Since 2014, if all statutory conditions are satisfied, disposals of shares to an EOT, amounting to at least a 51% controlling interest in a trading company, willattract complete exemption from capital gains tax. On the face of it, this affords an extremely attractive means of allowing private company proprietors, and particularly owner-managers, to pass on ownership to a trust for employees controlled by (i.e. the power to appoint and remove trustees is vested in) the directors of the EOT-owned company and for the purchase to be paid for out of the company’s own profits and/or borrowing facilities. Furthermore, a company owned by an EOT may pay tax-free bonuses, of up to £3,600 per tax year, to all qualifying employees on an ‘equal terms basis’ – a significant benefit to smaller companies.
It is understood that some 80+ companies have so far each been sold to an EOT, although the majority of these are believed to be relatively small in value (and many of which were formerly run as quasi-partnerships distributing profits in full each year).
A description and commentary on the statutory rules governing EOTs is to be found in Chapter 24 of “Employee Share Schemes” (Thomson Reuters).
Having now advised on a significant number of actual and potential ‘sales to an EOT’, the following points, born of practical experience, may be of interest and assistance to those proprietors and their advisers contemplating such a transaction:
- An EOT is necessarily restricted in how it can benefit employee beneficiaries if penal tax charges are not to be triggered on the part of the trustees. In short, any disposition of trust property must be on an ‘equal terms’ basis and only to those who are current employees. A subsequent sale of the company by the trustees will trigger a clawback charge. It might be worth pausing to consider if, rather than selling tax-free for, say, 100, a sale at a higher price of, say, 111 to a more conventional discretionary employees’ share trust might be justified, the vendor(s) presumably qualifying for the reduced 10% (entrepreneurs’ relief) rate of CGT and therefore being in no worse position. The trustees might be justified in agreeing to pay such a higher price (always provided it does not exceed the market value of the company) given the freedoms they would then enjoy to on-sell the company or pass a controlling interest into the hands of management by the grant and exercise of EMI share options and participation in a SIP and/or SAYE share option scheme.
- In most of the cases on which I have advised, the sale has been ‘vendor-financed’. In other words, the company has insufficient funds available to pay the agreed consideration in full up-front. The question arises as to how best to protect the interests of the vendor(s) , and ensure that the company does in fact make further cash contributions to the trust, without triggering charges to tax on the part of the trustees or prejudicing the tax relief afforded to the vendor(s)? There is no reason why a vendor cannot remain on the board of the company and/or hold office as a trustee, although care is needed in addressing the obvious conflicts of interest which then arise. In practice, a more effective protection may be afforded by having the company first issue to the vendor a redeemable ‘golden share’ which carries negative control rights, and entrench those rights in the articles (i.e. making it impossible, once the sale has been completed, for the controlling trustee shareholder to abrogate the rights of the vendor as holder of the golden share until the consideration is fully funded and paid by the trustees and the share redeemed for a nominal amount). The negative control rights of the golden shareholder provide, in effect, that until the consideration is paid in full, the company is restricted in how it may apply its profits save for making contributions to the trust.
- Vendors should bear in mind that, if the company cannot fund the consideration in full up-front, the vendors cannot take security for payment of the balance in the form of a charge over either the shares held by the trust or (although on the wording of the legislation this is not beyond doubt) the assets of the company. Remember also that, whilst the shares will have qualified for Business Property Relief from inheritance tax, the rights as unsecured creditors acquired in exchange will not – a matter which will be of concern to older vendors in particular.
- Legal costs of the documentation and the sale are rightly of concern, especially in the case of smaller companies, the value of which will not justify substantial fees. To address this, I have developed a set of ‘standard-form’ documentation comprising the EOT trust deed, trust company articles, company governance and additions to Table A articles as well as the SPA documentation, all intended for use in the case of straightforward vendor-funded sales to an EOT. Accountants and other advisers interested in making use of such pro-forma documentation should contact me for further details and costings.
- It has been suggested that the penal clawback charge (which falls on the trustees) arising if, for example, the trust ceases to own a controlling interest, might be avoided if the trustee is an independent offshore trustee services company so that the trust is outside the scope of the charge to UK capital gains tax. This is permitted under the legislation (although, following publication of the ‘Paradise Papers’, it may attract opprobrium….) which was prevented, by EU freedom of movement of capital rules, from stipulating that the trustees must all be UK resident. However, the use of any independent trustee – whether or not it is UK resident – rather than either a specially-formed wholly-owned subsidiary of the company being sold or individual trustees a majority of whom are long-standing directors and/or employees of the company, gives rise to a number of difficulties and, in practice, offshore trustee service providers have shown an understandable reluctance to accept office as sole corporate trustee of an EOT (although, to my knowledge, there are a number of such overseas-controlled EOTs in existence including, for example, that which now owns The Adam Smith Institute and was the subject of reports in The Sunday Times early in 2017). Not least is the duty of trustees to understand what it is they are investing in. The duties of an independent trustee company holding a relatively small proportion of the issued share capital for the purposes of giving effect to employee incentive plans are very different from those of a trustee being recommended to acquire a controlling interest in a company. The latter needs to undertake full due diligence and seek appropriate warranties and indemnities from the vendor(s) so as to ensure that the price being paid, and the funding obligations, do not leave the trustee exposed to liability if their acquisition proves to be a ‘pig in a poke’. Going forward, it is insufficient for controlling trustees to rely upon information from the directors of the company without troubling themselves to make appropriate enquiries and take an active role in overseeing the management of the company, as would any other controlling shareholders of a trading company.
To be continued…..
© David Pett November 2017