EOTs were originally introduced by the coalition government in 2014 to encourage wider employee ownership. EOTs provide capital gains tax (CGT) relief for owners of companies selling the shares of their trading company into a trust set up for the benefit of the company's employees. A number of requirements must be met for the relief to be available. (It is worth noting the relief is a relief for the sellers, but is really a deferral of tax as any gain will ultimately come into charge on the trustees if the EOT sells the business in the future.)
We have advised company owners, trustees and third party funders on EOTs structures and we have seen them grow in popularity after a relatively slow start. The increases in CGT announced in the Budget make EOTs even more attractive to business owners.
The consultation in 2023 sought to make some changes to the EOT rules to ensure that the legislation operated as the Government had intended.
The majority of the changes were anticipated but there were a few surprises. While we do not have the draft legislation yet, the announcements set out the following changes.
- Former owners of the company (or persons connected with them) are restricted from retaining control of the company after a sale to an EOT, by controlling the EOT itself.
- The trustees of the EOT, must be UK resident at the time of disposal to the EOT. This is to ensure that the EOT relief acts as deferral of tax rather than an exemption by allowing non-UK resident trustees to realise a gain by selling the shares in the company, which would have escaped UK CGT.
- Finally, there has been some doubt as to how contributions to the EOT from the company should be treated for tax purposes, as this is not dealt with in the legislation. It was therefore routine for EOTs to obtain a non-statutory clearance from HMRC that the contributions would not be taxed in the hands of the trustees. The response from the Government confirms that these contributions will be treated as distributions, but they will be tax free if the contribution is to repay the sellers for the shares in the company and meet the costs of acquiring the shares (including stamp duty and reasonable interest on deferred consideration).
These three changes were largely expected.
In addition, a number of other changes were made that were contemplated by the consultation but were less widely considered.
1) Employees of companies owned by EOTs can receive a "bonus" of up to £3,600 each year that is tax free (but not free of national insurance). This bonus must be paid to all staff on the same terms (with some limited exclusions). The changes from today will allow bonuses to be awarded to employees but not to directors. This provides some flexibility and may allow the bonuses to be paid to the less well remunerated staff rather than to the directors of the company.
Before 30 October 2024, CGT relief that sellers enjoy will be withdrawn if the company fails to meet the qualifying conditions for EOT before the end of the tax year following the tax year in which the disposal occurs. This withdrawal is now extended if the conditions are not met before the end of the fourth tax year following the tax year of disposal.
This is quite a significant change and one that could potentially cause problems. If the seller does not control the business after the sale, which it cannot, and now under the changes announced today it cannot control the EOT; how does the seller ensure that the company continues to meet the necessary conditions and does not trigger a claw back of the seller's CGT relief? This is already a problem for sellers but the problem is now more of an issue as the period is extended significantly
The way in which this is typically dealt with is that the most sellers require the trustees of the EOT to provide an indemnity to them to cover the CGT if the EOT CGT relief is withdrawn as a result of failing these conditions. This will become more important for sellers, and potentially more onerous for trustees, who may suffer a "dry" tax charge.
2) The new legislation will also require that the trustees must take "reasonable steps" to ensure that the consideration paid to acquire the company's shares does not exceed the market value of those shares. It is not clear what steps these may be or what HMRC will consider is "reasonable", but trustees should now have any valuation reports addressed to them as well as the sellers. If the trustees do not take reasonable steps then the disposal may not qualify for relief and the trustees may be taxed on the distributions from company.
We think that this is probably a sensible change as EOTs are intended to allow the business to flourish for the long term under employee ownership and EOT relief is not intended to weigh down a company with long term debt. Valuation is obviously a crucial consideration when any part of the consideration is funded by third party debt secured on the EOT assets and the company. It should also probably be welcomed by sellers who genuinely want to pass the benefit of the business to its employees and who have technically run the risk of an employment related securities charge if the company's shares were sold to an EOT for more than market value.
3) Finally, in an administrative change to the rules, that is effectively retrospective, for the 2024/25 tax year onwards, sellers of shares to EOTs must include details of the consideration they have received for the shares and the number of employees of the company at the date of disposal when making a claim for EOT CGT relief in their self-assessment tax return. This is intended to allow the HMRC to, "better monitor and evaluate the relief". This will affect anyone who sold their shares to an EOT since 6 April 2024.
