Employee Ownership Trusts: Tax Rules and HMRC Consultation

Employee ownership in the John Lewis mould, and Employee Ownership Trusts (EOTs) in particular, have been attracting more and more attention in recent years. This is clear not only from comment in the financial press, but also in figures published by the Employee Ownership Association (EOA).

Apart from the potential benefits in terms of succession, business continuity and employee engagement, EOTs open the door to two particular tax reliefs. One of these can eliminate Capital Gains Tax (CGT) altogether on a sale of company shares, while the other allows the payment of tax-free bonuses to employees which, while the annual limit is fairly modest, can in time amount to a tidy sum.

It is perhaps not surprising, therefore, that HM Revenue & Customs (HMRC) have expressed concern at potential abuses by unscrupulous business owners who, they suspect,  may be looking to reap the tax benefits of an EOT while only paying lip service to the true spirit of employee ownership.

Qualifying conditions for an EOT

There are five main conditions for EOTs, broadly as follows:

• the shares being sold to the EOT must be in a trading company or the holding company of a trading group
• a maximum of 2 in 5 employees can be ‘participators’ (individuals owning or entitled to more than 5% of a company’s share capital) or connected persons (such as spouses)
• the EOT must hold a controlling interest in the target company
• the EOT must be for the benefit of all employees on the same terms (although the amounts paid to employees can vary by reference to remuneration, length of service or hours worked); and
• the selling shareholder must be UK tax resident and not a company or an institution.

Potential advantages of an EOT

These include:

• no CGT for the seller – saving tax at up to 20% (potentially a very significant sum)
• the seller is able to remain involved in the business – perhaps continuing as a director until all proceeds have been received
• increased employee engagement from their entitlement to share in the profits of the business
• no income tax on bonuses of up to £3,600 a year per employee.

HMRC Consultation

The consultation asked for comments on a dozen questions and proposals, a number of which are likely only to be of interest to tax professionals, but readers may wish to note the following proposals:

• to prohibit former owners and connected persons from retaining control of the company post-sale by appointing themselves in control of the EOT trustee board
• to require that the EOT trustee board includes persons drawn from specific groups, such as employees or independent persons

• to limit to 25% the number of employees connected to a participator who are able to receive income payments
• to ease the EOT bonus rules so that tax-free bonuses can be awarded to employees without directors necessarily also having to be included.

HMRC also asked respondents to submit other ideas for consideration. Suggestions that we are aware of include:

• clarifying and/or relaxing the test for trading status to take account of the business need for many companies to hold substantial cash reserves in the current economic climate
• raising the £3,600 limit on tax-free bonuses, which has not changed since it was introduced in 2014
• permitting additional criteria for the allocation of bonuses, such as job role/level.

It is disappointing that the outcome of the consultation, which closed in September 2023, is yet to be published. In the meantime, the questions that HMRC have raised are fairly benign, and there seems no reason to fear that they are opposed to EOTs in principle, nor that the main advantages of EOTs will be curtailed as a result of the consultation.

While EOTs are not for everyone – for example, where a sale to a third party could generate a higher return net of CGT than a tax-free sale to an EOT – they are likely to remain a popular alternative where the circumstances are right, and should always be considered during pre-sale planning.

It seems safe to assume that an incoming Labour government would be in favour of further widening employee ownership, but that any radical Corbyn-era plans for compulsory “Inclusive Ownership Funds” are probably not on Rachel Reeves’s agenda. And so EOTs – perhaps with further limited adjustments – should be with us for some time to come.

If you are interested in discussing EOT as a possible succession planning option for your business, please call Paul Harris on 0330 058 6559 or email hello@scruttonbland.co.uk