Employee Ownership Trusts
Employee Ownership Trusts (EOTs) were established in 2014 with the aim of promoting employee ownership as a business model in the UK. Some of the better-known EOTs include Waitrose, John Lewis, Arup Group and Richer Sounds.
What is an Employee Ownership Trust (EOT)?
An EOT is a trust (or trust company) established to own shares in a trading company for the benefit of the employees of the company, thereby creating indirect ownership of the company by the employees.
Under the Finance Act 2004, the UK government made using EOT’s very attractive by granting a number of tax reliefs:
- Any individual who disposes of shares in a company to an EOT will be exempt from capital gains tax (CGT). This will become more important in the future with rumoured changes to the rates of CGT and removal of Business Asset Disposal Relief;
- The EOT can pay each employee an annual bonus of up to £3,600 free of any income tax; and
- There is relief from inheritance tax on certain transfers into and from the EOT.
There are several conditions that need to be satisfied to obtain the tax reliefs, including:
- The EOT must hold more than 50% of the ordinary share capital of the company;
- The benefits of the EOT must be available to all employees;
- All employees must be treated equally (subject to some limited exceptions); and
- The target company must be trading.
This is not an exhaustive list of the conditions, and it is crucial that an eligibility assessment is conducted at an early stage of planning to implement an EOT. We can work with you and your accountant or tax advisors to assist in ensuring the structure of an EOT is correct.
Our Approach to Employee Ownership Trusts
We have significant experience in advising clients on establishing and creating EOTs. Whilst there are many advantages to creating an EOT, there are some pitfalls, and it is important to take professional advice in planning and structuring the transaction.
An EOT will involve the sale of more than 50% (and in some cases 100%) of your company to the EOT. As part of the sale process, you will need to consider various factors, including:
- Share Purchase Agreement – Effectively, the sale of the shares will be a form of management buy-out, with the trustees representing the employees, and will need to be negotiated accordingly;
- Valuation and funding – Typically, an independent valuation of the company will be carried out, and a market value determined. The payment of the purchase price is commonly funded from current cash reserves and future profits. However, debt finance is also an option which can be explored.
- Deferred consideration – Depending on the funding, it is common for the purchase price to be paid on a deferred basis, often over several years. Consideration will need to be given as to cash flow, how to best structure the payment terms and whether security is necessary (and the extent of such security without breaching the rules to meet an EOT transaction);
- Management Team – It is key to ensure that the management team “buy in” to the deal as they will be key to ensuring the future success of the company and that any deferred payments are made; and
- Shareholder arrangements – Where a seller is retaining any interest in the company post-completion, a shareholders’ agreement (and suitable articles of association) will need to be considered and the appropriate documentation produced to manage those relationships.
In some cases, an EOT has not been suitable, and we have worked closely with our clients to consider the requirements of all parties in order to come up with an alternative structure which benefits everyone, although not necessarily with the same tax benefits.v
Here are some of the most frequent questions we receive, answered by our expert EOT solicitors.
What are the advantages of an EOT for the selling shareholders?
A key incentive for the selling shareholders is the beneficial tax treatment offered. The Finance Act 2014 offers 100% relief from Capital Gains Tax (“CGT”) provided strict requirements are adhered to, which include (amongst others) that:
- the current shareholders cease to have control, and the EOT must acquire more than 50% of the issued share capital of the company (this is known as the “Controlling Interest Requirement”);
- the benefit derived from the EOT must be to all employees (subject to limited exceptions) and must be on the same terms. Employees can receive different amounts depending on their length of service, hours worked, and remuneration, but this requires careful planning to ensure it aligns with the equality principles of the EOT legislation; and
- other conditions, including that the company is a trading company, as well as a requirement that the number of employees who own 5% of the company must not exceed two-fifths of the workforce generally (known as the “5/2 rule”).
These rules require careful consideration, and there are additional nuances to each of them. However, subject to the satisfaction of the criteria, the selling shareholders effectively get a CGT rate of 0% on the disposal of their shares.
The sale to an EOT can also offer the opportunity to the selling shareholders to either continue working in the business or allow them to retire and provide a full exit route. The EOT model allows the business to continue to operate as it has done to date and can, therefore, prove an attractive option for the company owners to preserve the company’s independence and values whilst creating a legacy for the owners.
The sale of shares to an EOT can save time and money as it provides the selling shareholders with an exit without the need to find a buyer that will conduct extensive due diligence on the company (following which they may seek to change the terms of the proposed sale or ultimately withdraw their offer to purchase) and require the selling shareholders to give a series of warranties and indemnities relating to various aspects of the company and its business. The selling shareholders will also lead the transaction, which allows them to set the timescales and control the implementation of the transition to EOT ownership.
Are there any disadvantages of an EOT for the selling shareholders?
As there are strict qualifying conditions attached to the available tax reliefs, there is a risk that the tax reliefs could be lost if a disqualifying event occurs following the end of the tax year after the one in which the CGT relief is claimed, for instance, the Controlling Interest Requirement ceasing to be met. Usually, the trust or the company will, therefore, undertake not to take steps that would result in the occurrence of a disqualifying event and possibly even indemnify the selling shareholders against the loss of any CGT relief.
It is important to consider how many shares the EOT can afford to acquire (noting that it is customary for the purchase to be funded out of future profits), and it may be that the transition to an EOT may take many years. There are, however, debt finance and future refinance, opportunities available which may help with this.
The primary disadvantage of the EOT for selling shareholders who are not seeking a full exit is the loss of control over the company. This could lead to conflicts of interest with the selling shareholder(s) who retain a minority stake. The selling shareholders should, therefore, be comfortable with this transition of power. A shareholders’ agreement may help and is permitted under EOT ownership, provided that it does not indirectly preserve control with the selling shareholders.
What are the advantages of an EOT for the employees?
Under an EOT, the future profits, growth of the business and any further eventual sale will be for the benefit of the workforce as a whole.
The employees of a company that is owned by an EOT can benefit from the future success of the company and be eligible to receive an annual bonus of up to £3,600, which will be income tax-free (although the bonus will remain subject to national insurance contributions). This relief is only available, however, if certain conditions are satisfied, some of which mirror those that are applicable for CGT relief.
The EOT ownership model is an indirect employee ownership model whereby the shares in the capital of the company are held for the benefit of the company’s employees. Whilst the employees will not be able to directly control the direction of the company, sometimes companies with a larger number of employees may elect to set up an employee council, whose role will be to listen to the concerns of employees and feed those views back to the trustee which may influence how the company operates.
The sale of shares in a company to an EOT can offer continuity to the current employees as they will continue in their current roles on their present contractual terms, and there may be less change than what they may otherwise experience if the company was sold to a third-party buyer (as the selling shareholders are likely to stay in place as the company’s management team).
Are there any disadvantages of an EOT for the employees?
There are few disadvantages for the employees, although some employees who foresee themselves as future business owners may feel that there is less scope for this under the EOT ownership structure. However, it is still possible to award employees with direct share ownership or offer share options alongside the EOT (but not to give those persons a controlling stake).
Are there any advantages for the company itself?
For the company, the EOT ownership model can help improve productivity and, in turn, the financial performance of the company, as employees feel incentivised as they have an indirect stake in the business.
EOT ownership can also assist with the recruitment and retention of employees as it can act as a key differentiating factor of the company within the market in which it operates.
Who will act as the trustees of, and manage, the EOT?
The trustee of an EOT can be an individual or a corporate trustee (e.g. a private company limited by guarantee). It is usually recommended to use a corporate trustee, where the individuals who would be trustees of the trust would be appointed as directors of the corporate trustee. This saves the administrative “headache” of retiring/appointing trustees, as the appointment and retirement of directors is much simpler. Furthermore, as acting as a trustee brings with it significant responsibilities, trustees can be sheltered from personal liability if they perform their role by acting as a director of a corporate trustee, which provides limited liability (although the responsibilities and duties of acting as a director of course remain).
It is important to have a broad make-up of the trustees/directors of the EOT, essentially ensuring that the selling shareholders(s) (who can be trustees/directors) do not have control. It is usual that an independent trustee be appointed along with a representative of the employees of the company. In contrast, it is not necessary for the make-up of the board of the company to drastically change, other than to perhaps involve more of the (non-selling shareholder) senior management.
What are the funding options for an EOT?
It is common for some of the purchase prices for the shares sold by the selling shareholders of the company to be funded by way of the company’s current cash reserves (usually the payment on completion), with the balance of the price being paid to the selling shareholders on deferred payment terms using future profits.
In most cases, therefore, the EOT will be reliant on the future financial performance of the company to enable the EOT to pay the selling shareholders. It will be important for the EOT to accordingly consider company cash flow, and any share purchase agreement documenting the sale of the shares will need to include flexible repayment terms to accommodate changes in the company’s financial performance.
It is, however, possible to source third-party lending to fund a proportion of the purchase price due to the selling shareholders. If security is required by the third-party lender (which is most likely to be the case), it will be important to consider an event of default on the terms of the loan and the security which may enable the lender to acquire control of the company (and so result in a disqualifying event under the governing legislation for EOT’s meaning any tax reliefs for the benefit of the selling shareholders may be lost).
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