Employee Ownership Trusts

Introduction

Employee Ownership Trusts (EOTs) are intended to support employee ownership of companies and are becoming more common. This note sets out a high-level overview of the tax reliefs that apply to employee ownership trusts. 

What are Employee Ownership Trusts? 

EOTs are a form of trust that own shares in a trading company or the principal company of a trading group and which operate for the benefit of that company or group’s employees. On the basis the EOT is discretionary, the trustees can decide if and when employees should be able to receive payments or other benefits from the EOT. EOTs should be viewed as a long-term vehicle. Due consideration should be given as to whether an EOT is suitable, taking into account the company’s culture and incentivisation of both current and future employees, including the management team. 

Tax reliefs 

The reliefs below are available in connection with EOTs where certain conditions are met: 

• Capital Gains Tax (CGT) relief on disposals to EOTs: Individuals, trustees and personal representatives who transfer eligible ordinary shares to an EOT may be able to claim CGT relief on the transfer. Where CGT relief is claimed, the transfer to the trust is deemed to give rise to neither a capital gain nor a loss.  

• Inheritance tax exemption: No inheritance tax arises on eligible gifts or sales at undervalue to EOTs. In addition, trustees of EOTs are exempt from inheritance tax charges that may otherwise apply, such as the up to 6% inheritance tax charge that can arise on each ten-year anniversary of a trust being created. 

• Income tax exemption on bonus payments to employees: Bonus payments of up to £3,600 per annum are exempt from income tax for the recipient employees. No national insurance contribution exemptions apply and so both the employees and their employer will need to pay these. 

• Corporation tax deduction: The employing company is eligible for a corporation tax deduction when bonuses eligible for an income tax exemption are paid to employees. 

Further detail on the CGT relief and income tax exemption is set out below. 

Key conditions that must be met for CGT relief to be available

The key conditions that must be met for CGT relief to be available on the transfer of shares are summarised below: 

• The trading requirement: The company must be a trading company or the principal company of a trading group. A ‘principal company’ is essentially a holding company that owns at least 75% of shares in its subsidiary companies and meets certain other requirements. 

• The controlling interest requirement: The trustees must have a controlling interest in the trading company (or principal company) at the end of the tax year of the transfer(s) on which CGT relief is to be claimed, which they did not have at the beginning of the tax year. CGT relief is not available on transfers to the trust in other tax years. 

• All employee requirement: Broadly, all employees must be able to benefit from the EOT, though there are exceptions to this rule. For example, new joiners with less than 12 months service can be excluded from benefit. Office holders can benefit from the trust, though the trust will still be eligible to qualify as an EOT if they are excluded. When determining the benefits to confer on employees the trustees can consider each employee’s remuneration, length of service and/or hours worked, provided all eligible employees receive at least some benefit. 

• Excluded participators: Certain persons must be excluded from benefiting from the trust. These are certain persons who, either from the date of transfer or at any point in the preceding ten years (or since 10 December 2013 if later), beneficially own or are entitled to acquire at least 5% of shares or any class of shares in the company, and who would be entitled to receive 5% or more of the company’s assets on a winding-up. People connected with such participators must also be excluded. Connected people for this purpose is widely defined but includes spouses, civil partners and children.

• Limited participation requirement: Broadly, either (i) the person making the transfer must not have been a participator in the company during the twelve months ending immediately after the transfer to the EOT and/or (ii) immediately following the transfer and for the remainder of the tax year of the transfer, fewer than 40% of the total number of employees and office holders in the company are participators (as defined in the preceding bullet point).

There are set time periods over which the above conditions must be met for CGT relief to be available. Notably, any CGT relief claimed will be lost if the above conditions cease to be met between the point of transfer and the end of the following tax year. Where this occurs, the person who made the transfer is deemed to have sold their shares to the trustees for market value and CGT may arise as a result of this. If the aforementioned conditions cease being met at some point after the end of the tax year following the transfer, the trustees are deemed to dispose of the shares they own and reacquire them for market value when the conditions cease to be met. This may result in a CGT liability for the trustees.  

Income tax

• Qualifying bonus payments of up to £3,600 per employee per annum are exempt from income tax, though both employee and employer national insurance contributions must still be paid, as must the apprenticeship levy where applicable. 

• Bonuses must be paid by the employing company – not by the EOT. 

• The income tax exemption is only available provided all eligible employees receive a bonus from their employer, including ‘excluded participators’ who must be excluded from benefiting from the trust for CGT relief to be available. Employees can be excluded from receiving bonuses if they are new joiners with less than 12 months’ service or in certain circumstances where an employee has committed gross misconduct or is summarily dismissed before the bonus is paid. 

• Either all employees must receive the same amount of bonus or, where the bonus amount varies, it must only do so based on (i) remuneration; (ii) length of service and/or (iii) hours worked. Exemption is denied if the effect of the variation is to confer relief wholly or mainly on directors, the highest earners or people employed in specific parts of the business or undertaking certain kinds of activities. 

Practical considerations 

Several additional points should be considered when deciding whether to pursue an EOT, including: 

• Funding the EOT: No exemptions apply to enable the EOT to be funded in order to purchase the vendor’s shares. In practice, this may result in sale proceeds being left outstanding and gradually repaid using company profits. Any impact on the total amount receivable and cash flow implications should be considered. 

• Tax clearances: It is prudent to apply to HMRC for tax clearances, including on whether HMRC consider that a proposed trust would qualify as an EOT and on the tax position of the vendor’s consideration. 

• Governance: Consideration should be given to how the EOT and company will be run, taking into account the interaction between the company’s directors and the trustees.  

• Employee communication: Employee ownership can act as a powerful employee incentive, though effective communication is essential. This may include establishing an employee council. This could also aide effective governance. 

• Succession: Thought should be given as to how the current and future management team will be incentivised. This could include such individuals directly owning shares in the company. Alternatively, employees could be granted share options, such as through the Enterprise Management Incentive (EMI) scheme, the rules of which are modified to enable share options to be issued by companies controlled by EOTs. 

Consultation

A consultation is underway with the aim of seeking views on targeted reform to the EOT taxation regime, to ensure that it remains effectively focused on the policy objective of encouraging employee engagement. Changes under consideration include i) restricting former owners and connected persons from retaining control of the company post transfer to the EOT, ii) requiring the EOT to be UK tax resident and iii) changing some of the details concerning the tax-free bonus rules. 

The consultation will close on 25 September 2023. The government will then consider received responses and how to proceed.