To EOT, or not to EOT

With the Government consultation to review proposals targeting (amongst other things) the tax regime of Employee Ownership Trusts (EOTs) being due to close on 25 September 2023, we thought it a good time to set out the basic landscape of EOTs as things stand today.

What is an Employee Ownership Trust?

An EOT is a trust set up to purchase a controlling interest in a company. The trust will hold the shares in the target company for the benefit of the employees, thus giving the employees an indirect ownership of the company. This break from the traditional corporate structure was introduced in 2014 and has grown in popularity, particularly in the past few years.

The main benefit of EOTs is that there are certain exemptions to tax for those selling their interest in the company and for the employees (in terms of an entitlement to an annual tax-free bonus), which are not otherwise available. However, these are only available if certain requirements are met, which are summarised below.

What are the requirements of an Employee Ownership Trust?

• the EOT must acquire more than 50% of the company’s ordinary share capital, be entitled to more than 50% of the profits and hold the majority of the voting rights in the company
• the company must be a trading company or the principal ‘holding’ company of a trading group. This must be the case at the time the shares are transferred to the EOT and for the remainder of that tax year
• distribution from the trust fund or the bonus scheme must be for the benefit of all eligible employees of a company or a group on the same terms
• if any shareholder holds 5% or more of the share capital in the 12 months before the transfer of shares to the EOT, the number of shareholders that hold 5% or more of the share capital cannot exceed 40% of the total number of employees of the company.

What are the benefits of an Employee Ownership Trust?

One of the main benefits and incentives of structuring a sale like this is that tax reliefs are available. Primarily, if the relevant criteria is met, the sale of shares is exempt from Capital Gains Tax.

As mentioned above, there is also income tax relief on bonuses of up to £3,600 per year per employee paid by an employer company owned by an EOT. Relief from inheritance tax can also be sought on certain transfers.

The ability to remain involved in the business is also often appealing to sellers as it will often reduce some of the disruption to the company, which can arise when otherwise selling to an external third party. Similarly, the ability to not have to find a third-party buyer is also an attractive benefit as this should allow for a friendlier and more time-efficient sale whilst maximising employee engagement and commitment to the business.

What are the risks of an Employee Ownership Trust?

Although a seller can remain involved in the business, they will lose the control of the company that they have held, so will need to be prepared to rely on the directors of the company and (where applicable) the trustees of the EOT to ensure that the business remains financially successful – especially where the sale involves any deferred payment(s).

If any of the requirements are not met before the end of the tax year in which the sale to the EOT takes place, these would each be deemed a disqualifying event and would result in a clawback of Capital Gains Tax from the seller(s).

What is the Employee Ownership Trust process?

1. the company will need to be valued, trustee(s) identified, a decision on how much share capital will be sold and funding route determined
2. the EOT will be set up using a trust deed, which is entered into by the EOT and the target company
3. the share capital will be purchased
4. payment will be made to the selling shareholder(s) either upfront or on a deferred payment basis.

How will an Employee Ownership Trust be funded?

Funding an EOT can be achieved in many different ways. However, care and diligence must be taken when deciding on this as there will be a number of competing interests to be considered, particularly where the current director(s) is also a recipient of the proceeds of the sale as a selling shareholder.

Seeking funds through a third-party

It may be difficult for the trustee to secure funding in the form of a loan (owing to the fact that it will have no financial history and/or stand-alone trading ability). The trust would, therefore, likely look to the target trading company to secure the necessary funding from a third party – and, in turn, lend this to the trustee. This does not come without its complications, as lending the money to the EOT will come with tax charges.

Gift from the trading company

The target trading company could gift the funds to the EOT. However, it must ensure sufficient distributable reserves are in place. If this is not carried out in strict compliance with the relevant legislation, the whole transaction would be void (meaning that the transaction as a whole would be ‘undone’ and the seller(s) regain ownership of the shares otherwise sold to the EOT).

Deferred payment basis

Often, together with one of the above funding options, funding an EOT commonly contains future deferred payments, which are based on and paid out of the company’s future profits. This method of funding comes with the obvious risk to the seller(s) that they will have to rely on the future performance of the trading company after the sale.

Contact our Corporate and Commercial solicitors today

If you would like to discuss the process of transitioning your business into becoming employee-owned, please contact our Corporate and Commercial team using our online enquiry form or by calling 0330 191 4835.