The concept of employee ownership is nothing new in tax legislation (see, for example, tax-advantaged share schemes and employee benefit trusts within Part 7, Income Tax (Earnings and Pensions) Act (ITEPA) 2003). However, government policy to encourage employee ownership on a grander scale led to the commissioning, in 2012, of a report by the then Conservative-Liberal Democrat coalition government (the Nuttall review of employee ownership).

Fast forward to 2014, and the EOT provisions were enacted into s236H-236U, Taxation of Chargeable Gains Act (TCGA) 1992 by the Finance Act 2014.

For more than a decade, provided certain conditions are met, this legislation has allowed shareholders to realise a capital gains tax (CGT)-free gain where a trading company is sold to an EOT, and for employees to benefit from income tax-free bonuses of up to £3,600 per year. As a result, The Employee Ownership Association’s website now reports that there are approximately 1,650 employee-owned businesses in the UK. 

In this article, I’ll set out some of the non-tax benefits of employee ownership, explain the typical structure of an EOT and highlight some accounting issues I have come across in practice. In a second article I will look more closely at the tax benefits for the vendor shareholders and the employees. All references to “draft legislation” are to Finance Bill 2024-25 as introduced to Parliament on 7 November 2024. This gives effect to the measures relevant to EOTs announced at the Autumn Budget 2024.

Why employee ownership?

Evidence shows a number of potential benefits, including a company that is more productive, innovative and resilient to economic turbulence, and employees that are more engaged, more fulfilled and less stressed. Altogether, an employee-owned business should provide growth to the economy as a whole.

Clearly, telling shareholders they can realise a sale for full market value and pay no tax regardless of the amount involved will attract vendor shareholders. However, headlines such as “How to sell your business tax-free” are, in my opinion, against the spirit of the EOT legislation. 

To be clear, an EOT should primarily be viewed as a business structure rather than a form of tax relief. This distinction is crucial because, while a tax-free sale is rather enticing, an inappropriate or poorly planned sale into an EOT could push the business into financial hardship and jeopardise the business’s ability to repay any amounts outstanding to the vendor shareholders.

In a wider succession planning conversation with clients, the commercial aspects of employee ownership must be considered. For example, who is going to run the business if the vendors are retiring? If a management team is already in place, how will they feel about not having the opportunity to lead a management buy-out and owning shares directly?

The sale into an EOT is merely the beginning of a new journey for the company. If done right and communicated effectively to the workforce, it can produce significant benefits and growth.

Structure of the EOT

The concept of an EOT is that a discretionary trust is set up to acquire the shares of the target company from the vendor shareholders. The beneficiaries of the trust must be the employees as a whole, with only limited reasons why an employee may be excluded (eg, the employee is a participator in the company). 

Until recently, there was nothing within the tax legislation stating who the trustees should be. However, draft legislation introduces a new “trustee independence requirement” with effect for disposals to an EOT made on or after 30 October 2024. This ensures that excluded participators (ie, the vendors) cannot control the EOT by constituting 50% or more of the trustee board or by controlling the trustee company. 

A typical structure is for there to be at least one vendor as a trustee, at least while they have consideration outstanding; an individual to represent the employees as a whole (often elected by an employee council); and an independent trustee. Trustees must act only in the best interests of the trust.

It is common for a new company to be incorporated to be the sole corporate trustee (TrustCo) of the EOT. The above individuals would then be directors of TrustCo to undertake their duties. TrustCo is often incorporated as a company limited by guarantee. It is likely to do nothing other than have its directors fulfil their trustee duties. TrustCo is the corporate trustee of the discretionary trust, and it is the discretionary trust that holds the shares and owes the deferred consideration to the vendors.

Example structure of a company under employee ownership

In practice, there are a number of variations to the above. For example, you may see a form of circular ownership where the trading company is the member of TrustCo, as this seems to have become a standard model for some advisers. However, it may be best for TrustCo to be an independent company owned by its directors, as this may avoid confusion in governance arrangements and have some tax benefits as well. The point being, when dealing with the ongoing compliance of an EOT structure, it will be important to scrutinise the structure to ensure a full understanding, as they are not all the same.

Sale value

The trustees have an obligation to the beneficiaries not to overpay for the shares, and for disposals made on or after 30 October 2024 draft legislation imposes a statutory requirement to this effect. Therefore, an independent valuation should be obtained. 

There are no tax issues with the vendors selling at an undervalue. Some vendors may wish to do this as part of a reward for the employees’ work, while others may consider the fact that they are saving CGT of up to 24%, which means that some of that saving may be given up in a lower sales price. This also puts less pressure on the company while it repays third-party funding or deferred consideration.

Funding

It is common for an EOT sale to be funded out of existing cash reserves and the remaining consideration to be deferred and paid out of future profits. Where this is the case, the company must provide the funds to the EOT, which the EOT can then use to pay the vendors.

Common practice has been to apply for a non-statutory clearance from HMRC to confirm the payments would be treated as ‘contributions’ and therefore not taxable as distributions in the hands of the trust. However, for distributions made on or after 30 October 2024, draft legislation provides a statutory relief where the distributions are used to fund the consideration, as well as interest on deferred consideration (up to a reasonable commercial rate) and the stamp duty charged on acquisition. The relief must be claimed. 

This new legislation does, however, introduce some uncertainty, as costs previously approved via the non-statutory clearance (most notably professional fees and trustee costs) are not included within the draft legislation. Furthermore, HMRC will no longer respond to non-statutory clearances on this matter. This could mean the trading company will pay any other trustee expenses directly as a term of the transaction, which is common practice.

Whether payments are treated as contributions or distributions, for company law purposes they are no different. They are still distributions, meaning the company requires distributable reserves to make them.

Should the vendors require a higher upfront cash payment than the company can afford, bank funding is possible. The company will likely find it easier to acquire financing by securing the loan against its assets. However, this then creates the problem of how the company pays this to the trust as the receipt of the loan will not create distributable reserves.

Alternatively, the trust itself may obtain finance. In my experience, there are very few banks willing to lend to an EOT directly, although this has improved recently. A bank securing its loan against the company’s shares should not be fatal to the control condition for CGT relief by virtue of s236T, TCGA 1992. I will look at the control condition in detail in my next article. 

Accounting implications

Now that we are seeing so many more EOT sales being undertaken, there have been numerous iterations of company accounts in an EOT structure and we have received many queries in relation to this.

As explained above, TrustCo does not own any shares or have any debt due to the vendors. Furthermore, it is often a company limited by guarantee meaning it doesn’t even recognise share capital on the balance sheet. 

If the discretionary trust produced a balance sheet it would show an investment in the company. This is likely to be its only asset. It will also have any deferred consideration due to the vendors as a liability. The trust must follow normal trust rules, including being registered with HMRC. 

As regards income, for distributions made up to and including 29 October 2024, the trust was unlikely to have any taxable income given that contributions are not treated as taxable, in accordance with the HMRC clearance.

However, it seems distributions made from 30 October 2024 will be treated as taxable income. As stated above, relief may be claimed if they are used to fund consideration, interest or stamp duty. The result appears to be that the discretionary trust will have to file tax returns in future years, adding an administrative burden. For other costs, such as professional fees that have to be paid out of trust funds and not covered by the new distributions relief, the trust may well now have taxable income.

For EOTs established before 30 October 2024, having obtained non-statutory clearance regarding contributions, the position is somewhat in doubt. While HMRC says that all previous clearances will be honoured, there is uncertainty as to how this will be achieved in respect of payments by the company to fund other legitimate costs incurred by the trustees, such as professional fees on valuations and acquiring the shares, fees to professional trustees, etc.

The accounts of the trading company or group are unlikely to change. Importantly, the deferred consideration owed to the vendors is not a debt of the trading company. Although, in reality, the only way for the EOT to pay the vendors is out of profits from the company, this is not a formal debt of the company. Further, as the trading company does not have control or de facto control over the EOT, despite often being the sole member of TrustCo, there is no consolidation of either TrustCo or the discretionary trust in the entity’s accounts. 

Nick Wright, Director, Jerroms Miller