This article first appeared in Tax Journal Magazine.
The 2010 coalition
The last time there was a hung-Parliament in the UK, Norman Lamb MP (the then Minister for Employment Relations, Consumer and Postal Affairs) said that growing the UK economy was the coalition’s most pressing priority. The coalition agreement between the Conservatives and Liberal Democrats recognised that the financial crisis had exposed the UK’s economy as too narrowly focused on certain sectors and regions, with the majority of UK companies structured around one type of business model.
To ensure that the long-term growth of the UK economy was strong and more evenly balanced, one of the coalition’s aims was for there to be a “decade of wider employee ownership”. The feeling at the time was that this would create long-term sustainable growth and encourage more responsible and diverse ways of running a business in Britain. Nick Clegg, the then Deputy Prime Minister, set a challenge in 2012 to move employee ownership “into the bloodstream of the British economy”.
So, has this been achieved?
A key challenge to achieving this goal was correcting the misconception that establishing and maintaining employee-ownership structures was complex and tax-inefficient.
So, what do we mean by employee-ownership?
Previously the typical employee-owned companies were owned by employee benefit trusts (indirect ownership) or shares held by a wide group of employees (direct ownership) or a combination of the two.
The legal ownership of employee-owned companies can differ significantly and, as a consequence, so can the way in which the profits are extracted. Where employees are owners of the company, they may extract profits via a combination of employment income and/or dividends. Employees holding their interest via an employee benefit trust are likely to extract profit by employment income only.
Arguably one of the most important benefits of being an employee-owned business, and the element that the government is really trying to foster, is the fact that employees have a stake in their company and the greater employee engagement and commitment that results from this. Employee ownership is as close as a company can get to reflecting the culture and business model of a traditional partnership structure. Though, from a legal and tax perspective, the structures are of course very different.
Employee Ownership Trusts
The employee ownership trust legislation was introduced by FA 2014, Schedule 37 following a long and detailed consultation, which resulted in a new form of employee trust.
Key tax benefits
If key qualifying conditions are met, the following tax benefits are available:
- full CGT relief for the shareholders on a disposal of a controlling interest to an employee ownership trust
- tax-free bonuses of up to £3,600 per year to each employee of the company owned by the employee ownership trust
All references are to the TCGA 1992 unless otherwise stated.
Key qualifying conditions
- The “Trading Requirement”: the company whose shares are transferred must be a trading company or the holding company of a trading group (s236I)
- The “All Employee Benefit Requirement”: the trustee of the employee ownership trust must restrict the application of any settled property for the benefit of all eligible employees on the “same terms” (s236J)
- The “Controlling Interest Requirement”: the trustee of the employee ownership trust must acquire and then retain, on an on-going basis, at least a 51% controlling interest in the company (s236M). In order to meet this requirement, the settlement must meet the conditions set out at s236T.
- The “Limited Participation Requirement”: the number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% of the total number of employees of the company or group (s236N). This is reason behind this requirement to show that there has been a significant change of ownership. This can be an issue for companies with a small workforce as compared to the number of shareholders who are employees/officeholders.
- The “Equality Requirement”: the employee ownership trust deed must state that any employee ownership trust assets must not be applied at any time otherwise than for the benefit of all “eligible employees”, other than “excluded participators” (s236J(5)), on the same terms. All “eligible employees” include any individuals that are employed by either the holding company or a member of the group (s236J(3)(b)). The trustee may, however, distinguish between employees on the basis of the following factors (i) levels of remuneration, (ii) length of service and (iii) hours worked (s236J to s236L)
Although the statutory tax exemption is aimed at shareholders, those businesses that are held by partnerships could also be sold to an employee ownership trust via a two-stage process:
- The partnership is incorporated and provided the relevant conditions are satisfied, incorporation relief should be available (s162); and
- The shareholders in the newly incorporated company (i.e. the former partners) would then sell a controlling interest (at a minimum) to the employee ownership trust.
How is a sale to an employee ownership trust structured?
There are three key steps.
- A qualifying employee ownership trust will be established with a trustee (the “Trustee”).
- The shareholders in the trading company will sell their shares to the Trustee under a share purchase agreement. The amount paid for the shares will be determined by a share valuation expert. The purchase price will be left outstanding as a debt owed by the Trustee to the shareholders.
- The trading company will continue to generate profits each year and it will use after tax profits to make payments to the employee ownership trust (these payments are unlikely to be tax-deductible as the employees will not be receiving any taxable benefits (CTA 2009, s1290)). The employee ownership trust will use the payments in order to pay the deferred consideration to the former shareholders.
The typical structure of a company being sold to an employee ownership trust which is funded via trading profits is as set out below:
Debt financing within an employee ownership trust disposal
It is possible for a proportion of the purchase price to be funded via debt financing. This can be useful where the selling shareholders are looking to receive a proportion of the purchase price at completion.
In practice, it is rare for a bank to loan an employee ownership trust, or the company, a substantial proportion of the purchase price. In such circumstances, it is likely that the purchase price would be part-funded by loan financing, with the bulk of the purchase price funded from the trading company’s future profits.
What are the advantages of selling to an employee ownership trust?
There are numerous advantages for the shareholders, the employees and the company. The main benefits are highlighted below:
- It creates an immediate purchaser (i.e. the group’s employees) for a trading company of any size operating in any sector where, ordinarily, the employees may not have sufficient funds or risk appetite to buy out the majority shareholders. We have implemented employee ownership trusts for corporate finance houses, construction companies, insect breeders and architects, to name but a few, with employee populations ranging from 15 to over 500.
- It addresses succession issues. This can be useful in circumstances where the owner of the company is within a few years of retirement and there is no one within the family or company who is willing or able to continue the business. It also avoids the potentially unpalatable option of selling to a competitor or third party.
- Employees usually take a more active and constructive interest in the business. The higher the proportion of employees that are stakeholders within the business, the greater the commercial benefits are likely to be.
- On many trade sales, a purchaser will only buy a trading company if all of the issued share capital can be acquired; whereas, on many private equity backed deals, selling shareholders may be permitted or required to rollover a proportion of their equity into the acquisition vehicle. On a sale to an employee ownership trust, and providing the key qualifying conditions are satisfied, shareholders can choose whether to sell some or all of their shares.
- No CGT tax liabilities should arise on the disposal of a controlling interest in a company to an employee ownership trust. Therefore, for those shareholders that don’t qualify for entrepreneurs’ relief, or have used up their lifetime allowance, there is currently up to a 20% CGT saving.
- The directors of the company can remain in situ post-disposal and can continue to receive market-competitive remuneration packages. In comparison, on other transactions, some or all of the management team may be replaced on or shortly following the transaction.
- Companies controlled by employee ownership trusts are able to pay tax-free bonuses to their employees up to the “exempt amount” (see below). NICs remain payable.
- An employee ownership trust is generally seen as a more ‘friendly purchaser’ than the usual third party acquirer; this means the sale process tends to be much quicker, with lower professional fees and less aggressive warranties and indemnities as the trustee of an employee ownership trust is often familiar with the company. In practice, the trading company will usually continue its day to day operations in a similar manner after the sale to the employee ownership trust. Whereas, if the trading company was sold to private equity, it’s likely that the private equity firm would appoint a director to the trading company’s board. It’s also likely that there would be new stretching financial targets and expectations together with a long list of “reserved items” that the trading company’s directors would be unable to do without the express consent of the private equity firm.
- If the company already has a form of employee-ownership in place, the move towards an employee ownership trust may be a natural progression. Where the wider workforce is a company’s most significant asset, an employee ownership trust seems like an obvious cultural fit and a great way to lock in:
- Greater employee engagement and commitment - as you would expect, employee owners are more likely to be engaged with their company if they may profit from its success.
- Greater drive for innovation - the Burns Report in 2006 found that 44% of respondents to their survey strongly agreed that employee-ownership makes employees more committed to company success and that innovation happens more effectively.
- Improved business performance - the Cass Business School found in 2010 that employee-owned companies created jobs faster and were more resilient through the economic downturn.
What are potential areas of concern when selling to an employee ownership trust?
An important point to be aware of when a company is sold to an employee ownership trust is that the purchase price is fixed at the point of sale. Therefore, should the value of the company increase post-disposal, the selling shareholders would not be entitled to any additional consideration.
Due to the way in which these transactions are generally financed, it is important that the trading company remains profitable and cash-generative post-disposal.
This is because, as the original shareholders’ deferred consideration is generally financed via the post-tax profits of the trading company, should the trading company become loss making then it may be unable to make payments to the employee ownership trust which in turn would mean that the trustee of an employee ownership trust may unable to pay some, or all, of the deferred consideration.
Depending on how the transaction is structured, it is possible that the consideration received from the trustee of an employee ownership trust could be subject to the “transactions in securities” anti-avoidance legislation within the ITA 2007, Part 13.
HMRC may serve a counteraction notice under ITA 2007, s698 to tax the receipt of any upfront and deferred consideration as a “disguised distribution”. It is therefore generally advisable to seek a clearance from HMRC under ITA 2007, s701 and, in particular, confirm that the proposed transaction does not have as its main purpose, or one of its main purposes, the obtaining of a tax advantage ITA 2007, s684(1)(c).
On what basis do shareholders get a CGT-free disposal?
When shareholders sell a controlling interest in a company to an employee ownership trust that meets the key qualifying conditions, then provided that a disqualifying event has not occurred by the end of the tax year following the tax year in which the disposal to the employee ownership trust took place, those shareholders should be able to claim the CGT exemption on their self-assessment tax return (s236H(1)(c)).
The transfer of the shares to the employee ownership trust is treated for CGT purposes in a similar way to a spouse transfer. The transfer to the employee ownership trust is on a “no gain, no loss” basis, meaning that the employee ownership trust will inherit the selling shareholders’ base cost for those shares that it acquires.
Inheriting the selling shareholders’ base cost may have no practical implications for the trustee of an employee ownership trust if the shares are held in the employee ownership trust in perpetuity and no disqualifying events occur. However, should a disqualifying event take place (which would include the trustee of an employee ownership trust selling all of the shares to a third party), then the trustee of an employee ownership trust would be subject to a CGT liability which would be calculated using (a) the market value of the shares within the employee ownership trust at the time of the disqualifying event and (b) the trustee of an employee ownership trust’s inherited base cost.
Who should be the trustee of the employee ownership trust?
The answer, as is often the case, is that it depends. There are many issues to consider when appointing the trustee of an employee ownership trust; some may be cost-related, while others relate to whether the trustee of an employee ownership trust should have a connection with the trading company. It should always be remembered that the trustee of an employee ownership trust should be someone that all parties will be happy to work with in the long-term.
Although many trusts have individuals as trustees, usually the trustee of an employee ownership trust is a UK resident company. There are several key reasons for this.
- Having a corporate vehicle avoids any personal liability which may otherwise arise for individual trustees.
- From an administrative perspective, it is much easier to replace a director of the trustee company rather than an individual trustee. This is an important point as the employee ownership trust is seen as a stable and long-term structure of employee-ownership. Therefore, the position of the trustee of an employee ownership trust needs to be considered beyond the term of those individuals that may initially be able to serve as a trustee.
It may, of course, be possible to appoint a professional trustee to be the trustee of an employee ownership trust but there may be reluctance on both sides. The professional trustees may not wish to acquire a controlling interest in a trading company with the responsibilities and risks that this may entail (e.g. reputational risks should the trading company get into difficulties). Any trustee of an employee ownership trust would be duty bound to take an active interest but the directors of the trading entity may not appreciate third party input unless the trustee of an employee ownership trust has knowledge and expertise within the applicable business sector.
Many professional trustees are based offshore. One of the advantages of having a professional offshore trustee is that in the event that the employee ownership trust is subject to a disqualifying event, no UK CGT liability should arise as a result of a deemed disposal and re-acquisition of the shares held within the employee ownership trust.
Tax-free bonuses to employees
ITEPA 2003, Chapter 10A, Part 4 provides relief from income tax on “qualifying bonus payments” of up to £3,600 per employee per tax year (referred to as the “exempt amount” – ITEPA 2003, s312A(2)). However, there is no equivalent exemption for NIC purposes.
The conditions that need to be satisfied for a “qualifying bonus payment” are set out in ITEPA 2003, s312B. It is important to note that the payments must be paid by a company which is owned by an employee ownership trust and not by the employee ownership trust itself.
What happens if a disqualifying event occurs post-disposal?
The impact of a disqualifying event (as defined in the box below) depends on when it takes place. If a disqualifying event occurs in the same tax year in which the employee ownership trust acquires a controlling interest, or in the following tax year, s236O states that:
- the selling shareholders would not be able to make a claim for CGT relief under s236H on or after the day on which the disqualifying event occurs (s236O(3)); and
- any claim for CGT relief which has already been made by the former shareholders under s236H before the disqualifying event took place will be revoked and the chargeable gains or allowable losses would be calculated as if no claim had been made under s236H (s236O(4)). This means that the shareholders would be subject to CGT (calculated in the normal way) on the disposal of their shares to the employee ownership trust.
If the disqualifying event occurs after the selling shareholders have received full CGT relief under s236H on the sale of their shares to the employee ownership trust (i.e. from the start of the second tax year following the tax year in which the employee ownership trust acquired a controlling interest), the trustee of an employee ownership trust will be treated as:
- disposing of the applicable shares (i.e. those it acquired and on which s236H tax relief was given to the original shareholders) immediately before the applicable disqualifying event; and
- then immediately re-acquiring them.
As the trustee of the employee ownership trust will have acquired the shares on a “no gain no loss” transfer, the deemed disposal and re-acquisition will trigger a UK CGT liability for UK resident trustees on the current market value of those shares at the date of the disqualifying event minus the original shareholders’ base cost. Although this will be a liability of the trustee of an employee ownership trust, it will clearly delay the repayment of any outstanding deferred consideration to the former shareholders. In these circumstances, there are likely to be some negotiations with HMRC regarding the amount and timing of any CGT liability and the tax status of the payments to fund the CGT liability.
Whether a disqualifying event occurs or not is generally within the control of the trustee of an employee ownership trust. Therefore, we would not expect a disqualifying event to occur unless it is an intentional act of the trustee of an employee ownership trust (i.e. such as sale of the shares that it holds to a third party acquirer).
“Disqualifying Event” includes:
- The company, or holding company, ceasing to meet the Trading Requirement
- The employee ownership trust ceasing to meet the All Employee Benefit Requirement or the Controlling Interest Requirement
- A breach of the Limited Participation Requirement
- The trustees of the employee ownership trust acting in a way which the trust, as required by the Equality Requirement, does not permit.
s236O(2) and s236P(2)/ See Key Qualifying Conditions (above)
What happens if a third party acquires the trading company from the trustee of an employee ownership trust?
The default position is that the employee ownership trust is a long-term structure for employee-ownership. Therefore, it is anticipated that the trustee of an employee ownership trust will continue to hold shares in the trading company in perpetuity.
If the trustee of an employee ownership trust sold shares within the employee ownership trust to a third party such that the Controlling Interest Requirement was no longer satisfied, then this would be a disqualifying event. If this disqualifying event occurred at a time when the former shareholders had received full CGT relief under s236H, then these disposals (i.e. the “deemed” disposal and actual disposal by the trustee of an employee ownership trust) should result in just one CGT liability for the trustee of an employee ownership trust. Therefore, this should not prevent the trustee of an employee ownership trust from selling the trading company to a third party provided that, when considering its fiduciary duties, the board of the trustee of an employee ownership trust resolves the sale would be in the best interests of the beneficiaries of the employee ownership trust.
Locking-in and incentivising the next tier of management post-disposal
The employee ownership trust generally works well for those selling shareholders, and the group’s wider workforce. However, one key group that will need to be given special consideration is the senior management team: they may not have been shareholders at the time of the transaction but may have been expecting to acquire and hold equity in the near future.
The All Employee Benefit Requirement and the Equality Requirement are restrictive and mean that any benefits delivered to employees from the employee ownership trust must be paid out to all employees on the “same terms”. However, any bonuses and/or share awards granted by the trading company do not have to comply with these restrictive requirements. This would allow the trading company to cut through many of the restrictions that may otherwise cause retention issues.
There are many ways to lock-in and incentivise key management in a tax-efficient way. A trading company owned by a corporate vehicle would not ordinarily satisfy the “independence requirement” for the purposes of the Share Incentive Plan (ITEPA 2003, Schedule 2), Save As You Earn scheme (ITEPA 2003, Schedule 3) Company Share Option Plan (ITEPA 2003, Schedule 4) or Enterprise Management Incentive Plan (ITEPA 2003, Schedule 5) legislation. However, a company which is controlled by an employee ownership trust will be regarded as “independent” for the purposes of this legislation and will not be regarded as a “close” company (ITEPA, paragraph 27(1)(ba) and 27(1)(3) of Schedule 2, paragraph 19(1)(ba) and 19(3) of Schedule 3, paragraph 17(ba) of Schedule 4 and paragraph 9(5) of Schedule 5).
This means that any companies controlled by a corporate trustee of an employee ownership trust should be able to grant tax-advantaged share options or awards (subject to satisfying the statutory qualifying conditions for such options or awards).
Many of the trading companies/shareholders that we have advised have implemented statutory tax-efficient incentive plans following the sale of the trading company to an employee ownership trust. However, care must always be taken to ensure that any options and/or awards granted would not result in the Controlling Interest Requirement being breached which would trigger a disqualifying event.
Companies that are acquired by employee ownership trusts sometimes adopt governance processes and representatives (such as employee councils) at both the trading company and trustee level to ensure a balanced and fair decision-making process.
From the employee ownership trust beneficiaries’ perspective, consideration will also need to be given to who has the power to appoint and remove the individual trustees or directors of the trust company.
If you are, or your client is, thinking of selling a controlling interest in a company to an employee ownership trust, then the first point to consider is whether the key qualifying conditions are met. If they are, then you will need to consider many practical issues on how the sale would be structured.
As outlined above, if the sale is not correctly structured, it can have adverse and unexpected tax consequences. Therefore, it is extremely important to speak to a professional advisor who has experience in structuring the sale of trading companies to employee ownership trusts.
Selling to an employee ownership trust can result in tangible benefits to shareholders, trading companies and their employees as well as the wider UK economy. Now, more than ever, the UK economy needs employee-controlled businesses to provide the long-term sustainable growth that the employee ownership trust legislation was designed to create.
The 2010 coalition Government’s intention of encouraging more responsible and diverse ways of running businesses in Britain is certainly on track. We have numerous examples of great companies that are now employee-controlled via employee ownership trusts.
It may be a step too far to say that employee-ownership has now moved “into the bloodstream of the British economy”, but we have certainly come a long way since 2012.
For help and advice on selling your company and on all employee share schemes please contact Matthew Emms.