 40% of the workforce. For example, if you have five staff of which two are also shareholders/directors that is fine, but if you have four staff of which two are shareholders/directors, and two are employees, that would be in breach of this condition. Only shareholders with more than 5% are counted for this purpose. This highlights that an EOT may not be suitable for very small companies.
Crucially, a condition that is often forgotten is the need to demonstrate a commercial motivation for the transaction that is of genuine benefit to both the company and its employees. This doesn't sound like a tax matter, but this might be the most important tax question the company will need to answer.
Funding an EOT
Typically, an EOT transaction is similar to a leveraged Management Buy-Out (MBO) when financing it via debt. However, the majority of EOT transactions rely on vendor loans rather than third party commercial loans. That is not necessarily a bad thing, vendor loans tend to be more flexible and tax-deductible, but it needs to be structured in the right way, i.e., striking the right balance between repaying vendors in a timely manner and not unduly pressurising the business by trying to repay too quickly.
Three key elements to this are:
- Interest - Depending on the loan agreement, the interest rate can be set as low as 0% or as high as feasible. Several things need to be considered when determining loan size and interest levels such as cash available, required investments for future growth, financing of projects etc.
- Timeframe of repayments - The time required to pay debt tends to be more generous than with a commercial loan, and repayment can range from around 5 to 10 years. Setting a timeline should be well considered and will depend on the objectives of the stakeholders. This might mean higher interest after five years, in doing so, encouraging the EOT to refinance with corporate debt and speed up value realisation for the shareholders, or trigger a sunset clause to release the EOT from the liability, if the company is not able to pay the loan in 10 years.
- Tax - Finally, any contributions/expenses made to an EOT is tax-deductible.
Critical planning before tax clearance application
From a tax perspective, the EOT process of tax clearance is very important, but relatively straight forward once the structure and EOT objective is clear. In our experience, HMRC typically approves these in 4-6 weeks with clearance subject to the conditions being met.
The more complicated and lengthy process is the discussions with employees and the setup of an EOT structure, which needs to take place well in advance of HMRC clearance application.
Key things to agree on before the tax clearance application:
- What is the commercial purpose of an EOT?
- Who will be in charge of the company? Will EOT have 51% or 100% controlling interest?
- Who will be managing the EOT?
- What is the value of shares to be sold?
- What is the market value of the company?
- How will the share purchase be funded?
- If the company is going to fund the trust to make the share purchase, then how many years will it take to repay?
When thinking about these questions, don't forget:
For a tax clearance, the most important question is what the primary motivation for an EOT is. This is something the owners of the company and the advisors need to be clear about. The lawyers and the accountants will be on hand to help with an independent valuation of the company, financial models, legal documentation and other supporting documentation. Still, the business owner needs to decide why they are doing this and how involved they would like to be in the business once the controlling interest is sold to an EOT. The driving reason for the EOT establishment will make or break an HMRC tax clearance application.
What is the anti-avoidance provision that clearance is sought for, and why is it so important for an EOT?
The anti-avoidance provision that applies here is called 'transaction in securities', and it potentially applies as the share sale by the shareholder(s) can be seen as "disguised distribution". Thus, getting clearance for an EOT transaction is important to ensure the provision doesn't apply.
Why is it important?
To avoid the argument over the profit and loss account reserves, which could otherwise have been paid as a dividend. For example, if a company with small retail shops has recently sold 9 out of 10 shops, and then with one remaining trading shop applied for clearance to sell shares to an EOT, it would probably not get clearance because the profit made on the sale of the shops could have been distributed as dividends rather than to finance an EOT with an objective to get 0% CGT. HMRC could see this as an example of tax avoidance that has no main benefit for the company or its employees.
The government encourages companies and their shareholders to consider setting up an EOT through the application of significant tax benefits. Still, with the risk of future CGT increase in rates, this will certainly attract speculative applications. That is why an advance clearance is recommended before setting up an EOT to ensure the success of the scheme and benefits of the tax reliefs.
Originally published 23 February 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.