If you feel like opting out, Employee Ownership Trusts could be the solution


The most uncertain election in years presents business founders and owners with a challenging environment for making important decisions on what to do with their company. Our new government on 13 December may impose some radically unfriendly policies for business in the UK, and some sectors are of course likely to be more impacted than others. The potential impact of Brexit, hard or soft, could also be immensely damaging to a number of industries.

If your decision is that you are better off cutting your losses and selling out of your business, there is some consolation in deciding how best to do so. Employee Ownership Trusts (‘EOT’) offer the mutual benefit of giving a new future to the business under the control of employees, with all of the engagement and good will that engenders, as well as generous exemptions to capital gains tax (‘CGT’) on the value of the company shares.

Background

EOTs are a particular form of trust designed to facilitate employee-ownership of (and engagement in) businesses.

With the EOT, a trust is formed for the purpose of taking shares in the company through which a business is being operated. Although the concept of facilitating employee-ownership through a trust is not new (the John Lewis Partnership has had a form of employee ownership since it began trading in 1929), with the EOT regime introduced in 2014, there is a key change to the UK CGT regime.

The EOT form can offer an exit route for retiring entrepreneurs, it has a specific tax relief and it may offer succession planning advantages.

Prior to the introduction of the EOT regime, a transfer of shares to a trust by the founder of that company would have resulted in an immediate CGT charge on the part of the founder. If the transfer was by way of sale, the transferee trust might, ultimately, have been able to pay for the shares, but there was no certainty that it could, as this would depend on its future profits.

Under the EOT regime, the sale of shares to the EOT is entirely free of CGT. This is a key advantage of the EOT as an option, particularly for founders holding shares standing at a material capital gain.

Meeting changing needs

The EOT regime was introduced to facilitate employee-ownership of businesses on the basis that this was seen to offer a number of social and economic advantages. Research has demonstrated that employee-ownership, and the engagement it creates, is beneficial to businesses (increasing productivity and ultimately profitability).

From an entrepreneur’s perspective, a move to employee-ownership may be something that could be of more interest in the present day that it would have been historically:

  • For many businesses, there may be more value in their employees and their intellectual capital than their traditional assets, such as plant and machinery. The long-term success of the business may require employees to remain in the business and engaged. With the EOT, an entrepreneur can sell part, but not all of his shareholding. If the entrepreneur effects a part disposal, he will want to do so in a manner that best secures the value in his retained shareholding, and this may be the business’s continuation with its existing staff.
  • CGT rates have changed over time. The current CGT rate of 20% is relatively low, but still higher than the rate that applied when the ‘business asset taper relief’ system was in place. With the EOT, there is a distinct cash flow advantage on exit through the tax relief. The business owner/seller will look to obtain a fair market price for the shares on sale to the EOT.
  • Thinking may have changed on succession to businesses. There is an emerging view that entrepreneurs may no longer wish for their children to succeed to their business interests.

Overview

The EOT regime is relatively flexible: it envisages a trust being formed for employees and an interest in a company operating a business then being sold to that trust. There are some key requirements for a trust to fall within the scope of the EOT provisions:

  • The trust must take a ‘controlling interest’ in the business. This means that the trustees must hold more than 50% of the ordinary share capital and voting rights of the company and be entitled to more than 50% of the profits available for distribution or assets on a winding up. The EOT need not be the sole shareholder, but it must be the majority shareholder.
  • The business must be operated through a ‘trading company’. This means that the EOT regime is not available to investment vehicles (although it could be available to an investment manager).
  • The EOT must hold the company’s shares (and the dividends arising from them) for the benefit of all eligible employees on the same terms. The class of beneficiaries must (in principle) include all officers and employees of the company (including those who are non-UK resident). Employees with less than 12 months’ continuous service can be excluded from benefit. An EOT cannot have as its beneficiary anyone who has rights to 5% or more the shares in the company.
  • There is an equality requirement so that any distributions from the EOT must be for the benefit of all eligible employees of a company or group on the same terms. This need not mean that all employees receive equal amounts: it is possible to determine the size of awards by reference to remuneration, length of service and/or hours worked.
  • The EOT regime provides an exemption from income tax for qualifying bonus payments of up to £3,600 per employee per tax year.

Practical considerations

  • Once a trust has been formed which will meet the requirements noted above, the owners of the business can sell shares to the EOT, ensuring that the EOT has control of the business at the end of the tax year in which shares were sold. When considering who might be appointed as trustee, a corporate trustee is advisable when considering capability to administer the EOT.
  • There are governance considerations both on the trust and in relation to the company itself. It is important to ensure that the EOT is adequately represented in company matters, and to guard against potential conflicts between director and shareholder interests.
  • The appointment of non-executive directors can assist with the management of the conflicts of interest that can arise with EOT ownership of a company, as can the use of an employee council or appointment of employee representatives to the board of directors of business and/or the corporate trustee of the EOT.
  • If the business has a significant number of employees who are not directors, it may be possible to elect members of an ‘employee council’ to be consulted by the board of directors on an ongoing basis.
  • Where any minority shareholdings remain following a transfer of a controlling interest in the business to the EOT, parties will also often enter into a shareholders’ agreement to regulate their relationship.

Financing arrangements

The EOT regime is designed to facilitate the sale of the shares to the EOT. There will be stamp duty on the transaction whereby shares in the company are sold to the EOT, but there will be no CGT on the part of the selling business founder.

The trustees of the EOT will need to finance the purchase of the shares. There are a number of options in this regard which are not mutually exclusive:

1. The trustees could use bank lending;
2. The company whose shares are being sold could borrow and lend to the trustees; and
3. The seller could sell the shares on a deferred payment basis.

If you have any questions regarding the UK General Election 2019, please contact your usual Withers contact. You may also wish to view our dedicated webpage which will be updated regularly before Thursday 12 December, click here to view it.

Category: Article