What is an employee ownership trust?
An employee ownership trust (an EOT) is, as the name suggests, a trust established for the benefit of a company’s employees. The EOT is formed to acquire the controlling interest (being more than 50% of the shares) in the target company. The EOT will hold this controlling interest in the company for the benefit of its employees in the long-term.
EOTs were introduced to increase employee owned businesses in the UK. For this reason, the sale of a business to an EOT will not attract any capital gains tax liability (subject to the conditions below being complied with). As a result of this preferential tax treatment, the EOT structure is a useful method for company owners to exit or wind down their day to day involvement in their companies.
We have seen the EOT structure become increasingly popular. Whether that popularity is as a desire to achieve 0% capital gains tax on the disposal of shares or to genuinely empower and encourage the workforce is questionable in some cases.
What is the typical process of selling shares to an EOT?
- An EOT will be set up and governed by a trust deed, which clearly defines that the EOT has been set up solely for the benefit of the target company’s employees.
- The EOT will acquire the shares in the target company via a share purchase agreement and such shares shall be placed under the control of the trustees (for example, a corporate trustee whose directors may be employee representatives chosen by an Employee Council) who is under a duty to administer the assets for the benefit of the employees.
- The selling shareholder(s) of the target company will be paid the consideration due on completion. Although it is common to see most of the consideration left outstanding to be paid to the seller(s) on a deferred basis (as explained in more detail below).
Are there any conditions to satisfy to make use of the CGT exemption?
Yes, the following conditions must be satisfied:
- The target company must be a trading company or the holding company of the trading group.
- The EOT must hold a ‘controlling interest’ after the acquisition. This means that the EOT should (i) hold more than 50% of the shares in the company, (ii) hold the majority of voting rights and (iii) be entitled to more than 50% of the profits.
- The terms of the trust deed must be on equal terms for the benefit of the employees (subject to differentiation permitted in respect of remuneration, length of service, and hours worked).
- The number of shareholders who hold 5% or more of shares in the target company and are officers and employees cannot exceed 40% of the total number of employees of the target company.
- The seller(s) claiming the relief (nor any person connected) has not claimed relief in any earlier year in respect of any disposal of shares in the target company (or the target company’s group).
How can an EOT fund the acquisition of the target company?
The EOT when established will have no assets and no means of generating assets, therefore the EOT will need to raise funds to finance the purchase of the shares in the target company, in one of the ways set out below:
- The EOT can borrow money from a lender
It is unlikely that the EOT will borrow money independently. It has no assets to grant security and the lender may require a guarantee from the target company which itself depends on the amount of the target company’s existing security and covenant status. This also causes a potential conflict of interest issue for the directors of the target company who must act in the target company’s best interests – giving a guarantee in favour of another company may not necessarily be in the target’s best interests.
- The target company can borrow the money and lend it to the EOT
The target company could borrow the money and pass the funds to the EOT, however, the same questions above apply regarding the directors’ conflicts of interests and again, this depends on the amount of the target company’s existing security and covenant status.
- The target company can gift money to the EOT
The target company can gift cash to the EOT if it has enough surplus cash available. This will be treated as a distribution so the rules relating to distributable reserves will apply. There is no tax charge as the target company and the EOT form a group for tax purposes.
- The seller(s) sell their shares on a deferred basis (also known as seller finance).
In practice, it is common for most of the consideration to be deferred and paid in instalments to the seller(s). For example, the EOT can issue loan notes to the seller(s) which will be drawn over a given period on the terms agreed by the EOT and the seller(s) pursuant to a loan note agreement. The loan notes can be secured against the assets, but not the shares of the target company as the controlling interest requirement would not be met, of the target company (depending on the level of the target company’s existing security).
Are there other benefits to using an EOT structure?
- The company can pay employee bonuses of up to £3,600 in a tax year per employee free from income tax (not national insurance contributions).
- The employees are likely to see enhanced career progression which should, in turn, allow the company to retain and attract ambitious employees.
- The seller(s) can remain involved in the business by retaining a minority shareholding and/or remaining as directors.
- Generally, the share purchase is ‘friendly’ and so the transaction will be less timely and smoother than selling to an external third party.
Are there any risks for the seller(s)?
Whilst the seller(s) can retain a seat on the board of directors, control of the target company will be lost after the acquisition by the EOT, so the seller(s) will need to rely on, and ultimately trust, the direction of the directors to continue to operate the target company profitably if a proportion of the consideration is deferred.
Similar to a standard trade sale where there is deferred consideration, there are various provisions that we can be include within the share purchase agreement to deter the board from taking such actions that would negatively affect the profitability of the target. Although it is of paramount importance not to tr and gain control.
What happens if there is a disqualifying event by the EOT?
- If the EOT sells its controlling interest in the target company or ceases to trade before the end of the tax year following the purchase, it will lose the tax relief, and this can be clawed back from the seller(s) by HMRC.
- If the EOT sells its controlling interest in the target company or ceases to trade after the tax year following the acquisition, the EOT may itself be subject to CGT.
There are protections, such as indemnities, that we can insert into the share purchase agreement to protect the seller(s) whereby HMRC attempt to clawback the tax payable due to a disqualifying event by the EOT.
How we can help
Whilst there are significant benefits to selling your business to an EOT, it may not be suitable for every business to use this structure. The sale of a business to an EOT does provide a tax efficient way for seller(s) to transfer ownership to employees to retain and attract ambitious employees.
It is vital to ensure that the transaction is properly structured to minimise the risk for all parties involved and ensure a seamless transition takes place.
If you would like to discuss the sale of your business to an EOT, please get in touch with one of our advisers.