The snappily named Assured Tenancies and Agricultural Occupancies (Forms) (moratorium Debt) (Consequential Amendment) (England) Regulations came into force on Monday 3 May 2021.
EOTs have been aggressively marketed as a tax-free share sale, but that should not deter practitioners from raising EOTs as a standard discussion point for any business owner considering the future of a private business.
One of the original purposes of the EOT was to embed the concept of employee ownership and, in the post-Covid economy, they provide a viable alternative for business ownership to enhance productivity with a stable and highly motivated workforce. EOTs are another form of MBO for an existing business, and they are also an equally valid option for start-ups.
This journal published a guide to EOTs in January (‘Back to basics: Employee ownership trusts’ (Oliver Dewdney, Tax Journal, 29 January 2021) which gave a thorough review of the tax rules but only had space for a brief mention of why anyone might want to consider using an EOT. This prompted us to wonder why it is that we have had so many conversations about EOTs but have seen only a modest number being put in place – although this thought was immediately followed by the realisation that most people have come to EOTs having heard about a tax-free sale of shares.
In 2020, there was a surge of interest in EOTs fuelled by rumours of an increase in CGT rates. There was so much interest, in fact, that it got to the point where we started warning clients that the government might abolish or scale back the EOT tax reliefs in the March Budget – partly because some of the EOT structures being promoted looked like a throwback to the days before DOTAS and GAAR. At the extreme, some of these arrangements had a breach of trust built into them from the outset, with a view to selling tax-free and recovering shares or share value later as well.
Despite this, we are not aware of any HMRC enquiries into EOTs to date, although this is perhaps not surprising given that there were so few EOTs in existence before 2020. If it turns out that there has been a sudden increase in EOTs in the last 12 months, that may itself trigger HMRC to take a closer look at this area. For the more aggressive EOT structures, an HMRC challenge under the transaction in securities rules (ITA 2007 s 685) could be a logical approach. With the Boulting case as back-up (R (on the application of Boulting & another) v HMRC  EWHC 2207), HMRC might feel that it can reopen any share sale to an EOT where it transpires that the selling price is excessive or the vendors continue to access a disproportionate share of future company profits.
Why EOTs are worth another look
It is disheartening to see that EOTs are being marketed primarily as a tax dodge when there are more positive reasons for their consideration.
Research shows that employee-ownership has a positive influence on productivity, employee retention and economic performance of firms – all of which is important for a post-Covid economic recovery. Over the long run, firms with a larger employee-ownership stake demonstrate stronger performance and are more able to deal with economic and business crises (see The ownership effect inquiry: what does the evidence tell us? (Alliance Manchester Business School and Cass Business School), June 2017).
Renewing employee commitment and engagement is a critical issue for many businesses at the current time, especially for those which have suffered during the pandemic – and this is where moving to an employee ownership model can help. Some employees have reportedly felt let down by being rushed through furlough and redundancy programmes. Some employees in highly leveraged businesses have felt unfairly left out of pocket where business owners had de-risked themselves by taking dividends, bonuses, interest or management fees. In a recent survey (bit.ly/3uBknpM), 91% of business thought they should operate in a more transparent and ethical way, including in their dealings with staff, with many citing the pandemic as a factor.
It is notable that the devolved governments in Scotland and Wales have been looking at ways of promoting greater employee ownership, and both Sheffield University and Cardiff University have worked up functioning legal models for both employee-owned and multi-stakeholder businesses using direct share ownership. In addition, the Treasury Committee referred to the problem of growing wealth inequality in the launch of its report into tax after coronavirus on 1 March. EOTs offer a solution here, as they give the potential for salary to be enhanced by a share of business profit for individuals who may not otherwise have the spare funds to invest in shares. There are examples of businesses which are paying above market rate salaries to staff, reinvesting a greater part of annual profit in innovation and operating profit share arrangements.
With problems being identified by both national and devolved governments, there is the potential for employee ownership to join the mainstream as a completely normal way to run a business.
Practitioners should therefore keep EOTs in mind when advising clients about succession or exit planning (or indeed for those clients starting new businesses, especially where a skilled workforce is required).
As the original Nuttall Review on employee ownership acknowledged, a key obstacle for converting an existing business to employee ownership can be the limited availability of capital funding (although the lack of external capital was also noted as a positive, as it reduces risk in a downturn and so can improve business resilience). This remains a problem today: it is still extremely difficult for an EOT to raise external funding to buy-out a successful trading business. However, the EOT framework provides a solution to this problem by offering CGT relief to business owners who were willing to self-fund a business conversion. Therefore, rather than viewing the CGT relief as a tax benefit, it should perhaps be thought of as compensation for the business owner for converting to employee ownership, as their consideration will ordinarily be less than they would get on a comparable trade sale or private equity backed sale. In addition, they remain ‘on risk’ as the inevitable deferred element of the consideration depends on the future fortunes of the business. It would clearly not be wise to rush a client into an EOT purely for the tax benefits without first testing the market value of their business and the appetite among potential buyers.
Although the EOT tax rules are detailed, the complexity arises not from the legislation itself but from trying to force-fit an EOT into a situation for which it was not intended (and in that regard, the situation for EOTs is similar to that for enterprise investment schemes). The five basic conditions for the CGT relief are set out in TCGA 1992 s 236H, as follows:
- trading requirement;
- all-employee benefit requirement;
- controlling interest requirement;
- limited participation requirement; and
- no related disposal requirement.
There are sufficient precedent trust deeds in circulation to help ensure the basic legislative conditions (TCGA 1992 ss 236I–236N) are not breached. There are, however, more subtle tax risks facing advisers, as the following examples illustrate.
The trustees agree a share price without taking independent advice. With no third-party validation of the share purchase price, what evidence is there to counter a challenge of the sale being at an over-value under the employment-related securities rules (in ITEPA 2003 Part 7 Chapter 3D)? A quick check for advisers is to work out how many years it is likely to take to pay off the deferred consideration. If it is going to take 15 or 20 years’ worth of profits to do so, or where the sale price is at a clear over-value, it might also beg a question about a tax avoidance motive for transactions in securities purposes.
Assume the vendor sells 51% to an EOT and retains 49% to benefit from further capital appreciation. The first issue is that a 51% interest is not worth a pro-rata 51% of total company value because, for example, a 51% shareholder cannot unilaterally pass a special resolution. The second issue is that the 49% retained interest is now an illiquid and noncontrolling minority interest, so its value is materially lower than your client might expect. ACCA’s Technical factsheet 167 suggests a discount of 30%–40% for a shareholding between 26% and 49%. There is then a separate debate about what extra value there is for the trustees in buying out a minority interest and what they might be prepared to pay for it, with affordability being the major concern. The articles of association could be amended to dictate the transfer value of shares (for example, envisaging the sale of a 49% interest under compulsory transfer provisions as a good leaver), but that could crystallise an immediate income tax charge (under ITEPA 2003 Part 7 Chapter 3B) or HMRC could challenge the leaver buy-back price as being at an overvalue if appropriate
minority discounts and illiquidity discounts were ignored.
The vendor sells 75% of their A shares to an EOT and retains 25% as B shares to receive dividends. Vendors may have been told that, once they have extracted their tax-free sale proceeds, they can carry on taking profit through dividends. However, as regards the trustees’ fiduciary duties, it is unclear why the trustees would authorise the payment of a disproportionate dividend on the B shares without securing at least a similar benefit for beneficiaries. The EOT is unlikely to ever need dividends so the only practical benchmark might be to link a payment on the B shares to payments under the employee bonus scheme envisaged by ITEPA 2003 Part 4 Chapter 10A. The trustees and vendors may enter into a shareholders’ agreement at the outset which could set out dividend policy; without that, though, there would seem to be no particular impetus for trustees to authorise dividends for minority interests.
Assume the vendor has failed to achieve a trade sale, so sells 100% of their shares to an EOT as an interim measure with the intention of seeking a trade sale later to accelerate payment of the deferred consideration. Having converted to employee ownership, the trustees’ primary responsibility is to safeguard the business in the interests of the beneficiaries of the EOT (basically, its employees). The trustees would have no reason to seek a sale of the company which only results in the EOT paying off the consideration due for the initial purchase. The trustees would need to consider a claim for breach of trust if they consented to a sale which saw the majority of the proceeds being paid out to the original owner.
While some structures create a material tax risk, it is just as important to keep in mind non-tax aspects. In particular, there is often insufficient attention given to trustees’ legal responsibilities and the risk of a breach of trust. For any new structure, we would normally advocate a significant degree of independence between the current owners of the business and those responsible for employee interests. In contrast, where the vendors continue as board directors and they also become trustees, this raises the potential for conflicts of interests and breaches of fiduciary duties. EOTs may not, therefore, be the best fit where the vendors want to retain absolute control. If a business is to benefit from the gains identified in the research cited above, this will necessarily entail a shift in corporate governance towards the workforce as a group.
EOTs and post-covid economic recovery
It can feel like there is a political agenda for the promotion of employee ownership, but that doesn’t mean that it is not a natural fit for many businesses. The original Nuttall Review talked of moving employee-ownership ‘into the mainstream of the economy’. That review was published back in 2012 when the UK economy was recovering from the credit crunch, and EOTs would seem to have their place again as part of a post-covid economic plan. EOTs may have been marketed for their tax benefits, but they are also a viable way for businesses to enhance productivity with a stable and highly motivated workforce. EOTs provide an alternative form of MBO for existing businesses, and they are also equally valid for startups. Perhaps the time has finally come for them to move into the mainstream.
This article was first published on 16 April 2021 by Tax Journal.
For more information
If you have any questions in relation to any of the matters covered above, please do contact your usual contact or David Alcock.
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