Founders’ Shares: Are they Employment-Related Securities (“ERS”)?

HMRC clearly think so!

The term “founders’ shares” is not a “term of art” and does not appear in the legislation. However, it is widely used to refer to shares acquired by an individual when, or immediately after, a new company is first incorporated for the purpose of developing a new business and when the company has no value other than the capital subscribed.

Instinctively, one feels that such shares should not, as a matter of policy, be ERS if the opportunity to acquire them has been created by the individual subscribing for the shares and not made available by an existing or past employer or connected person(s).

Arguably – but so far as I am aware, it has yet to be argued before a Tribunal or court – such an acquisition is not caught by s421B ITEPA 2003 because:

  • sub-section (1) does not apply because, as a matter of causation, the subscription for shares is not “by reason of” any employment, subsisting or prospective. Rather, the employment follows from and is “by reason of” the share acquisition;
  • as regards the application of the deeming provision in ss(3): “employer”, as that term is used in s421B(3) is defined in s421B(8), for the purposes of the section as a whole, as the employer in relation to “the employment by reason of which the right or opportunity to acquire the [ERS] is available” and if, as a matter of fact, the opportunity was made available by the individual him- or herself and not by reason of an employment, there was no such employment, and therefore no “employer”.

(It is not possible to argue that s421B(1) does not apply for a similar reason as, on a close reading, the term defined in s421B(8) is not “employment” but “the employment”, whereas s421B(1) refers to a right or opportunity being made available by reason of “an employment”. For the purposes of ss421B(1) “employment” includes a prospective employment (s421B(2)(b)) and therefore the definition in s421B(8) is of no relevance to s421B(1).)

  • the “friends & family” exclusion from s421B(3) applies because the person making available the opportunity to acquire the shares is the individual themselves and there is no more personal relationship than that which one has with oneself.

Nevertheless, HMRC guidance at ERSM20240 makes clear that, in HMRC’s view, such founders’ shares are ERS:

“Founders’ shares

It is sometimes suggested that shares are not employment-related securities because they are acquired by “founders”. There is no concept of “founders’ shares” in the legislation. The founder of a company who is to be a director of that company from the start acquires employment-related securities and is within the scope of the rules.”

Whilst, for the reasons given above, the legal basis for this is not beyond doubt, HMRC is understood to base its view on statements of Lord Hodge in Vermilion to the effect that if the opportunity for the shares to be acquired was made available by the company itself, because its directors resolved to issue the shares, that is sufficient to cause those shares to be ERS in the hands of the individuals to whom they are issued, being individuals who are then, or are intended to become, directors or employees.

Arguments to the contrary (that this does not reflect a realistic view of the facts and that HMRC’s propositions are far too broad) were rejected by the First-Tier Tribunal in Coopervision– see paras [52] – [55] and beyond. However, although they saw themselves as entrepreneurs and investors, the employees in that case were clearly not “founders” as that term is understood.

For the time being, the correct advice must be to treat shares subscribed by a founding director, or an individual intended to become a director or employee, as ERS, even if those are the only shares in issue and at the time of acquisition the company has no assets beyond the capital subscribed. This, of itself, would have no immediate adverse tax consequences if, at the time of issue, the company has no assets, as the shares would have been acquired for a consideration which was not less than their actual market value. Section 431 tax elections should be made within 14 days of acquisition but only on a precautionary basis, and the strict need for such elections would depend upon the shares counting as “restricted securities” per s423 ITEPA.

Whether such an acquisition is reportable is unclear, and the better view is that it is not. If shares are ERS only because their acquisition falls within the deeming provision of s421B(3), and not because the opportunity to acquire them was in fact by reason of an employment (or office) then it appears that the acquisition is not a reportable event (per s421K(3)(a) ITEPA).This is because section 421B applies only for the purposes of Chapters 2-4A of Part 7, ITEPA and not to Chapter 1. The application of the deeming provision does not therefore bring within the reporting requirement an acquisition which is not, as a matter of fact, by reason of employment, even it is deemed to be for the purposes of other Chapters of Part 7. The position would be different if the words in parenthesis in s421K(3)(a), namely|, “… or an event treated as…”, qualified the words “..a right or opportunity…” rather than “an acquisition”.

This view is supported by HMRC guidance at ERSM140040, as follows:

Company incorporations

Where a limited company is incorporated in the UK and initial subscriber shares (also called founder shares) are acquired

  • directly on incorporation, or
  • on transfer from a company formation agent, or
  • from another person forming the company, for example a solicitor or accountant;

a report is not required if all of the following conditions are met:

  • all the initial subscriber shares are acquired at nominal value, and
  • no form of security other than shares is acquired, and
  • the shares are not acquired by reason of or in connection with another employment (whether that is the only employment or one of a number of employments), and
  • the shares are acquired by a person who is a director or prospective director of the company, or someone who has a personal family relationship with the director and the right or opportunity is made available in the normal course of the domestic, family or personal relationship of that person.

Company incorporations – allotment of further shares

Where a limited company has been incorporated in the UK and further shares are allotted prior to the commencement of trading or transfer of assets to the company and all of the following conditions are met:

  • the additional shares are acquired by a person to whom some of the initial subscriber shares have been transferred or the person is a director or prospective director of the company, and
  • the shares are acquired at nominal value, and
  • the shares are not acquired by reason of or in connection with another employment (whether that is the only employment or one of a number of employments).

If such shares are allotted following the incorporation of the company it will not be reportable even if the initial subscriber shares were acquired before 5 April and the allotment of further shares is made after the 5 April.

The majority of newly incorporated companies should meet the above conditions and will not have to complete the ‘Other’ template in respect of the founder shares.

This does not, of course, mean that a chargeable event specified in s421K(3)(b)-(i) in relation to such ERS need not be reported. It must.

…………………………….

What are Employment-Related Securities? The Fallout from Vermilion

The decision of the Supreme Court in Vermilion Holdings v HMRC ([2023] STC1834) (“Vermilion”) has not clarified what is, and what is not, an employment-related security (“ERS”) for the purposes of Part 7, ITEPA 2003. I say that because each of the relevant sections of the legislation (sections 421B and 471 ITEPA), in at least five places, differentiates between (a) acquisition of a share or the grant of a share option, and (b) the right or opportunity to acquire that share or be granted that option. So, s471does not say that an option is an employment-related securities option (“ERSO”) if granted by the employer or a connected person. Rather, it says an option which is not granted “by reason of employment” is nevertheless deemed to be an ERSO if the right or opportunity for that option to be granted was made available by the employer or a connected person.

On the facts of Vermilion, the opportunity for the employee to be granted what was a replacement share option, on terms little different in substance from those of the option he already held (agreed not to be an ERSO), was made available by a consortium of non-controlling shareholders (unconnected with the employer). However, and simply for ease of administration, the new option was granted by the employer company. On that basis, according to Lord Hodge, in doing so, the employer company had itself “made available” or, to use his words, “conferred” the opportunity. See paras [24] and [25]. To his mind, this avoided any question of causation.

This, however, ignored the substance of the situation which was that, in granting the option, the employer company was merely giving effect to an agreement between the non-controlling consortium, the other members and the individual that, inter alia, if he accepted office as a director (and became chairman) and agreed to a reduction in his option rights, the consortium members would put up the funds to save the company. The opportunity for that individual to be granted the option (by accepting office as a director and agreeing to a reduction in the “slice of the cake” to which he would be entitled upon an exit event) was created by the non-controlling shareholders, not by the employer company or any connected person(s). In resolving to grant the option, the directors of the employer company simply acted as agent of the members in enabling the option to be acquired pursuant to that opportunity.

It is the answer to the question: “who made available the right opportunity for it to be granted?” – which should be determinative. That does require an enquiry into how and why the grant of the option came about. In the mind of Lord Hodge, as it was the employer which granted the option, so, to use his language, it was the employer who “conferred” the right or opportunity for that option to be granted. He did not look behind the mechanics of the grant to ask “who created the opportunity for the employer to do so?”

So, now it would appear that, if two directors are each granted options on similar terms otherwise than by reason of an employment, one option being granted by the employer and the other by a non-connected shareholder, the tax consequences for the grantees will be different even if the opportunity for the directors to be granted the options was, in both cases, made available by the non-controlling shareholder (as in Vermilion) rather than the employer company.

It is widely accepted, not least by HMRC, that the ruling in Vermilion, although concerning options, applies equally in relation to acquisitions of shares and other forms of “security” as the wording in s421B is similar, if not identical.

A recently-published decision of the FTT in the case of Coopervision Lens Care Limited v HMRC [2026] UKFTT 324 illustrates how that Tribunal Judge (Harriet Morgan) has attempted to “push-back” against the approach taken by Lord Hodge. (At the time of writing, enquiries as to whether the decision will be appealed by either party have been rebuffed on the basis that the parties and their counsel have been “sworn to secrecy”!) The case concerned whether income tax charges arose under Chapter 3D, Part 7 because ERS had been sold for a consideration greater than their market value (answer: yes). A preliminary question was whether the shares sold were ERS in the first place. Over time there had been four distinct acquisitions of shares by the individual directors concerned, Messrs Wells and Maynard.  In relation to the first three acquisitions, the Tribunal readily decided that the shares were in each case acquired as ERS. This was not a situation in which the individuals were founders of the company (as to which, see my separate post) or had established its business from the outset. The business had been that of a group owned by other individuals (“the CLM owners”) which had been demerged into a company controlled by the CLM owners but in which Mr Wells and Mr Maynard – who had been keen to acquire the business as entrepreneurs – agreed in 1985, and pursuant to what was described as a “shareholders’ agreement” (although they did not yet hold shares), to become employees and directors. The agreement provided for them to be granted options to subscribe for up to a total of 36% of the issued share capital of the company. At that time only the CLM owners were members of the company. Nevertheless, Mr Wells became effective controller of the business. Messrs Wells and Maynard gave evidence that they would not have joined the business had they not been given the options and the opportunity to become part-owners. The Tribunal, however, determined that the options were an incentive for them to agree to become directors and were part of their remuneration for acting as such.

Some of the options were later exchanged for convertible loan notes and, in 1987, these were converted into shares. The Tribunal held that the shares acquired on this first acquisition were ERS both under s421B(3), the deeming provision, and s421B(1), the “by reason of employment” provision. The employments were the effective cause of the acquisition of the loan notes, and the first tranche of options were granted by reason of their prospective employments as directors.

In 1988 the company was in financial trouble. The shareholders’ agreement was varied in part to allow Messrs Wells and Maynard to purchase shares from the CLM owners at a price far below the option exercise price. The Tribunal held that this was nevertheless a fulfilment of the option exercise rights and that the shares so acquired were therefore ERS under s421B(1).

In 1991, related private equity funds (“Questor”) invested and one of the funds granted options to acquire shares from that fund to each of Messrs Wells and Maynard. These were exercised shortly thereafter using their own monies. Thereafter, they together held 39% of the company. The Tribunal held that this third tranche of shares acquired were acquired as ERS under s421B(1): the options were granted in return for continued employment and were conditional upon the optionholders continuing to remain as employees. They were, at least in part, like-for-like replacements of the balance remaining of the options granted in 1985, save for the change in exercise price, being subject to Mr Wells remaining with the business at the time of exercise, and the fact they were options to buy existing shares from the fund. The Tribunal held that this did not “[change] the essential character of the option rights…originally acquired in 1985 by reason of their employments.” The Tribunal held that the third tranche of shares acquired were acquired “by reason of employment”.

That the first three tranches of shares acquired should be held to be ERS is at least consistent with the authorities. The employees were not “founders” of the company (see my separate post) which already existed and had acquired, by demerger, a subsisting business. The individuals may have adopted a “risk-taking”, or entrepreneurial, stance in negotiating to join the business and effectively take over day-to-day operational control, but the deal struck with the owners was that they would do so, and become employees, partly in consideration of being granted options to become shareholders. The original options were by reason of the employments even if it was equally true that the original employments were by reason of the CLM Owners agreeing to the individuals having the opportunity to become shareholders.

In 1995, the CLM owners wanted to sell their remaining shares to the other members but, after negotiation with the other members, sold the shares back to the company itself for £3 per share. The other parties agreed between them that the company would then issue the same number of shares to the remaining shareholders (Messrs Wells and Maynard, Questor and certain other employees) at the same price, but part-paid as to only 25p per share. As a result, Messrs Wells and Maynard acquired in total more than 50% of the issued share capital and control of the company.

In relation to this fourth tranche of shares, the Tribunal held that:

  • as the right or opportunity to acquire the shares was made available to all shareholders and resulted in other shareholders acquiring shares on the same terms, albeit in different proportions, it was not tenable to characterise that right or opportunity as having been made available “by reason of employment” per s421B(1) : it was available because they were shareholders and their employment had nothing to do with it;
  • the right or opportunity for Messrs Wells and Maynard to acquire the shares was made available by the CLM Owners as part of their decision to sell their remaining shares to the existing shareholders and the company merely fulfilled that opportunity. It was not linked to their continuing employment, therefore s421B(3) did not apply and the shares were not acquired as ERS.

Whilst, as a matter of simple fairness, this may appear to be the “right” answer, and consistent with what should have been the decision in Vermilion, it is difficult to reconcile with the approach taken by Lord Hodge. As in Vermilion, what was acquired (here, shares, in Vermilion the share option) was actually provided by the company itself. That – according to Lord Hodge – avoided the need for an enquiry into causation: the company “conferred” (to use his word) the opportunity for the individual to acquire the option, and therefore s471(3), the equivalent of s421B(3), applied and the acquisition had to be regarded as made by reason of employment.

Why did the Tribunal feel able to ignore the approach of Lord Hodge and instead look behind the question of “who conferred the benefit?” to see “who made available the right or opportunity for the shares to be acquired?”. It is to be hoped that this Tribunal decision points up a “chink in the armor” of HMRC seeking to avoid the need for any enquiry as to who provided the right or opportunity, as opposed to asking who transferred the shares or granted the option. The approach of the Tribunal would appear to be more consistent with the clear intention of the legislation than was the line taken by Lord Hodge.

The circumstances of the fourth acquisition pre-dated s421D ITEPA (“replacement” and “additional” shares). Nevertheless, one point made by HMRC was that, if an employee has acquired shares as ERS, any further shares acquired are to be regarded as ERS if the reason why the opportunity to acquire the further shares was made available was the existing holding of ERS. The Court of Appeal, in Charman v HMRC ([2022] STC 157) had rejected the idea that such a causal link was broken by the fact that the shares were, on the same occasion, offered to non-employees (see Charman at [52]). The Tribunal in Coopervision gave no explanation for side-stepping this reasoning, appearing to differentiate on the basis that the fourth tranche of shares acquired were part of an exiting member’s holding offered to all other shareholders on the same terms.

Of course, had the shares been made available by connected controlling shareholders, the position would have been squarely within s421B(3), but the CLM Owners had, by 1995, then reduced their holding to below a controlling interest.

The decision of the Tribunal has “muddied the waters” and made it all the more difficult to advise as whether on any given set of facts the shares acquired are, or were, ERS.

It is surely also wrong in principle that a question of whether ERS charges arise should be dependent upon circumstances over 25 years ago. Perhaps the government should consider waiving the ERS-specific charges if the shares have been held by the same individual, or “associated persons” for at least, say, 21 years.

   EOTs – The New “Trustee Independence Requirement”

What follows may be of interest (only) to those who advise in relation to the establishment and operation of “employee ownership trusts” (or “EOTs”).

Non-corporate shareholders who sell shares in a trading company or holding company of a trading group (“C”) to an EOT may claim relief from capital gains tax if all the relief requirements are satisfied. The Finance Act 2025 made a number of changes to the requirements as they apply to EOTs to which disposals are made on and after 30th October 2024, including an entirely new “trustee independence requirement” which must now be met.

HMRC have acknowledged that there is an error in the drafting of the new “trustee independence requirement”. Read literally, no trustee of an EOT (“T”) would satisfy the new requirement. This is because T will always be an “excluded participator” (as specially defined) and the requirement is not met if half or more of the trustees are such “excluded participators”. But there is good news.

For the purposes of this requirement, an “excluded participator” has the meaning given in s236J TCGA 1992, but does not include a trustee who is so excluded only by reason of its deemed connection (per s286(3)) with the settlor.

Looking at the definition of “excluded participator” in s236J: in every EOT situation, T, as a holder of shares, is a participator in C. However, a participator is not an excluded participator if T holds shares in C only in a fiduciary capacity (see s236J(6)(a)) and is not entitled to more than 5% of assets of C on a winding-up (s236J(6)(b)). The problem is the absence, from s236(6)(b), of the words “…beneficially entitled to…”. T will be legally, but not beneficially, entitled to more than 5% of assets on a winding-up of C. T is therefore an “excluded participator” as defined in s236J.

Until the new requirement was introduced from 30th October 2024, this did not matter.

Looking at the exception, in new s236LA(2)(a),  to being an excluded participator as defined for the purposes of the new “trustee independence requirement”, T is not  “an excluded participator only as a result of a connection falling within section 286(3)”. T is an excluded participator by virtue of being entitled to more than 5% of assets on a winding-up, per s236J(3).

On a literal reading, trustees could never meet the “trustee independence requirement”.

The good news is that HMRC have confirmed that, adopting a “purposive approach”, as this is clearly not what was intended, HMRC would not seek to argue that trustees would be considered excluded participators in such circumstances. In other words, s236J(6)(b) will be read and construed as if it said that excluded participators do not include any participator not beneficially entitled to 5% or more of any class of shares and who  “on a winding up of the company would not be beneficially entitled to 5% or more of its assets”.

Separately, HMRC have confirmed that the new trustee independence requirement will not preclude the use of a corporate trustee with a share capital, the shares in which are owned by C (affording a circularity of ownership: C owns T, which owns C).

…………………………

24th October 2025

Help from HMRC….or is it really?

I am highlighting a small point, of restricted interest to those involved with employee share schemes, but one which suggests that standards may not be what they were at HMRC.

Last month, HMRC published a revised Helpsheet 287 on the topic of the CGT consequences of disposing of shares acquired under a tax-advantaged employees’ share scheme. (https://www.gov.uk/government/publications/employee-share-and-security-schemes-and-capital-gains-tax-hs287-self-assessment-helpsheet/hs287-capital-gains-tax-and-employee-share-schemes-2025). This has excited some interest, as it clarifies how, by arranging for shares to be transferred directly from an SAYE share option scheme or a SIP into an ISA or personal pension arrangement, individuals may avoid triggering a liability to capital gains tax. However, it goes on, in para 16, to suggest (as did earlier helpsheets) that relief from CGT is available to both employees and non-employees who sell shares in an unlisted company to the company’s SIP trustees:

“This relief is designed to encourage shareholders disposing of their unlisted shares to sell them to the trustees of the company SIP for the benefit of all the employees of the company. You do not have to be an employee to claim it.”

There follows a note of how to claim the relief.

To the casual reader, this appears to be an attractive prospect, enabling any individual or corporate shareholder in an unlisted company to avoid CGT by selling their shares to SIP trustees.

What it fails to highlight is the key condition for the relief (which is afforded by s236A and Schedule 7C, TCGA 1992), namely that the SIP in question must hold/acquire (including shares awarded to, or acquired on behalf of, plan participants as Free, Matching or Partnership Shares) not less than 10% of the issued share capital of the company.

In practice, the relief (a form of CGT rollover relief, as the proceeds must be reinvested) is of very limited application, and certainly not as readily available to all and sundry, as the Helpsheet suggests. It is as if an officer at HMRC only read the first para of Sch 7C TCGA and did not bother to read the conditions in paras 2 and 3.

At best, it is hardly fair to “dangle the carrot” of relief from CGT without signalling that the detailed conditions mean that it is of only limited interest or application. “Help” is not what this is!

New Edition of “Employee-Ownership Trusts”

Cover of Employee-Ownership Trusts, second edition

Intended for all those advisers, trustees, officers and directors of companies owned by, or to be sold to, an Employee-Ownership Trust, the second, revised and enlarged edition of my book, “Employee-Ownership Trusts” has just been published by Claritax Books, priced at £95 + postage.

So far as I am aware, it remains the only comprehensive guide to the tax and legal issues around the establishment and operation of an EOT and the corporate governance of a company acquired by the trust and will be of interest to all lawyers, accountants, trustees, and other advisers, vendors of shares to an EOT, as well as all those involved with an EOT-owned company.

The work covers all of the changes made by the Finance Act 2025 to the tax rules relating to EOTs and includes much that has been gleaned from experience of advising proprietors, companies and EOT trustees since the book was first published in 2022.

For more details, and to order a hard copy, visit: https://www.claritaxbooks.com/product/employee-ownership-trusts/

When, if ever, does Abbott v Philbin still hold good?

In Michael Saunders v HMRC ([2024] UKFTT 300 (TC)), the First Tier Tax Tribunal has held that a cash payment received by an ex-employee pursuant to the terms of “share appreciation rights” (“SARs”), awarded under an L-TIP established by the holding company of his former employer company, fell to be taxed as employment income when received. It was not, as the appellant contended, a sum derived from the SARs which, in line with Abbott v Philbin ([1961] AC 352), fell to be charged to income tax only when first awarded (as “money’s worth” which constituted an emolument of the employment at that time).

Under the terms of the SARs, Mr Saunders was entitled to a payout of an amount, calculated by reference to growth in value of shares in the holding company, if (i) his award had “vested” when he ceased employment and, (ii) the company was, inter alia, sold within 2 years after he ceased employment. In the event, the company was sold within two years after Mr Saunders had ceased employment holding vested SARs. The substantial sum to which he therefore became entitled was received by him in the overseas portion of a split tax year in which he became permanently resident outside the UK. Even if the payment was of general earnings, it was, so he argued, outside the scope of the charge to UK income tax as being attributable to the overseas part of a split year (per s15(1A)(a) ITEPA 2003).

Rights under such SARs are neither securities nor securities options and do not fall within the scope of the charging provisions in Part 7, ITEPA 2003. What Mr Saunders was granted was a conditional entitlement to future payment of a cash sum of an amount dependent upon growth in value of shares in the grantor company.

In Abbott v Philbin, the option purchased on favourable terms by the employee was “something” that could be turned into money (albeit that, by its terms, it was non-transferable). The terms of the option did not link its exercise to continued employment or the circumstances in which Mr Abbott might cease to hold the employment. It was the acquisition of the option itself which was the taxable perquisite from employment and not the gain realised upon subsequent exercise of that option. The gain realised upon its exercise was derived from that asset, not from the employment. (That decision was, of course nullified, at least in relation to the grant of “rights to acquire employment-related securities”, by what is now Chapter 5, Part 7, ITEPA. However, it is still good law to the extent that it has not been reversed by statute.)

The question for the Tribunal was whether, in this case, the SARs amounted to “something” which was itself an emolument of the employment taxable when acquired by the employee, or whether the sum eventually paid, being an amount paid pursuant to what was a conditional contractual entitlement to a sum of money, was derived from the employment, not from that “something”. The Tribunal held that the receipt of the payment arose from the employment relationship, not from the SARs. The terms of the SARs were closely linked to the employment. It did not matter that the quantum of payment was not directly and specifically linked to the performance of the duties of that employment. It was part of the reward for his services and comprised general earnings for the period of his employment since the award was made. By reason of s17 ITEPA, the general earnings were “for” the last of those earlier tax years but, by reason of s18, were taxable in the tax year of receipt. It was not attributable to the overseas part of the split tax year in which it was received.

The decision did not explore the parameters of exactly what would amount to the grant of rights (not being rights to acquire securities) which is taxable as an emolument at the time of grant per Abbott v Philbin, but was content to rely upon the idea that the sum eventually paid derived from the employment, not from such rights. The question is important in the context of identifying the correct UK tax treatment of different forms of employment-related cash-based incentive awards made by US and other overseas companies to internationally-mobile employees. Does a liability to UK employment taxes arise at grant/award (per Abbott v Philbin), or only at the later time when the benefit of the award is satisfied by a cash payout? This decision suggests that it is difficult to craft a form of contingent contractual entitlement to a cash sum linked to ongoing employment which amounts to something capable of being converted into money or something of direct monetary value so as to be a taxable emolument when first received.

………………………………………..

David Pett

14th May 2024

Selling an EOT-Owned Company: Can It Be Done, and What Are the Consequences?

It is now ten years since controlling interests in companies were first sold to “employee ownership trusts” or “EOTs” (as provided for in the Finance Act 2014). Perhaps not unexpectedly, some of those companies are now being sold on by the trustees, and the EOTs are being brought to an end. However, given that the original policy intention was to encourage the long-term ownership of such companies for the benefit of their employees, there is invariably a tension between that and the idea that the company should now be sold on, typically to a trade purchaser. In particular, it is all too easily assumed that if, by doing so, the trustees are able to discharge their outstanding liability to the original vendors, that must be in the financial interests of all concerned, including other shareholders and those employees holding options to subscribe for shares in the company, and is therefore “a good thing”.

Who are the beneficiaries of the EOT?

However, the first question – often overlooked – must be: is a sale by the trustee, of its controlling interest in the EOT-owned company, really in the best interests of the beneficiaries of the EOT as a class?

To answer this, it is necessary to identify who exactly are the members of the class of beneficiaries. This will depend upon the drafting of the trust deed. They will typically be either (a) all employees, past, present and future, or (b) those individual current and former employees in whose favour the trustee may exercise its dispositive powers, these being defined in a manner consistent with the statutory “all-employee benefit requirement” (for the initial relief from capital gains tax afforded to the original vendors of shares to the EOT). If the latter, the trustee must also identify at this stage all those who are “excluded participators” as defined in s s236J(5) (which should have been mirrored in the trust deed).

Such a sale must be for a consideration which is not less than the market value of the shares sold. The trustee will need independent professional valuation advice to support their acceptance of an offer on terms which include a given level of immediate and deferred and/or conditional consideration.

Is a sale in their best interest?

Having identified who are the members of the class of beneficiaries, the next question for the trustee is whether a sale, and the tax and commercial consequences of such a sale, would be in their best interests as a class? Whilst “the best interests” has been taken to mean “the best financial interests” (per Sir Robert MeGarry VC in Cowan v Scargill [1985]), more recent decisions suggest that broader factors, such as future security of employment, may be taken into account.

Too often, the suspicion is that, whilst a sale may clearly be in the best interests of the original vendors (if they are owed money by the trustee), if the tax and financial consequences for the trustee and beneficiaries are such that there will be little or no cash benefit to the beneficiaries (who may, in consequence of a sale, lose job security and pension entitlements), it may be difficult to see on what basis a body of trustees, acting reasonably, could conclude that such a sale is in best interests of the beneficiaries.

It is worth noting that:

  • the trustee, or directors of the trustee company, have a duty to determine such questions independently and without regard to their personal interests;
  • the trustee should be separately advised – meaning that it is not sufficient for the lawyers acting for the EOT-owned company and/or the original vendors to procure the provision of advice by different teams after “Chinese Walls” have been put up between them. Rather, the trustee(s) should appoint distinct legal advisers who have no conflict of interests with those of other interested parties such as the original vendors or the EOT-owned company itself. (See the comments of the judge in the case of South Downs Trustees [2018].
  • ceasing to meet the “controlling interest requirement” will trigger a disqualifying event giving rise to a clawback charge to capital gains tax on the part of the trustee (calculated by reference to the base cost of the original vendors). This, when added to the amount of any outstanding consideration due from the trustee to the original vendor(s), plus any interest thereon, will eat into the net proceeds available for distribution to beneficiaries.

Reducing the tax cost of a sale

It has been suggested by others that the clawback charge may be avoided by the trustee first distributing its shares in the EOT-owned company to beneficiaries. The thinking here is that, if the shares are transferred out for a nil consideration, the trustee is protected against any charge to CGT by s 239ZA TCGA 1992, and no further clawback charge may then arise. In my view, this is not correct. Even assuming that the grant of such options is structured to avoid breaching the “all-employee benefit requirement” (which may, in practice, be difficult to achieve), a clawback charge would be triggered immediately before the controlling interest requirement ceases to be met, and in advance of the disposal of shares by the trustee. However, if the EOT-owned company, or an employer subsidiary, is able to claim relief from corporation tax under Chapter 2, Part 12 CTA 2009 for the value of the shares so acquired by the employees, this will enhance the value of that company and, presumably therefore, the amount of consideration paid to the EOT. That said, as HMRC appear to treat a company under the control of an EOT with a corporate trustee as being under the control (per s1124 CTA 2010) of another company (hence the need for the wording in parenthesis in para 27(4)(d) of Sch 2 (SIPs) of ITEPA 2003), it will be necessary – if a claim for such relief is to be relied upon – to ensure that the EOT trustee is not, or is not solely, a corporate trustee.

If the trustee or trustee directors are in breach of their duties, they will be at risk of a class action by or on behalf of beneficiaries for damages for breach of trust. The Roadchef saga is illustrative of the fact that, if a law firm is able and willing to take on such a challenge on a “no win, no fee” basis, the risk to the individual trustees or trustee directors could be real and significant – particularly if they are held to have benefitted personally from the sale.

Conflicts of interests

If, as is not uncommon, trustees or trustee directors include an original vendor and/or a director of the EOT-owned company, it is necessary to examine carefully the provisions of the trust deed and the articles of association of the EOT-owned company to understand what if any provisions apply to relieve such individuals of the consequences of conflicts of interests arising from them acting in different capacities. If necessary, an individual may need to recuse themselves from any participation in the decision-making which may, in turn, give rise to issues of quorum and capacity of the trustee(s) to determine matters relating to the sale.

Who is eligible to participate in a distribution of net, after-tax, sale proceeds?

A further point for the trustees to consider is how, and when, any net proceeds of a sale of shares in the EOT-owned company are to be distributed amongst the members of the class of beneficiaries. Those eligible to participate in any distribution must, if the EOT-owned company is sold, include those ex-employees who have left within the 2 years ending with the sale (see s236J(4) TCGA). Those employees who leave after the sale by the EOT will remain members of the class of beneficiaries and, if they die and the trust deed so provides, their personal representatives will remain beneficiaries for a period of 12 months thereafter.

A question often asked is: can new joiners, after the sale, be excluded from participation? Typically, the directors of the company being sold, and its new owners, would wish to do so on the basis that value accruing up to the point of sale should benefit only those who contributed up to that time. Against that argument is the assertion that crystallising entitlements at the time of sale results in a two-tier workforce – those with an interest in any distribution, and those without. If the amount of sale consideration, and therefore any distribution, is dependant upon a post-sale “earn-out”, this could afford a disincentive on the part of those so excluded from participation in a distribution.

However, the position is not entirely clear and depends upon the interpretation of s170(1)) TCGA – defining what is a member of the group of companies – and s236J(3) TCGA. The trust deed will restrict the distribution of trust assets to those who are “eligible employees”, as defined. Even if the better view is that new joiners should participate, so that their exclusion is technically a breach of the all-employee requirement, the question is “so what”? Once a disqualifying event has occurred and the clawback charge (if any) has been accounted for, HMRC presumably have no further interest in policing compliance by the trustee(s) with the “relief requirements”. The company could possibly afford some protection for the trustee by imposing, as a term of employment, a disclaimer of benefit (although quaere is this “a written request from” the new joiner – see s236K(1)(c)?).

The eligible employees, amongst whom any distribution must be made, will necessarily exclude “excluded participators” as defined in s236J(5). This will mean that, for these purposes, the class of eligible employees will differ from the class of eligible employees to whom annual tax-free bonuses may have been paid. If the trust deed so provides, non-executive directors of the EOT-owned company and its subsidiaries who are not otherwise eligible employees may also be excluded.

How is the available sum to be divided amongst those eligible?

Having identified who must participate in a distribution from the EOT, the next question is how the amount to be so distributed is to be divided between them, bearing in mind that there may be a series of distributions if the sale consideration is not immediately received in full.  The legislation allows for amounts to vary according to different levels of remuneration, length of service and/or hours worked, provided such differentiation is on a linear basis weighing each such factor separately, but every eligible employee must receive something in each distribution. The legislation leaves open the question of whether such factors are to be applied at the time of the sale or the later time of a distribution.

Logically, it would be the former, as crystallising entitlements as at the time of sale operates most fairly and, otherwise, a post-sale salary increase (for example) could unfairly increase an eligible employee’s entitlement, relative to that of others on the same rate of pay at the time of the sale. Likewise, if determined as at the time of distribution, the passage of time could unfairly alter relative individual entitlements.

Distributions are taxable as employment income

Amounts distributed are taxable in the hands of recipients as employment income, and attract NICs, to be accounted for under PAYE. If the distribution represents the net proceeds of sale of the EOT-owned company, this is unfair when compared with the tax treatment of other shareholders who will typically suffer only capital gains tax. It is a concern which has prompted representations to government in response to the 2023 consultation on EOTs.

……………………………………………..

4th May 2024

More About the Loan Charge

Those who follow the debates about the impact of the 2019 Loan Charge on employees and directors who had outstanding loans made to them by an employees’ trust or other third party will be interested to read the following exchange of letters between the Parliamentary Treasury Select Committee and the head of HMRC:

Letter from Chair of the Treasury Select Committee to Jim Harra dated 5 February 2024

https://committees.parliament.uk/publications/43894/documents/217675/default

Letter from Jim Harra dated 11 March 2024 in response:

https://committees.parliament.uk/publications/43895/documents/217677/default

Jim Harra’s response to specific questions asked by the Committee about the Loan Charge, is – at least in part –  a masterpiece in “yes Minister”-style obfuscation and half-truth. Specifically, the answers to questions 2 – 5 give only a partial picture of how disguised remuneration tax avoidance schemes were established and operated in the decade or more before 2010.

Those questions were:

1. Please provide a diagram of how typical disguised remuneration schemes work.

2. Please provide the Committee with a timeline regarding disguised remuneration schemes and HMRC efforts to tackle them, beginning in 2000. This should include, but not be limited to:

the development of such schemes, HMRC actions, court cases and legislative initiatives, including the General Anti-Abuse Rule (GAAR).

3. Given the above timeline, is HMRC confident that it acted swiftly in seeking to counter disguised remuneration schemes?

a) Please list any constraints HMRC faced in its actions and the effectiveness of any measures taken by HMRC or HMT listed in the timeline.

4. Were HMRC confident that the department was in a position to win disguised remuneration cases in court prior to the introduction of the Loan Charge legislation? If so, how long would it have taken to clear all the cases through this route alone?

5. Without the Loan Charge legislation announced at the 2016 Budget, what courses of action would have been available to HMRC?

a) Did you cost those options at the time and what were their estimated costs?

Most importantly, it is necessary to correct the impression given by Jim Harra that HMRC had judicial authority for its campaign to recover income tax on (real) loans made by trusts funded otherwise than by way of “re-directed earnings” before 6 April 2011, and that the actions it took were the only courses of action reasonably open to it.

The making of loans from a trust, as a means to avoid PAYE tax and NICs on moneys advanced to a director or employee, was becoming a widespread practice amongst both listed and independent private companies well before 2000. The use of such structures to avoid tax was made known to HMRC officials on multiple occasions in the 1990s, and concern was expressed at the loss of tax and failure on the part of HMRC to respond effectively or at all. The idea of using such loans from a trust to avoid income tax and NICs can be traced back to material published by respected counsel in or about 1992, relating to the taxation of employees’ trusts.

It was suggested to HMRC well before 2010 that new legislation could impose a “loan to participators” – type charge[1], which is a primary liability of the employer, if it (or a connected company) causes monies to be put beyond the reach of its creditors by funding a trust. The tax deposited might then be available for credit against PAYE liabilities to income tax arising on the provision of benefits out of the trust. Alternatively, or in addition, a charge similar in effect to the 2019 “loan charge” could have been imposed at a much earlier date if any form of beneficial employment-related loan was not repaid in full after, say, 5 years.

When, in 2010, a draft of the Disguised Remuneration legislation was disclosed by HMRC officials to selected advisers for comment, it was queried why the charges to income tax were structured as charges on individual employee beneficiaries, and not as a primary liability of the employer. The response was that Ministers were anxious to avoid the new charge to tax being perceived as an additional tax on businesses.

In those cases in which an advance of moneys to an employee or director was purported to be a loan, but the facts supported the view that any such loan was a sham, HMRC had good authority on which to recover tax on the basis that the advance was a payment of earnings (see, for example the case of Philip Boyle v Revenue & Customs ([2013] UKFTT 723)).

Until 2015, HMRC sought to assert that the making of a loan to an employee by trustees in circumstances in which there was no expectation of repayment until after the death of the employee was, in effect, an earmarking of the funds (similar to the idea of an earmarking described in the Disguised Remuneration rules[2]) and that this was itself a form of payment of earnings which was liable to income tax and NICs, for which the employee is liable but which is collected from the employer under PAYE. It was only in that year, and in the course of the litigation with Glasgow Rangers’ football club (“the Rangers’ case”[3]), that HMRC changed tack and argued instead that it was the contribution made to the trust which, if on the facts was a payment of re-directed earnings of the employee, was liable to income tax and NICs.

This, however, was not a complete answer to the avoidance of tax by the use of loans from a trust. In many instances it was clear that the funds in the trust did not represent payments of re-directed earnings of specified employees. In the case of such loans (assuming they were genuine and not sham loans) made before the introduction of the Disguised Remuneration rules in 2011, there was no judicial authority supporting the imposition of a charge to income tax on the making of such a loan – although more modest annual charges arose under the “benefits-in-kind rules”. Settlement agreements secured by HMRC have, in many cases, been (in effect) imposed on the basis of a questionable representation of the law as it then stood. It is no answer for HMRC to assert that, whilst HMRC has power to collect income tax from an employer under PAYE, it is also justified in side-stepping the PAYE rules and collecting it directly from the employee: if there was no general earnings charge on the making of a genuine loan, the collection mechanism is not in point.

The truth is that, for more than a decade until 2010, HMRC were like the proverbial rabbit stuck in the headlights, aware of the issue but unable or unwilling to respond effectively by securing an early change in legislation and/or securing judicial guidance in all those situations in which real loans (etc) were not made out of re-directed earnings.

………………………………………….

David Pett

March 2024

[1] See s455 Corporation Tax Act 2010

[2] See s554C ITEPA 2003

[3] RFC 2012 Plc (in liquidation) (formerly The Rangers Football Club Plc) v Advocate General for Scotland [2017] UKSC 45

Tax Journal Interview

Published on 15 March 2024. See original article here

One minute with…David Pett

David Pett is a tax barrister at Temple Tax Chambers. Whilst he advises on all direcct taxes, David is best known for his advice on the income tax, PAYE, NICs and CGT aspects of employees’ and directors’ remuneration, incentives, and all aspects of employment-related securities and employee share plans.

What’s keeping you busy at work?

At present, I am principally fielding technical queries about the disguised remuneration rules, employee share schemes and sales of companies to employee-ownership trusts (“EOTs”), although my practice extends to all direct taxes and related trust and company laws.

If you could make one change to a tax law or practice (anywhere in the world) what would it be (and why)?

It would be to allow trustees of a bona fide employees’ trust holding ordinary shares of the principal class in the employer company or group to receive distributions free of UK tax provided that, within, say, 30 days, they are fully distributed amongst beneficiaries on an “all-employee and similar terms” basis. Subject to safeguards against abuse, such amounts should then be taxed as dividend, not employment, income in the hands of existing and ex-employees. This would encourage the collective ownership of shares in (especially P/E-backed) companies, and meaningful financial participation, for the benefit of all of a company’s employees.

Is there anything you know now that you wish you’d known at the start of your career?

How enjoyable and intellectually satisfying life as a tax barrister can be. I transferred from practising as a solicitor in 2017 but should have done so 20 years ago! The support of my clerks and of other members of chambers has been fantastic and helped me to produce two new tax books in 2021 and 2022 (Claritax guides to Disguised Remuneration and Employee Ownership Trusts), and to accept instructions on, and deal with, some very challenging and high-value matters. Being entitled to lunch in Hall in the Inns of Court is also a tremendous benefit.

Who do you see as your mentors over the years?

David Gottlieb, then head of tax at Clifford-Turner (and who died prematurely at the age of just 39), in the early 1980s, instilled in me both the need to examine all the detail and the maxim “always assume you are wrong and question your own opinion” (He would then add: “always assume your adversary is more right than you are…. but still assume they too are wrong.”). He gave me the time to study, understand and absorb the tax, trusts and company legislation without the pressure to meet financial targets. It was a fantastic training.

Is there a recent tax case has caught your eye (and why)?

The 2023 decision of the Supreme Court in HMRC v Vermilion Holdings Limited has given rise to widespread uncertainty as to what is and is not an employment-related security or option, falling within the charging provisions of Part 7, ITEPA 2003. The ratio is that the deeming provision in s471(3) is a “bright line rule”, but the conflation of identifying who provides shares or share options with that of identifying who provided the right or opportunity for an employee to acquire them, has muddied the waters.

What should we be looking out for later this year?

Getting one’s head around the proposed new residence-based tax regime for non-doms will be a challenge this year, but an important issue ignored in the Budget, is the ongoing plight of those lower-paid employees caught in the Loan Charge scandal as a consequence of HMRC’s failure to act effectively, or at all, when tax avoidance schemes for contractors and others were being peddled in full sight. The resulting penury for so many caught up in HMRC’s zealous efforts to recover tax from the victims, rather than the promotors of such arrangements, in a scandal not dissimilar to that of the Post Office saga.

Finally, you might not know this about me but…

Since a teenager, I have pursued a parallel career as an orchestral timpanist. This has afforded opportunities to play much of the symphonic repertoire and in some of the finest concert venues in Europe. There is nothing like participating in a performance of a Tchaikovsky or a Mahler symphony for shedding frustrations and angst. I still enjoy time spent at the back of a large ensemble of musicians – much of it counting bars – and conquering the fear of coming in at just the wrong moment! It has some similarities with appearing before a court or tribunal.

Encouraging Financial Participation by Company Employees

What should be the underlying policy objective and how could that be achieved?

It is generally agreed by politicians of all parties that it is a good thing “to enable employees to share in the growth in value of the business to which they contribute by their labour”.

We have, on the statute book, provision for various long-standing tax-advantaged arrangements for employees of an independent company to be able both to acquire, and then sell, shares in their employer company on favourable terms. Specifically, and presently, income tax and CGT reliefs are afforded (within limits) to ordinary shares in the employer company acquired pursuant to a Share Incentive Plan, and to the grant and exercise of options to acquire employer-company shares granted to all qualifying and eligible employees as savings-linked share options, and on a selective basis as Company Share Options (“CSOPs”) or, if the company itself qualifies, as enterprise management incentives (“EMI share options”). In addition, employers may be eligible for relief from corporation tax for amounts corresponding to employee share option gains and certain other amounts on which employees are charged to income tax on the acquisition of employment-related shares.

Since 2014, relief (indeed, complete exemption) from CGT has been available (if claimed) for sales by individuals and their personal trusts of shares in a trading company (or holding company of a trading group) to a special form of employees’ trust (an “employee ownership trust” or “EOT”) which thereby acquires a 51%+ controlling interest in the company within a single tax year. Provided all statutory conditions are met and there is no “disqualifying event”[1] before the end of the next tax year, the vendors escape all liability for CGT on their disposal of shares to the EOT.

This legislation affords a powerful incentive to proprietors of private companies to sell their shares to such an EOT. Indeed, so far, there have been over 1,500 companies sold to EOTs and the trend has accelerated for fear of changes or restrictions being introduced (although this government has said it will only amend, not withdraw, the relief). Typically, the EOT is funded by the company being sold making cash contributions out of distributable profits, the vendors having to remain as unsecured creditors of the EOT until future profits have been generated sufficient to put the trustees in funds to enable them to pay any outstanding consideration.

Whilst an EOT-owned company can pay annual tax (but not NICs)-free bonuses of up to £3,600 to qualifying employees, employee beneficiaries of the EOT cannot – unless the company or its business is sold on – individually benefit from growth in value. Even if the trustees subsequently sell-on the company, the amount received by the trustees – after a clawback charge to CGT on their part and the payment of outstanding consideration due to the original vendors – is unlikely to leave much ‘in the pot’ for the employee beneficiaries, and what is paid to them is taxed as employment income, not capital gain (see the example below).

The legislation is flawed, and experience suggests that in many cases the arrangements are structured with the primary objective of allowing a tax-free sale and extraction of profits, rather than with any real intention of enabling the employees to benefit from future growth in value or from the company being owned and controlled by trustees on their behalf. Nevertheless, the EOT-ownership model, which in many respects emulates the example set by The John Lewis Partnership, is held up by some as the ideal way to maintain independent private-company ownership on a sustainable basis. Whilst it may afford an alternative to a trade sale or a disposal to private equity, it should be remembered that there is only one John Lewis…..and look at where that is now!

Crucially, The John Lewis Partnership is not – and an EOT-owned company is not – an employee-owned company. It is a company owned and controlled by a trust, and the question to be asked is: who are the trustees, and who appoints and removes them?

Further, individual employees of John Lewis/Waitrose do not own shares in the group. “Partners” so-called might (but have not recently) receive annual bonuses out of profits – taxed as employment income. What they do not enjoy is any ability to benefit financially from the growth in value to which they contribute.

In my experience – having advised upon and devised the ownership structures of multiple employee-owned companies, employees’ trusts, and employee share schemes, beginning with the privatised bus companies in the early 1980s – the most successful private company ownership structures (in terms of resulting in substantial growth in value and employee satisfaction and reward) are those which:

  • have enabled individual employees to benefit financially from an appropriate share in the growth in value to which they have contributed by their labour over the period of their employment, and to do so in a manner which is taxed in the same way as if such gain was realised by a non-employee shareholding investor; and
  • have a corporate governance structure which, whilst allowing the views of employees to be identified and taken into account, includes sufficient checks and balances to ensure that the directors are free to manage the business in the best interests of all shareholders.

The case for change

There is a strong case for a change in the UK’s tax (and company law) regime to allow and encourage employees, workers and others who contribute their personal services towards the business of a trading company, to be able both:

  • to participate in dividends out of profits generated annually on shares held on their behalf collectively in a trust; and
  • to benefit from growth in value of shares which they may acquire on and after appointment, and dispose of on or after leaving (or after a reasonable holding period).

We need a regime which encourages sustainable independent ownership of successful businesses, not one which positively incentivises individual shareholders to sell out and run away. We need a UK version of the German “Mittelstand”. Very broadly, our existing tax regime encourages the sale of successful private trading companies. It does not, as in many European countries, allow and encourage the maintenance of independence through succession of family and employee ownership.

The idea of “companies with employee ownership” (as opposed to “employee-owned companies”) as being “a good thing” was recognised by the former coalition government and model documentation to support its implementation was published on the Dept for Business website in 2013 and still remains accessible. By contrast, the EOT regime was independently devised by HM Treasury (without consultation with the Dept for Business as it then was).

The policy behind the EOT legislation should be to balance the interests of company proprietors – so as to offer them a financially viable alternative to selling the company to a trade buyer or to private-equity or other investors – with those of employees who should be enabled to benefit personally from the growth in value to which they contribute and to do so in a manner which is taxed no less favourably than if they were private investors and not employees.

As things have stood since 2014, the balance is firmly in favour of the vendor proprietors who are afforded total exemption from tax, and giving little or no opportunity for employees (supposedly those persons for whose benefit the EOT regime was enacted – the clue being in the title!) to benefit, other than by limited enhancement to their taxable employment income. I give you an example to illustrate the current position:

Rather than sell a company worth, say, £10m to a trade buyer keen to acquire it, and accept a CGT bill (assuming entitlement to BADR) of 10% on the first £1m, and 20% thereafter, Mr X can instead (i) sell, say, 75% to an EOT for say £7m (discounted to reflect the size of the holding) of which, say £2m is paid upfront, and (ii) retain 25% with a view to waiting until after the end of the next tax year. Then, the trustees (who may well be effectively controlled by the original vendor(s)) agree[2] to join in a sale to the trade buyer for, say, £10m in aggregate. If the trustees’ 75% is sold for, say, £7.5m, the trust fund (after (a) tax of, say, 20% on their gain, over the, say, nil inherited base cost of Mr X, and (b) payment of the balance remaining of the consideration due to Mr. X (£4m)) is left with (£9m – £6.5m =) £2.5m to be distributed amongst the qualifying employee beneficiaries subject to PAYE income tax and NICs. Mr X will have received £7m tax-free, and £2.5m subject to CGT (of which £1m is at the reduced BADR rate of 10%).

I set out below a summary of what might be done:

  •  to improve the EOT regime in order to enable and allow individual employees to benefit from distributions of profits and capital growth, and
  • to enable all employees, workers, consultants and individual contractors of an independent company (or member of an independent trading group of companies) to benefit likewise and in a manner which is treated for tax purposes no less favourably than that afforded to other investors.

Companies controlled by an EOT

I suggest the following changes:

  1. Restrict relief from CGT for disposals of shares to an EOT to no more than the (discounted) market value of the respective holdings of shares sold by claimants.
  2. Remove the provision for tax-free annual bonuses payable by EOT-owned companies and, instead, provide an exemption from income tax on the part of the trustees of an EOT for dividend payments received from the EOT-owned company if:
  3. the dividends are paid out to eligible and qualifying employees on an “all-employee and similar terms” basis; or
  4. the dividends are retained by the trustee(s) and applied (within, say, 3 years) in the purchase of shares in the EOT-owned company from employees who leave or who, with the agreement of the trustee(s) wish to sell having held such shares for a minimum period (of 3 years?) for a consideration which does not exceed the pro rata value of such shares determined by reference to the “market value” of the company as a whole as agreed with HMRC SAV (or certified by a recognised share valuer).

This need not be limited, as are the annual tax-free bonuses, as – unlike the payment of such bonuses – the ability of the EOT-owned company to pay dividends is dependent upon the generation of distributable profits.

3.     Provide that such payments, made out of dividend income of the trust, to employees of an EOT-owned company (and ex-employees who have left for whatever reason within the past 12 months) are taxed as dividend income, not as earnings.

4.     Amend the existing tax rules so as to provide that disposals of ordinary shares in the EOT-owned company beneficially owned by employees (as “employment-related securities”) to the EOT for a consideration which does not exceed the pro rata market value described at 2(b) above is taxed as capital gain, not as employment income (see Chapter 3D, Part 7, ITEPA 2003).

5.     Allow ordinary shares in the EOT company to be appropriated to employees and/or sold to employees by way of awards under a tax-advantaged Share Incentive Plan without that being a disqualifying event (see footnote above), and for so long as such shares are beneficially owned by individual employees and held in the SIP, allow those shares to be counted towards the percentage ownership of the share capital of the company by the EOT (so that the aggregate of such SIP shares, together with those beneficially owned by the EOT must not fall below 50% + 1 if a disqualifying event is to be avoided).

The combination of such changes, together with changes to SIPs, which have been separately suggested in a response to the Call for Evidence by HMRC on SIPs and SAYE share options, would enable an EOT-owned company to allow its employees to benefit directly from sharing in the growth in value of the EOT-owned company over the period of their employment in a tax-advantaged manner (within the confines of a SIP).

The suggestion at 4 above would afford a commercial freedom to allow an EOT-owned company to enable its employees to benefit from such growth in value, subject to CGT, by way of other (existing) mechanisms for the acquisition and disposal of employee shares (such as the grant and exercise of EMI and CSOP, as well as “unapproved”, share options to subscribe for new shares or the operation of an internal market in employees’ shares).

Other more detailed and technical changes recommended to HM Treasury are set out in my response to a Call for Evidence earlier in 2023. The detailed response is to be found at : https://davidpett.tax/2023/08/20/employee-ownership-trusts/

Changes proposed to encourage financial participation by employees in other companies

The ideas put forward in items 2 and 3 above may also be applied to all other independent companies or groups of companies, not just those which are majority owned or controlled by employees or trustees. It is often asserted that it is wrong in principle to encourage employees, by participating in employee share schemes, to “put all their financial eggs in one basket” by becoming dependent upon the fortunes of their employer to secure their employment income, their pension, and their savings. By allowing, without tax disadvantages, an employer to fund an employees’ trust to acquire a tranche of ordinary dividend-entitled and non-restricted, or publicly-traded shares, to be held on a collective basis for the benefit of employees, past, present and future so as to allow them to participate as suggested above and without individual risk, would be attractive to many, including private-equity backed, companies. At present, for example, a loan by a closely-held company to an employees’ trust for such a purpose attracts a penal tax charge under the “loans to participators” rules.

Finally, many larger companies, both publicly traded and privately-owned, do have employees’ trusts which they use to warehouse shares pending their transfer to participants in share-based incentive arrangements (such as L-TIPs, Restricted Share Plans. JSOPs, Growth Share Plans, etc.). It has been repeatedly pointed out to HMRC and Treasury Ministers that the reason why companies typically appoint offshore (typically in the Channel Islands or Switzerland) independent trustee services companies, not UK trustees, as corporate trustee of their employees’ share trust, is that existing tax rules treat them more favorably than UK-resident trustees. Why the government has not at least “levelled the playing field” and allowed companies to repatriate their employees’ trusts without penalty or risk of CGT charges on gains in the trust, is a mystery.

The government is expected to make changes to the EOT regime in the 2024 Finance Bill. It remains to be seen if the wider changes sought will attract support from a new government in 2024.

…………………………………………………….

David Pett

Temple Tax Chambers

30th November 2023

[1] Such as a reduction below 51% of the EOT’s interest or a sale of the company or its business or a distribution of benefits otherwise than on an all-employee/similar terms basis.

[2] If, but only if, they are of the reasonable judgement that to do so is in the best financial interests of the employee beneficiaries.