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.

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4th May 2024