Introduced in 2014, Employee Ownership Trusts (EOTs) are an indirect form of employee ownership in which a trust holds a controlling stake in a company on behalf of all its employees and provides an incentive for owners to sell a controlling stake in their business.
The EOT is an extension of the traditional employee benefit trust, but with distinctive features and tax advantages. Crucially, an EOT must hold a controlling stake in its company and must benefit all employees on an equal basis.
Often used as a succession planning tool, with the shareholders selling their shares to the EOT on deferred payment terms, there are some significant tax advantages associated with such a structure that are summarised below, but firstly we need to look at the key qualifying conditions that apply:
- The company whose shares are transferred must be a trading company or, where there is a group, the principal company of a trading group.
- The EOT must meet the ‘all-employee benefit requirement’, also known as the ‘equality requirement’ – any benefit to employees must be on the same terms for all eligible employees. So the trust cannot prioritise benefits to the advantage of particular employees, but it can allocate benefits of differing amounts according to factors such as salary and length of service.
- The EOT must not hold a ‘controlling interest’ in the company (ie more than 50% of ordinary share capital) before the transfer, but must hold a controlling interest at the end of the tax year in which the transfer takes place.
- Where the transferor has an interest of more than 5% in the company in the 12 months before they transfer their shares to the EOT, the ratio of employees who held 5% or more of the company to employees who did not, must not have exceeded 40% in that period.
Advantages for selling shareholders
Shares can be sold to the EOT at their full market value and there is a complete capital gains tax (CGT) exemption on gains made when a controlling interest in a company (or parent company of a trading group) is sold to an EOT. This compares to ordinarily paying 10% CGT assuming eligibility for Entrepreneur’s relief, or 20% without.
The EOT only needs to acquire a controlling interest, so not all shareholders are required to sell their shares to the EOT. While shareholders could, in theory, only dispose of only enough of their shareholding in order for the EOT to obtain control, this is unlikely to occur in practice as the CGT exemption will not apply to any later disposal.
The directors who have sold their shareholding can remain in post after disposal and can continue to receive a salary for their director’s duties.
By selling internally, the shareholders do not need to seek an external investor and can often save on time and fees in relation to the transaction.
Advantages for employees
Employees can be paid tax-free annual bonuses of up to £3,600 so long as these are paid to all qualifying employees on the same terms. This bonus is still subject to NIC though. This is a cash bonus, not a dividend, and so it can be paid without the company having to make a profit or have distributable reserves.
The legislation does allow for bonus levels to be determined by reference to:
- Length of service
- Hours worked
so allowing full-time employees to receive more than part-time employees, for example, without losing the tax-free nature of the payment.
One of the main issues surrounding a potential Management Buy Out (MBO) is the raising of funds by the acquiring employees. An EOT arrangement can often simplify this issue by acquiring the controlling interest on deferred payment terms. The company will then continue to generate trading profits each year and it will use these profits to make contributions to the EOT. The EOT will use these contributions to repay the outstanding purchase price that it owes to the shareholders.
In essence an EOT sale is a tax efficient form of MBO, and broadly similar considerations apply. That said, it is an increasingly popular exit route for private companies. As of September 2019, we have not seen a quoted company put in place an EOT structure.
This factsheet is based on law and HMRC practice at 1 October 2019.