A disqualifying event occurs if the company ceases to satisfy the trading requirement, the all-employee benefit requirement or the controlling interest requirement, or the participating fraction exceeds 2/5. Furthermore, if the trustees act in a way which the trust does not permit, in respect of the all-employee benefit requirement, this is also a disqualifying event.
If a qualifying event occurs in the tax year following that in which the relevant disposals were made (ie, those disposals for which a claim for relief would be valid), no relief is due to the vendor shareholders under these rules (TCGA 1992, s 236O). Of course, they will then be entitled to any reliefs available under the normal capital gains tax rules, such as business asset disposal relief and gift relief.
The overall effect here is that the relief requirements have to be satisfied at all times after the company is sold into an EOT. The Trustees have been appropriately advised on this point. Irrelevant
Do EOTs benefit the employees?
While employee ownership is generally considered a good thing, as noted above, it’s not clear that the tax rules for sale into EOTs generate anywhere near as much benefit for the employees of the company as they do for the vendors. The only obvious fiscal benefit to employees is that the company can pay them bonuses of up to £3,600 a year free of income tax. Employers’ and employees’ National Insurance is still due and there is another set of complex requirements that must be satisfied for relief from income tax on these bonuses to apply.
The £3,600 a year free of income tax might be welcome to many of the employees of a company, but the overall benefit pales into insignificance when compared to the capital gains tax saving for the vendors for having sold the company to an EOT in the first place. For example, say the proceeds of the sale by the vendors were £3mn, where two shareholders owned around 45% of the company each. Clearly it would take a lot of payments of £3,600 per employee to generate as much savings as either one of those shareholders will have obtained.
The benefits to employees might accrue more subtly. For the first few years of ownership by a trust, it is likely that the majority of profits will be contributed to the trustees to pay off the debt and associated costs. Once the trust is debt free, there is no obvious commercial reason to pay dividends to the trust. If the trustees did receive taxable dividends, they would suffer income tax. Any distributions of the remainder would be treated as earnings, which means there is double taxation – income tax on dividends, followed by income tax and National Insurance on earnings.
On the other hand, if the profits are not distributed to the trustees, they can be retained in the company and used to pay higher salaries to the employees, or for reinvestment into the business, from which everyone should benefit. In effect, therefore, one might argue that a major benefit of being owned by an EOT is that the company does not have to pay its profits to shareholders but can retain them for the benefit of the business.
Who runs the company after the transaction?
Before a sale into an EOT, a company will typically be run by its shareholder directors, perhaps assisted by a management team. There is no reason why the same group of people should not continue running the company immediately after the sale into an EOT. Of course, the sale of the shares is usually part of the retirement plan for the vendor shareholders, so it is expected they would pass on their knowledge and experience to the management team and retiring within a few years of the sale.
Obviously, if the directors of the company are also trustees of the trust, there is a potential conflict of interest, so it is usual to suggest that the vendor shareholders should not be the only directors. As with trustees, there should also be employee representative(s) and independent directors on the board of an EOT-owned company.
The other commercial aspect to consider is whether the management team might not, themselves, prefer to have taken over the company, perhaps through a management buyout. It’s important to keep the management team on side through these transactions and it is possible for them to acquire shares in the company following the disposal.
Who are the trustees of the trust?
The tax legislation does not prescribe who the trustees should be. It is not uncommon for the vendor shareholders to continue being both directors of the company and trustees of the trust. This does lead to the potential for conflicts of interest, which is a concern from a governance perspective, as a matter of general law, but the tax legislation is silent on these issues.
The best model, to avoid possible conflicts of interest, is one where, say, one of the vendor shareholders is a trustee, alongside an employee representative and an independent trustee. This allows for continuity, particularly given that the sale to the trust is likely to be part of the vendors’ retirement planning, so they are unlikely to want to be trustees in the long term.
Can the key management team be incentivised under employee ownership?
The income tax free bonus of up to £3,600 per year may be little incentive for the more highly paid employees.
Whilst there is the equality requirement within the EOT provisions, both for distributions from the Trust and for tax-free bonuses from the company, there are no rules specifying the level of remuneration each individual employee can receive. So with no shareholders requiring a dividend there is likely to be more cash to increase the key managers’ salaries.
However, an EOT may still disincentivise the key managers – who will be relied upon to deliver the deferred consideration – if they were expecting the opportunity to partake in equity ownership.
For this reason, share option schemes, in particular employment management incentives (EMIs), are commonly set up alongside the sale to the EOT. The vendors can sell a controlling interest whilst the key managers can be incentivised to deliver the profits to pay them off and, in return, they will receie shares once they have achieved this.
Furthermore, the fact EMI options must be exercised within ten years provides a deadline for which the company must repay the deferred.
Is there any downside to offering share options to key managers?
Whilst share options can be a benefit of the key managers and also give comfort to the vendors that the deferred consideration will be paid off in a reasonable timeframe, the trustees must be aware of how these will impact the EOT conditions.
The main concern is the limited participation condition, which requires that the number of 5% participators compared to the total number of employees does not exceed 2/5. Whilst, in the case of EMI options, this should not present a problem until the options are exercised (perhaps with the exception of ‘exit only’ options) the trustees should be aware that the exercise of the options will immediately affect the limited participation fraction.
The option holders should also be aware that, once they exercise the options and receive shares, they may be excluded from benefits as participators if they hold more than 5% of the company’s ordinary share capital (or 5% of any class of capital, so special share classes in these cases can be a bad idea). This means that they will not be able to benefit from a share of the EOT sale proceeds if the company were to be sold. However, the intention would be that the benefits of their direct shareholdings should outweigh this.
What happens if the trustees sell the company?
The intention behind the legislation is to encourage long-term ownership of companies by EOTs. However, from time to time, it is inevitable that offers will be made to the trustees to buy the company. The trustees are required, of course, to consider the requirements of the beneficiaries, first and foremost. This is an area where a conflict of interest might arise, because the trustees might also hold shares themselves, particularly if they are the vendor shareholders and have retained a shareholding (as highlighted above). So, it is important that the decision to sell is made bearing in mind the needs of the employees of the company and not the trustees’ own needs as a separate group of shareholders.
There are obviously a variety of issues that the trustees will need to consider, but primarily they need to be comfortable that, following the payment of the CGT on the transaction and any outstanding funds still due to the original vendor shareholders, there will be sufficient remaining to distribute to the beneficiaries to make the transaction worthwhile. Clearly, if there would be no surplus available for beneficiaries, then no matter how generous the offer looks, it seems unlikely that it would be appropriate for the trustees to accept it.
What happens when the trustees sell the company?
Any sums distributed to the beneficiaries will, under current law, be treated as earnings. Once again, there would be double taxation, with the trustees paying CGT on the proceeds and the net amount distributed to beneficiaries then suffering income tax and national insurance contributions as earnings.
Of course, another argument is that treating the net proceeds as earnings reduces the potential benefits to the employees. This might then reduce the likelihood of the trustees agreeing to a sale, if the net of tax receipts to the employees are not sufficient to make the sale worthwhile, meaning that the company would remain employee owned, coinciding with government policy.
Who are the beneficiaries?
To qualify for relief when the shares were originally sold into the EOT, the arrangements had to satisfy the all-employee benefit requirement. The beneficiaries are all of the employees of the company, except for the vendor shareholders, any other person who holds 5% or more of the company’s share capital or of any class of the company’s share capital, and anybody connected with them. In most cases the only two people excluded from benefit are the vendor shareholders.
One would assume, therefore, that, if somebody ceased to be employed by the company, that person would no longer be a beneficiary of the trust. However, where the trust ceases to hold any of the company’s share capital, the beneficiaries are taken to include both current employees and those employees who have been eligible employees at any time within the two years prior to the disposal. In some cases, with a relatively small workforce, the number of leavers in the previous two years might be relatively low, so this would not present any practical difficulties.
If the business involved has many hourly-paid employees, it could mean that there were a lot of people who had left the employ of the company in the two years prior to the sale. Furthermore, there could be issues in tracing the past employees.
This has nothing to do with tax per se, although the issue arises because of the tax rules, so provision needs to be made, and for how long, in respect of ex-employees who were theoretically beneficiaries of the trust under these rules but could not be traced.
The problem was exacerbated by virtue of the fact that where the consideration for the purchase of shares is partly deferred. The final tranches of consideration, which would include the amounts that would become distributable to the beneficiaries, would not be paid for up to say 12 months after the completion of the transaction. It makes no difference to the CGT position for the vendors, as deferred consideration left outstanding is simply brought into the capital gains computation in the year of completion. But it does create a further practical requirement to keep track of anyone who was a beneficiary by virtue of being an employee at the time of the sale, but who might leave that employment before the full consideration for the transaction had been paid.
Andrew is the director of Assynt Corporate Finance Limited and an Accredited Member of the Association of Crowdfunding experts.
Previously a partner and head of corporate finance at Baker Watkin LLP, Andrew has more than 40 years of experience in all forms of corporate finance across many business sectors.
Andrew was the Chair of Governors at a local school for six years retiring in December 2020 and continues to be an Assessor of Expeditions for The Duke of Edinburgh's Award.
You can find out more and connect with Andrew over on LinkedIn.