In my first article, I explained how EOTs can be used and set out some of the non-tax benefits. In this article I’ll focus on the main tax reliefs and conditions for the individuals selling their shares in the trading company to the EOT, and for the employees receiving bonuses from the company. 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 

Income tax relief for employees

During the lifetime of the EOT, the employees can benefit from an income tax-free bonus of up to £3,600 per tax year (s312A, Income Tax (Earnings and Pensions) Act (ITEPA) 2003). However, both primary and secondary class 1 national insurance contributions are still payable on the bonus as earnings. For a detailed analysis of this relief, see an earlier TAXline article: Employee ownership: paying tax-free qualifying bonuses.

Given that this limit has not changed since the inception of the EOT legislation in 2014, the value of this benefit has fallen in real terms. While we have seen some changes to EOT legislation as a result of the 2024 Autumn Budget, there is no proposed change to the tax-free amount. The only change is that draft legislation has been published, which provides that directors may now be excluded from benefiting from the tax-free bonus.

Other than the income tax-free bonus, there are no other direct tax benefits for the employee of a company owned by an EOT. However, once any deferred consideration has been paid off, a company wholly owned by an EOT will have no external shareholders requiring a return of value, meaning no dividends will be paid by the company. This typically means that the company will have more cash to either reinvest and grow the business or pay market-beating salaries.

Given the lack of direct benefit for key employees, a share option scheme may be set up (such as enterprise management incentives). This should incentivise the key managers to pay any deferred consideration to the former shareholders, following which they will be entitled to exercise their options and own shares directly.

CGT relief for vendors

Where an individual disposes of shares in a trading company to an EOT, the disposal, and the acquisition by the trustees, are treated as being made for such consideration as to secure that neither a gain nor a loss accrues on the disposal (s236H, Taxation of Chargeable Gains Act (TCGA) 1992). In other words, the disposal is CGT-free for the vendor shareholders and the EOT inherits the base cost of the shares. 

The relief is only available for the tax year in which the EOT obtains control of the company. Disposals in previous and future tax years are subject to CGT as normal. 

The following four basic conditions must be met for the CGT relief to be available:

The following four basic conditions must be met for the CGT relief to be available:

1. the trading requirement (s236I, TCGA 1992);
2. the all-employee benefit requirement (s236J, TCGA 1992);
3. the controlling interest requirement (s236M, TCGA 1992); and
4. the limited participation requirement (s236N, TCGA 1992).

Draft legislation has been published that introduces the following additional requirements:

5. the trustee residence requirement;
6. the trustee independence requirement;
7. the consideration requirement; and
8. the information requirement.

Conditions 5-7 apply with effect for disposals to EOTs made on or after 30 October 2024. Condition 8 applies for claims for CGT relief made on or after 6 April 2025. 

All conditions must be satisfied on the date the EOT acquires the shares and forever after. If any of the conditions are failed by the end of the following tax year in which the EOT obtains control, the original vendors will lose their relief and be subject to CGT. This is extended by draft legislation to the end of the fourth tax year for disposals to EOTs made on or after 30 October 2024. 

At any point following this, a disqualifying event will mean that the trust is treated as disposing of the shares and immediately reacquiring them at market value. Given the base cost from the original no-gain-no-loss transfer is likely to be low, this could cause a significant CGT charge for the trustees.

The trading requirement

The trading requirement is likely to be familiar to most readers and requires that the company is a trading company or the holding company of a trading group. This test is an identical test to other areas of the legislation such as gift relief, business asset disposal relief and the substantial shareholding exemption.

Non-trading activities are acceptable provided they are not ‘substantial’, which HMRC interprets to mean no more than 20% of its activities being non-trading activities. This is a holistic test considered based on a variety of factors such income, expenses, assets and management time.

The all-employee benefit requirement

The all-employee benefit requirement requires that all employees must be eligible to benefit from the trust.

This is extended by s236K, TCGA 1992 to state that this must be applied on “equal terms”. There is some scope for flexibility by varying how employees can benefit but only in relation to their remuneration, length of service and/or hours worked.

The beneficiaries cannot include “excluded participators” or anyone connected with them (spouse or civil partner, brothers, sisters, ancestors or lineal descendants, uncles, aunts, nephews and nieces). The only exception being where the participator does not hold 5% or more of the share capital or any class of shares.

This “any class of shares” wording creates difficulty. For example, a company has 10,000 ordinary shares held by a single shareholder, and five A shares each held by different key managers. Each manager holds 20% of the A shares and they are therefore also excluded participators.

For this purpose, anyone who has held 5% or more of any class of shares at any time in the previous 10 years must be considered.

The controlling interest requirement

The controlling interest requirement states that relief will only be available for disposal in the tax year that the EOT obtains control of the company.

In theory, there could be numerous disposals in the same tax year, all of which obtain relief once the EOT passes the 50% threshold. However, the main consequence is that when vendors do not wish to sell all their shares, they must be aware that any sales to the trust in future years will not benefit from relief. For example, if a shareholder sells 75% of the share capital to an EOT in 2024/25, this will obtain full relief from CGT. If they then sell their remaining 25% in 2025/26, this second disposal will be subject to CGT as normal.

The control test requires the EOT to hold more than 50% of all the following:

• ordinary share capital (measured by nominal value);
• voting power;
• profits available for distribution to equity holders; and
• assets on a winding up.

Furthermore, there can be no provisions in any agreement that could cause the EOT to lose control without the consent of the trustees.

The limited participation requirement

The limited participation requirement is the only one of the four requirements that must be satisfied for a period prior to the date the EOT obtains control. This condition must be considered for the 12 months prior to the sale as well as forever after.

The limited participation requirement demands the following fraction not to exceed two-fifths:

NP = Number of participators that are employees or office holders

NE = Number of employees

Participators who do not (together with their associates) hold more than 5% of the ordinary share capital, or 5% of any class of shares, are excluded from NP. Taking the same example as in the all-employee benefit requirement, where each of the five key managers holds 20% of the A shares, each manager therefore holds more than 5% of any class of shares and is included in the total for calculating NP, despite having only 0.01% of the total share capital.

Helpfully, there is a six-month grace period where a disqualifying event is not triggered despite the above fraction being exceeded, provided it is outside the reasonable control of the trustees.

The trustee residence requirement

Draft legislation provides that the trustees of the settlement (or the directors of the trust company) must be UK resident at the time of disposal as well as forever after. If the trustees cease to meet this requirement, a disqualifying event will be triggered as for the original relief requirements. While the draft legislation includes a six-month grace period, this is only in the event of the death of a trustee. There is no such grace period for other situations, for example, if the requirement is failed as a result of a trustee emigrating. In these instances, the trustee must resign before becoming non-resident and, subject to the terms of the trust deed, presumably be replaced. 

The trustee independence requirement

This requirement ensures that the original shareholders of the company cannot retain control of the trust following disposal. The draft legislation achieves this by requiring that less than 50% of the trustees are excluded participators, and excluded participators do not have control of the trust. As with the trustee residence requirement, a disqualifying event will also be triggered if this condition is failed at any point and, again, there is a six-month grace period on the death of a trustee of the settlement or of a director of a company that is a trustee of the settlement, as detailed above.

The consideration requirement

Draft legislation requires that the trustees must take reasonable steps to ensure that the consideration paid for the shares does not exceed market value and that, if any consideration is deferred, the interest payable does not exceed a reasonable commercial rate. Essentially, the trustees are now required to obtain an independent valuation to support the purchase price.

Given the trustees have always had a fiduciary duty to act in the best interest of the beneficiaries (the employees), this has always been good practice. The draft legislation simply makes this a requirement for relief as well.

The information requirement

The new information requirement states that, when claiming EOT relief, the vendors must now state the consideration for the disposal as well as the number of employees in the company (or group) at the time of disposal.

Clearances

It is normal to apply for clearance under s701, Income Tax Act 2007 (the transaction in securities (TiS) rules) to ensure HMRC does not consider the transaction to be undertaken for the main purpose of obtaining an income tax advantage. If the TiS rules did apply, then not only would the EOT CGT relief be denied but the proceeds would be subject to income tax as a dividend.

Prior to the Autumn Budget, there were also two non-statutory clearances commonly applied for. The first was to ensure that the benefits to participators provisions of s464A, Corporation Tax Act 2010 do not apply. The second is in relation to the distributions issue explained in my earlier article. HMRC has now confirmed it will not provide clearance in relation to these issues. The s464A clearance was always a low risk on the basis that tax avoidance was not involved in the transaction, and we now have a statutory relief in relation to distributions, although as I have discussed, this is limited in scope.

Nick Wright, Director, Jerroms Miller