Employee Ownership Trusts (EOTs) are increasing in popularity with many entrepreneurs and business owners now looking at this alternative structure of exit.
EOTs were introduced through the Finance Act of 2014 to encourage founders and other shareholders to pass ownership of their company on for the benefit of its employees. The John Lewis Partnership, a long-established brand, is well recognised for employee engagement, however EOTs were relatively slow to take off in the UK.
Now EOTs are increasing in popularity and many entrepreneurs and business owners are looking at this alternative type of exit. In June 2022, the UK Employee Ownership sector recorded the milestone of 1,000 employee-owned businesses.
We have seen increased interest in EOTs over the past 6-8 months across various sectors including: professional services; retail; wholesale; information and communication. We routinely explore how EOTs can be structured for the benefit of employees, businesses and other stakeholders.
Advantages of EOTs
- A simple and certain sale: from a sellers’ perspective it should be a relatively friendly transaction as it is to an internal buyer and therefore should run smoothly. There is no need to find a buyer to facilitate an exit (whether a trade buyer or private equity investor) so there is more certainty of completing a sale.
- Tax advantages: selling shareholders are able to claim 100% relief on capital gains tax arising from a sale to an EOT. After the transaction the company can provide tax free annual bonuses to employees up to a sum of £3,600.
- Employee engagement: one of the benefits of an EOT structure is enhanced employee engagement which also results in improved retention.
- Preservation of values: there is more certainty and stability for employees when the values and culture of an organisation are not disrupted through a third-party acquisition.
- Growth: a happy, stable workforce is likely to be more productive contributing to business growth.
- Incentivised management team: the EOT structure allows the core management team to set up share incentive schemes, such as share options, if desired.
Structure of a typical EOT transaction
- Setting up an EOT – the EOT is usually set up under a trust deed managed by a mix of vendor representative, executive directors of the company and independent directors. Often an employee council will be formed with a representative on board who would have primary responsibility for employee engagement. Some companies choose to set up the trust “offshore” with a professional trust company acting as trustee which shelters any future gains made by the EOT from UK capital gains tax.
- HMRC tax clearances – it is recommended and common practice for the company and selling shareholders to make clearance applications to HMRC, requesting that they confirm the sale of shares to the EOT (and future contributions to the EOT by the company to fund any deferred consideration) are not being carried out for tax avoidance purposes.
- Valuation and Sale – the EOT will buy the shares from the sellers which can range from just over 50% to 100% shares in the target company. It is recommended that an independent valuation is obtained to ensure that a fair price is paid and received for the shares. This will be of benefit if independent finance is sought. As a matter of good governance, trustees should consider obtaining independent advice on the transaction.
- Funding – typically the sellers would receive some consideration in cash upfront and the remaining will be deferred with an agreed payment plan with some flexibility. Upfront cash is funded either from an excess cash in the business or by a third party lender. A substantial part of the consideration is often deferred and funded from future profits and cash of the business. From a seller’s perspective, this structure is not risk-free if the business later faces financial difficulties.
Qualifying criteria for tax advantages
There are various qualifying conditions under the tax legislation that are required to be met for the associated tax reliefs. Confusingly, the criteria are slightly different although very similar for the capital gains relief (claimed by the sellers) and the income tax relief (claimed by the employees / company in connection with bonuses paid following conversion to an EOT). In summary they are:
- The target company must be a trading company or holding company of a trading company
- The property of the EOT must be applied for the benefit for all eligible employees (although it is possible to exclude employees who do not have continuous service of up to 12 months).
- Trustees should apply the trust property for the benefit of all eligible employees on the same terms. However, they can distinguish between the employees based on certain factors such as length of service, remuneration or hours worked.
- The EOT must own more than 50% of the share capital and be entitled to the majority of the voting rights and more than 50% of the company’s profits and assets on a return of capital.
- The number of employees holding more than 5% of the company (or more than 5% of any class of share of the company) cannot exceed 40% of total employees. This may pose a problem for companies with a small employee base or those with multiple share classes held by small groups.
In addition, there is a claw-back of the capital gains tax relief if there is a “disqualifying event” before the end of the tax year following the tax year in which the sale to the EOT takes place. A disqualifying means, broadly, any of the above criteria ceasing to be met.
The government is launching a consultation later in 2023 on the use and effectiveness of EOTs to ensure that these tax advantages are incentivising the employee ownership business model as it intended rather than being used solely for tax planning purposes. Therefore, it is possible that this tax regime may see some changes in the not too distant future.
Conversion to an EOT can bring many advantages to both existing shareholders and the employees of the Company going forward. Employee ownership is increasingly being recognised as delivering real value in the form of employee retention and engagement as well as company growth. However, structuring the conversion to an EOT requires careful planning and advice to ensure everything proceeds smoothly and there are no unpleasant surprises when it comes to claiming tax reliefs.
We have extensive experience at Shoosmiths of advising companies and shareholders who are looking to transition to an EOT structure and have dedicated specialist lawyers and qualified tax advisors to cover the various aspects of legal and tax advice required.