Employee Ownership Trust reform – what you need to know

Ten years on from the introduction of the Employee Ownership Trust (EOT) regime and following a consultation on the regime last summer, the UK government has introduced reform to the existing EOT regime, with a view to continuing to support genuine employee ownership and preventing abuse, whilst bringing welcome technical clarifications to the operation of the regime.

Summary of the current EOT regime

Introduced in 2014 to facilitate employee ownership of companies, the EOT regime enables an EOT to acquire a controlling stake in a company, offering capital gains tax relief (EOT Relief) to former owners upon the sale of their shares to an EOT.

In recent years where there has been a lack of willing trade or PE buyers in the market, structuring transactions within the EOT regime has become an increasingly popular route for owners looking to generate liquidity in a tax-efficient manner, particularly as other CGT Reliefs have been scaled back. For example, Business Asset Disposal Relief has become much less valuable (as well as more difficult to qualify for) in the last few years, with the lifetime limit for qualifying chargeable gains having been reduced from £10 million to £1 million, and the required holding period having been extended from 12 months to 24 months.  

It is apparent that HMRC perceive that for some EOT transactions, the tax benefits, rather than employee-ownership, have been the primary motivating factors.  The 2023 consultation raised potential areas of reform to the EOT regime to address HMRC’s concerns in this respect.  

Reform of the EOT regime (and the policy reasons underpinning this reform)

A new “day 1” requirement

A new “day 1” requirement for EOT Relief (which must be satisfied upon the sale to the EOT) will require the trustee(s) to take reasonable steps to ensure that the consideration paid for the company shares does not exceed market value, addressing concerns that former owners may be motivated to inflate the market value of their shares to maximise their cash proceeds and the benefit of the EOT Relief. There is a wider concern that the existing anti-avoidance rules in this area potentially do not provide an adequate toolkit for HMRC to challenge deliberate inflation of the sale price.

For example, the ‘transactions in securities’ rules, which could in principle counteract any capital gains tax advantage achieved, could not be applied where the majority sale to the EOT comprises at least 75% of the ordinary share capital (this is because there is a “safe harbour” from the application of the rules where there is an at least 75% acquisition).

We await further guidance on what ‘reasonable steps’ would be in this context, noting that a variety of share valuation methods are available (and some may be more appropriate for a trade buyer vs an EOT buyer (which will only be able to fund the consideration to the extent the business has sufficient cash receipts)) and so it may be difficult to precisely ascertain the market value. Noting these valuation challenges, it is welcome that an absolute requirement that a disposal to an EOT must be at no more than market value to qualify for EOT Relief has not been introduced – this would introduce an inappropriate element of uncertainty as to qualification for the EOT Relief.

It is not yet clear what a trustee must do to discharge its ‘reasonable steps’ obligation. We note that a professional valuer would in practice often be instructed to value the shares being sold to the EOT. Though HMRC is not bound by such a valuation, it is difficult to envisage what else a trustee could reasonably be expected to do in that scenario to discharge its obligation, and we trust that HMRC will provide some further guidance on this in due course.

Former owners (or persons connected with former owners) will be restricted from retaining control of companies post-sale to an EOT by virtue of control (direct or indirect) of the EOT

EOT Relief will not be available (or will cease to be available) unless a majority of the trustees of an EOT consists of persons other than:

• the former owners;
• persons connected with the former owners;
• companies under the control of the former owners or connected persons;
• companies where half or more of the directors are former owners or connected persons.

In addition, EOT Relief will not be available where the persons above are able to exercise control of the EOT through powers conferred to them under the EOT trust deed.

These restrictions will not apply to EOTs established before 30 October 2024, and have been introduced to ensure that the wider policy objective of EOTs (i.e. that businesses are employee-controlled) is actually achieved (and not undermined).

In connection with the restriction that there cannot now be a majority of former owner directors for a corporate trustee, only former owners beyond a threshold percentage shareholding (broadly, 5% or more) will be counted as a ‘former owner’ for this purpose – this addresses on a concern brought out in some of the responses to the consultation that, as employees are often gifted a small amount of shares prior to a sale to an EOT (or perhaps have exercised some share options), they would otherwise be precluded from joining the trustee board if other former owner directors were already on the trustee board.

The UK government has confirmed that legislation will not be introduced to mandate the appointment of an employee representative or an independent trustee on the trustee board.

Funding of the EOT

Sales to EOTs are often structured as the payment of initial consideration, followed by payments deferred consideration (recognising the commercial reality that the purchase price is effectively funded by the business, and it is often the case that the business will not have sufficient cash resources available to fund the entire consideration upfront).

As EOTs are often established shortly prior to the sale, they must be initially funded (to fund the payment of the initial consideration plus pay any stamp duty liability) and latterly funded (to fund the payment of the deferred consideration). These funds are generally gifted to the EOT by the business – in principle, the existing legislation indicates that this gift should be characterised as a taxable distribution to the EOT, even though the gift is only being made to fund the wider EOT transaction, and would be contrary to the spirit of the EOT legislation which provides for EOT Relief on the basis that tax charges (which might otherwise inhibit a move to an employee-owned structure) should be discouraged.

It is typical for a non-statutory clearance to be requested from HMRC that it will not seek to tax these payments as distributions – the UK government has confirmed that an explicit relieving provision will be introduced to put the position beyond doubt and confirm that any such payments made on or after 30 October 2024 are not taxed as distributions. This is a welcome introduction by the UK government and brings much needed clarity going forwards.

Tax residence of the EOT

A new requirement will be introduced which will require the trustees of the EOT to be UK tax resident (as a single body of persons), to guard against the risk that a future disposal (or deemed disposal) of the Target shares by the EOT would escape the UK tax net. A breach of this condition (either upon sale to the EOT or at any time following the sale) would result in the loss of the EOT Relief, and an ‘exit charge’ for the trust under existing chargeable gains legislation.

This restriction will not apply to EOTs established before 30 October 2024.

Ongoing satisfaction of the conditions for EOT Relief

The EOT regime has a ‘monitoring window’ up to the end of the first tax year following the tax year in which the sale to an EOT takes place, whereby the technical requirements for EOT Relief must continue to be met, otherwise EOT Relief ceases to be available. There was a concern that, following the (relatively short) monitoring window, there could be an immediate sale to a third-party, with the former owners retaining EOT Relief, which would frustrate the objective of long-term employee-ownership.

Any sale to an EOT on or after 30 October 2024 must now continue to meet these technical requirements for a period of four tax years after the end of the tax year in which the EOT sale takes place, with a stated aim of ensuring the long-term encouragement of employee ownership (by reason of meeting the technical requirements for a longer period).  

Other measures

Under the current regime, it is possible for an EOT-owned company to pay up to £3,600 annual as a tax free-bonus to employees (on the basis that such bonus is in principle available to all employees, including directors). With respect to bonus payments made on or after 30 October 2024, there will be an additional element of flexibility and it will now be possible to exclude directors from any such bonus award.

The UK government has indicated that it has no current plans to increase the amount of the tax-free bonus.

A new requirement has also been introduced which will require sellers to include within their claim for EOT Relief in their self-assessment tax return information on the sale proceeds, as well as the number of employees of the company at the time of disposal. This requirement will apply for claims relating to the 2024/25 tax year onwards, with the stated policy aim being to allow HMRC to ‘better monitor and evaluate the relief’.