The first Employee Ownership Explained webinar in the series kicked off with a look at the tax impact on the Employee Ownership Trust (EOT). This was a topic much requested by previous attendees and we were lucky enough to have speakers Nick Wright, Associate Director at Jerroms Miller Specialist Tax who has worked on a number of EOT transactions and Richard Jones, Senior Policy Manager within the Tax Faculty of the Institute of Chartered Accountants of England and Wales (ICAEW) who works closely with HMRC.
You can view the recording of the webinar below.
Nick Wright began by talking through the tax legislation that governs the EOT. He emphasised that the EOT was designed to be a long term plan for a company, although he has also advised on a sale out of an EOT.
Nick clarified the benefits of the EOT model, which go beyond the tax benefits. Increased motivation and staff retention, increased cash reserves for distribution to employees or reinvestment, and the opportunity to use the positive attitudes to employee ownership in marketing plans were all found to benefit businesses who become majority EOT owned.
Nick compared the MBO route with the EOT option. He told attendees he found that EMI options worked well to incentivise management teams once the EOT is in place. A key benefit for the seller is the MBO would attract Capital Gains Tax, with 10% Business Asset Disposal Relief whereas the sale to the EOT is completely free of Capital Gains Tax.
Nick explained he would normally apply for three clearances for HMRC transactions :
- ITA 2007 s.701 – Transaction in securities. To confirm HMRC agree obtaining an income tax advantage is not a main purpose of the transaction.
- Distributions clearance to ensure the Trust is not subject to income tax on the contributions it receives to pay off the vendors.
- 464 loans to participators.
Nick clarified the structure Jerroms Miller often see solicitors propose for structuring the EOT within the corporate framework. In this case the Corporate Trustee is a subsidiary of the target company. This can be an issue if there is an intention to implement EMI or Share Option Schemes at some point in the future as the Corporate Trustee would not be a qualifying subsidiary. There are other structures that can be used to get around this.
The relief requirements were considered :
- Trading Requirement
- All Employee Benefit Requirement
- Controlling Interest Requirement
- Limited Participation Requirement
On the Trading Requirement, Nick addressed the issue of excess cash in the business. Many companies hold large cash balances at time of transaction, and this is used to fund the share purchase. He reported that this shouldn’t be an issue for HMRC.
The Excluded Participators requirement is often rather thorny, particularly in family businesses as it applies not only to 5% shareholders, but also to those connected to them.
Another element of the legislation that can be problematic is the Limited Participation Fraction, particularly in smaller companies. Breaching this fraction can result in a tax charge on the vendor if it occurs at any point before the end of the following tax year in which the EOT acquires control and for the Trustees after that period. There is some flexibility in that if it is an unforeseen circumstance that breaches the Fraction, the company has 6 months to correct the breach.
Nick listed the Disqualifying Events that might trigger a tax clawback :
- The company ceases to satisfy the trading requirement
- Failing the all-employee benefit requirement
- The trust no longer meets the controlling interest requirement
- Exceeding the participator requirement
Any breach up to the end of the following tax year in which the EOT acquires control would result in the vendors having a tax liability. A Disqualifying Event in subsequent tax years would result in the Trustees having the tax liability. As the Trust is unlikely to have the cash to pay, the company would have to fund the tax charge. The Trust also inherits the base cost of the vendors so the capital gain arising is likely to be significant.
Nick talked through the payment of the tax-free bonus, and funding issues for the EOT transaction. He clarified that there are currently no tax rules on governance, nor on offshore trusts.
Richard Jones talked through the key proposals of the HMRC consultation into EOTs. He believes they are generally to be welcomed and are a result of a number of points the tax profession has raised over the years. It was good to know that HMRC is listening to views.
There is a concern around former owners forming a majority of the trust board. Would this constitute a meaningful change of ownership, even if legal ownership has changed? The proposal is that while former owners may be present on the trust board, they should not form a majority of the trustees. Richard said ICAEW would welcome this change.
There is a proposal that certain groups should be represented on the trust, with the example being employees. Richard’s views are that this makes sense (given that the trust is there to ensure the company is run for the benefit of the employees), but could potentially be problematic if, for example, there were no employees suitable or willing to take on the Trustee role.
Should EOTs be required to be UK resident? Some EOTs are offshore trusts. Richard believes that having trustees resident overseas might make sense for companies with offshore operations, for example. However, there is a risk that overseas resident employee ownership trusts would be used to avoid UK tax, so it is understandable that HMRC would want to clamp down on this.
The proposals include potential legislative changes which are designed to reduce HMRC’s workload in dealing with non-statutory tax clearances. The first of these relates to the potential income tax distribution treatment of deferred consideration left outstanding on the sale of shares to the EOT. Under the proposals, the legislation would be amended to confirm that no such distribution exists in these situations.
The second change relates to where a company makes a payment akin to a loan advance to its participators and this remains outstanding. In these cases, in theory a Corporation Tax charge could arise. HMRC says that it doesn’t want to give clearances on this point and believes that, as long as this payment isn’t for avoidance purposes, there shouldn’t be an issue. ICAEW believes this should be confirmed in legislation or, failing this, HMRC guidance.
The final points were around payments of bonuses to all employees and the fact that this this includes directors and non executive directors (NEDs). That can be problematic in cases where NEDs wouldn’t ordinarily receive a salary (or a bonus).
Richard touched briefly on the tax free bonus, with the proposal that this should be increased to reflect inflation from 2014 and then linked to inflation going forward.
The full webinar presentation can be viewed here: Taxation and the EOT – 13 September 2023
Question and Answers
Q. Given the EOT are not intended to be sold, are EMI options really an incentive for senior management?
A. Some EMI options can be seen as an exit strategy but we design them to crystallise when deferred consideration is paid within the agreed time period and are there not “exit-only options”.
Q. What are the three clearances required?
A. STAT CLEARANCE: Transactions and Securities (ITA 2007 s.701) i.e. one of the main purposes of the transaction is not to obtain an income tax advantage.
NON STAT CLEARANCES:
Under section 464 for loans to Participators
Distributions to vendors (deferred consideration payments) will be treated as contributions and not liable for income tax
Q. Raising the £3600 tax cap on bonus bearing in mind the rise in inflation over the past 9 years to take account of RPI, CPI, wage inflation?
A. This is not a proposal from HMRC but one that will be forming part of the speakers’ response. Perhaps to increase it by a round figure each year?
Q. Will a director, who is also a participator, qualify for the EOT bonus?
A. Yes, as the company pays the bonus, not the trust, then excluded participators will qualify for the bonus if they are employees of the business.
Q. It is usual for the Share Purchase Agreement to include a number of protections for sellers recognise the level of risk they are bearing with deferred consideration. Would HMRC view these protections as impinging on the control requirements?
A. This is a question that has arisen a number of times. We generally come to the view that the types of protections required are to stop the Trust from doing something i.e. negative control rather than having the right to pass a vote. In this case we do not believe this impinges on the control requirement.
Q. What do you think the outcome of this consultation will be? Will there be significant changes?
A. The consultation shows willingness from HMRC to engage with the EO sector and listen to suggestions. The general feeling is that there is a willingness to improve the legislation for the good of employee ownership. As we approach an election, and possible change of government, this may change. It’s a risk, but all being equal, HMRC are likely to make positive changes which will be welcomed.
Nick Wright is an Associate Director at Jerroms Miller Specialist Tax providing specialist corporate tax advice in areas such as transaction tax, company reconstructions and Employee Ownership Trusts, Employment Related Securities and employee share schemes both to individuals and to professional advisers requiring support for their own clients. A tax adviser since 2014, he is a regular contributor to Taxation magazine.
Richard Jones is a Senior Policy Manager within the Tax Faculty at ICAEW. He focuses primarily on the issues affecting businesses along with tax compliance and investigations matters. He regularly represents the Faculty in discussions with HMRC, other government bodies and tax industry stakeholders.