The process and benefits of employee ownership trusts

An employee ownership trust (EOT) is an attractive succession route for business owners.

Introduced as new legislation in the 2014 Finance Act, an EOT enables the shareholders of a trading company or group to sell a controlling shareholding to an EOT at a zero per cent rate of capital gains tax (CGT).

An EOT involves a Trust holding shares in a trading company or group for the benefit of all eligible employees. Trustees of the Trust are appointed to act in the best interest of its beneficiaries, being the employees of the underlying business.

As a result, the EOT model promotes long term employee ownership, facilitating the retention of a strong, positive culture within an organisation, protection of local jobs and enhanced employee engagement in the decisions and success of an organisation.

Following the introduction of EOTs the majority of shareholders of owner managed businesses that were looking to sell found traditional routes more desirable, such as sale to a trade party, private equity or their core management team as part of a management buyout. This was largely due to the generous 10 per cent CGT rate that applied to gains of up to £10 million, which qualified for Business Asset Disposal Relief (BADR) (known at the time as Entrepreneurs’ Relief), alongside the ‘unknown’ of what selling to an EOT meant.

In more recent times, due to a combination of the curtailment of BADR and the increasing activity in employee ownership transactions, many businesses owners are now more aware and engaged in the idea of selling to an EOT.

What does an EOT mean for existing shareholders?

The main attractions for a selling shareholder is the zero per cent rate of CGT that will apply to a qualifying sale, and the hope and expectation that the company brand, behaviours and cultures they have helped to build over a period of time will be retained. Other key points include:

  • A controlling interest in the company or group is sold to the EOT under a share purchase agreement. The EOT ownership must be over 50 per cent, and therefore not all shareholders are required to sell.
  • At least part (and often most) of the sale consideration payable for the shares will usually be paid over a substantial period of time, out of the future profits the trading group realises. This is often one of the main drawbacks for prospective vendors when comparing other exit options, such as a trade sale.
  • The sale price for the shares can go at full market value, or it’s possible for the vendor to sell at ‘undervalue’ with no adverse CGT or inheritance tax implications.
  • The vendor shareholders can still remain as employees or directors of the group, post-sale.
  • The vendor shareholder, or main vendor shareholder if there are numerous sellers, will commonly be one of the trustees of the EOT (or a director of any trustee company).
  • Any minority shareholding retained will not attract the zero per cent CGT rate if this was to be subsequently sold to the EOT.

 

What does an EOT mean for employees?

As employees receive an indirect stake in the business, there are a number of benefits to EOT’s for them. The main things an employee will want to know are:

  • An employee will not become a direct shareholder in the trading company or group.
  • An individual employee will have an indirect ‘ownership’ alongside all other eligible employees (broadly most employees), whilst they are an employee of the company or group.
  • While employees will not receive dividends, they will potentially be entitled to an annual tax-free bonus of up to £3,600 (the EOT bonus). The bonus is subject to National Insurance contributions (NIC) and is dependent on the financial performance of the group and the terms of the EOT bonus scheme. Any bonuses paid in excess of £3,600 will be subject to income tax and NIC and the possibility of this should increase over time, as the deferred consideration owed to the original vendor(s) is paid down.
  • One or more employee representatives will commonly be trustees of the EOT, to ensure the Trust is being governed in accordance with the EOT deed. They don’t usually comprise of the majority of the trustees, however.
  • While overall strategy, day to day decisions and governance remains with the Board of Directors, there’s often scope for increased employee engagement in respect to the strategic decisions of the business. This increased engagement often results in greater employee commitment, drive for innovation and consequently an overall improved business performance.

 

EOT taxation and qualifying conditions

The EOT rules only apply to a person other than a company who disposes of ordinary share capital to an EOT, so usually individual or trust shareholders.

As with most beneficial tax rules or reliefs, a number of conditions must be met by a taxpayer to access the preferential tax treatment. The ability to sell shares to an EOT is no different, as there are a number of CGT qualifying conditions to be met:

  • The trading requirement – The company or group being sold must qualify as a trading company or group for tax purposes.
  • The controlling interest requirement – The EOT must obtain a controlling interest, broadly at least 51 per cent of the ordinary share capital or voting rights.
  • The all-employee benefit (equality) requirement – The shares acquired by the EOT must be held for the benefit of all eligible employees on the same terms. Some employees will be ineligible beneficiaries, broadly those that have held at least a five per cent shareholding in the company in the 10 years prior to the EOT transaction.
  • The limited participation requirement – The vendor shareholders can’t constitute more than 40 per cent of the workforce.

Prior to the implementation of an EOT structure, it is highly recommended that advanced clearance is sought from HMRC. In addition, the trustees and directors will need to ensure they understand the qualifying conditions in order to avoid any post-transaction disqualifying events which could have serious tax consequences for both the vendors and the EOT itself.

 

Other important EOT conditions and frequently asked questions

When discussing the potential for an EOT with our clients, there are a number of key practical questions that commonly arise. These include:

What happens if the EOT decides to sell its shares in the company or group to a third party purchaser?    Can we still incentivise key employees with discretionary bonuses (for instance, non-EOT bonuses)?    Can we still incentivise key employees with equity? 
The tax analysis is dependent on whether or not the EOT is resident in or outside of the UK, but any distribution of ‘net of EOT tax’ proceeds to the employee beneficiaries (after any remaining deferred consideration has been paid to the original vendors) will be taxed as employment income. A carefully constructed non-EOT bonus scheme can be designed to incentivise and reward key employees to grow the business and to grow the value of the shares held by the EOT. As long as the rewards payable under the bonus scheme are established for genuine commercial reasons this should not compromise the qualifying status of the EOT. One of the main concerns or drawbacks with EOT structures, is the perceived inability to incentivise key management, in the form of equity. However, as long as it is structured appropriately, it is possible to implement a share or share option scheme for such individuals as long as the scheme doesn’t result in a disqualifying event, notably, that upon acquisition or exercise the EOT will still hold a controlling interest (at least 51 per cent).

 

Working with FRP

  • Our specialist advisers can assist with the structure of any EOT transaction, including percentage of shares to be sold to the EOT, and structure of any share option or bonus scheme;
  • We can undertake share valuation work to facilitate an agreed price for the shares being transferred to the EOT and financial modelling and forecasting work to predict the likely timescale for the payment of deferred consideration;
  • We can provide tax advice on the qualifying conditions relevant to EOT’s and the drafting of advance clearance applications to HMRC;
  • We will work collaboratively alongside your solicitors and existing business advisers to implement the EOT structure;
  • We can assist in sourcing appropriate and competitive finance options to provide additional ‘day one’ cash; and
  • Pre, during and post transition to the EOT structure, we provide ongoing advice to assist business owners who wish to transition to the EOT ownership model.

Getting in touch

Jon Dodge

Jon Dodge

  • Partner
  • Corporate Finance, Forensic Services
  • Norwich

Matt Field

Matt Field

  • Director
  • Corporate Finance
  • Norwich

Dave Howes

Dave Howes

  • Partner
  • Corporate Finance
  • Norwich

Tony Longman

Tony Longman

  • Director
  • Corporate Finance
  • Norwich