Rising interest in employee ownership as a succession strategy
Over the past two years, we have seen a dramatic increase in the level of public awareness of and interest in employee ownership trusts (EOTs). This is becoming an attractive exit strategy for a number of business owners, and in the right circumstances, can work well to facilitate an exit whilst also entrenching a culture of employee engagement and reward.
In amongst the raft of announcements made at the budget in October 2024, a number of changes were proposed to the EOT tax regime, which followed a consultation launched by the previous government in July 2023.
Whilst these amendments can be viewed as largely reassuring for businesses genuinely considering employee ownership, and suggest that the government remains committed to the employee ownership model, they also reinforce a narrative that the structure is intended to be used as a lasting and long-term model for business succession which reiterates the importance of carefully considering the appropriateness and feasibility before transitioning.
What do the changes mean?
None of the changes were fundamental, but refine and restrict certain provisions to ensure they remain fit for purpose. Altogether, the stated purpose of the amendments is to ensure that the EOT regime remains focused on its core objectives of encouraging employee ownership and rewarding employees, and to close certain opportunities which have been identified.
Ever since the legislation was first introduced in April 2013, there has been speculation that the generous tax reliefs could be exploited, particularly in scenarios involving premediated onwards sales or liquidation(s), situations where the vendor shareholders intended to retain or reacquire control of the company after selling their shares, often facilitated by offshore arrangements to shelter future gains outside the scope of capital gains tax. It is therefore reassuring that action has been taken to hinder possible avoidance. The changes do have potentially wider ramifications, which will also be relevant in benign cases.
As well as a couple of clarifications, the most significant changes are to narrow the scope of the EOT legislation and ensure that the reliefs are only applying in situations where the structure is genuinely appropriate:
Requirement as to residency
One significant change is the introduction of a specific requirement for EOTs to be UK tax resident. This is unsurprising, and will be welcomed by a number of advisers, as the possibility for EOTs being established outside the UK provided the most notable opportunities for tax avoidance which seemed contrary to the spirit of the regime.
For the majority of EOTs and owners considering employee ownership, this new requirement is, unlikely to be significant, but the change does reinforce that employee ownership should be a long-term vision.
Extended monitoring period
The other significant change is that the period during which the capital gains tax relief can be withdrawn if the EOT requirements are breached has been extended from one year to four years from the end of the tax year in which the EOT is established and acquires the company. In principle, the capital gains tax reliefs will be conditional upon specific conditions being met for up to five years after the disposal.
This change was presumably also introduced to tackle situations where EOTs were being established with no reasonable prospect of enduring for the long term. The purpose of the EOT legislation has always been to encourage employee ownership as a long-term structure and the extension to a four-year period would seem to reinforce this message and, on face value, would therefore not seem unreasonable.
That said, this does have wider reaching implications, and potentially creates or enhances a significant risk associated with individuals considering selling shares to an EOT. There may be situations or decisions which the trustees might reasonably make or which otherwise affect the business, over which the vendors themselves will have limited control or influence, but which could still inadvertently result in a breach of the EOT requirements. A lot can change over a five-year period, and the former shareholders could unexpectedly find themselves exposed to significant capital gains tax charges, even where they have acted with the best of intentions and in situations where the structure was implemented for all the right reasons.
This has always been a risk, but is now one that shareholders will need to be comfortable with over a longer period. It is therefore more important than ever that business owners considering selling shares to an EOT are comfortable that this is a sustainable structure, and that they have faith in the enduring management team and operating infrastructure.
The new legislation also introduced some other minor amendments to the EOT legislation, including that:
- Former owners and their families now must not make up more than 50% of the trustees, or otherwise retain control over the company; and
- The trustees must now specifically take reasonable steps to ensure they are paying a fair price for the shares.
The introduction of these specific requirements is no surprise, but the practical impact should be limited in most cases. Best practice has always been to have a trustee board made up of a mixture of sellers, employees and independent persons and the tax consequences of the trustees overpaying for the shares would already have been significant.
- An option to now exclude directors from the tax-free bonus that must be paid to all employees, which may provide additional flexibility for some businesses who felt this wasn’t appropriate.
- Some additional and specific reporting and disclosure requirements have been introduced.
The government has also finally introduced for a specific relief from income tax in respect of contributions to the EOT. This is an area where deficiencies in the legislation have historically created unnecessary uncertainty and administration, and so a clarification is helpful, albeit the specific form of this is narrower than we had hoped.
From October 2024, the legislation now actually makes clear that contributions and other distributions to an EOT will be taxable, but provides relief if the contributions are used to make payments to the sellers (or to pay stamp duty). It would, however, seem that the relief must specifically be claimed, and whilst it remains unclear what the process for claiming relief will be, this may result in additional administration for trustees who might otherwise have been under no obligation to make returns.
For the avoidance of doubt, most of these changes affect disposals or transactions taking place on or after 30 October 2024, and structures established before that date should largely be unaffected.
Could an EOT be right for my business?
In the right circumstances, an EOT can be an effective tool to facilitate a transition of ownership to employees, and nothing in the budget 2024 fundamentally changes the tax efficiency of this strategy.
In the round, the proposed changes do send a message that there continues to be support within government for the employee ownership model, but also that, such structures should be introduced with a long-term vision. With the extended monitoring period particularly in mind, it is more important than ever that due care is given in establishing the feasibility and sustainability of the process. Some relevant considerations will include the financial profile of the transactions and the companies, the level of competence and experience within the management team (or the prospect of recruitment), the strength and robustness of operating and financial processes, as well as the level of employee engagement and their motivations.
The appropriateness of an EOT should be considered carefully as part of a holistic review of all possible options for succession or exit from a business. Menzies have supported a number of businesses and their owners in assessing the appropriateness of employee ownership as a model for succession, and can work with you to explore the feasibility of selling shares to an EOT and operating the structure thereafter, as well as any other options that might be relevant in the circumstances.
Where relevant, our team of specialist tax advisers also have extensive experience advising on establish employee ownership trusts and associated matters.
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