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