03 May 2023
The employee ownership trust (EOT) legislation is now nearly nine years old so it seems sensible that HMRC has announced it will be reviewing how it works again. This legislation appears to have vastly extended employee ownership in the UK with the number of employee-owned companies more than doubling to 1,300 in the three-year period to December 2022. But, there is always scope for improvement.
Briefly, shareholders selling to an EOT don’t pay capital gains tax (CGT), but the taxable gain is effectively passed on to the EOT trustees, deferred until a sale. The other tax break is that employees could have a tax free (but not NIC free) bonus up to £3,600 each tax year. Both benefits are subject to some tight rules.
It’s clear from recent activity that HMRC is now checking compliance with those rules. We have seen increased enquiries about the transactions giving relief and requesting supporting documentation. It should come as no surprise that HMRC is keen to ensure the relief is claimed correctly. But given this is not an exemption but effectively a deferral, is there an actual loss to the Treasury?
As well as checking the facts of a deal, what areas could be looked at to help tighten up the rules? One place HMRC might start is CIOT’s representations to the government in 2021:
- Prohibiting offshore trustees. The current legislation allows EOT trustees to be resident abroad. That means the EOT may be outside the scope of UK capital gains tax in the future. While this is rare in our experience, there are certainly examples of companies that have taken this route. EOT relief, whilst often portrayed as “0% CGT”, ordinarily defers the CGT liability from the vendors to the trustee on a future sale, rather than exempting the liability entirely. Therefore, the offshore trust planning may result in a loss of UK CGT currently at the rate of 20%.
On the other hand, where UK employees receive pay outs following a sale, the tax and NIC rate can be over 60%, a healthy rate for the UK.
- Reduce freedoms on choice of trustee board. Many EOTs have a company as trustee, and the legislation does not specify the board structure. Typically, trustee boards are recruited from the vendors, trading company directors, employees and independents. The CIOT recommended either (i) a majority of trustee directors are not connected with the vendors or (ii) requirements are imposed on how the board is made up from these typical groups. In our view, greater employee participation through trustee board representation and independence would be worthwhile. However, for the diverse range of companies (size, business, location) that seek employee ownership, excessive bureaucracy and cost will ultimately discourage employee engagement.
What else the consultation may focus on is less clear.
- Concerns have long existed that unscrupulous vendors may seek to sell their shares to an EOT for more than market value, effectively converting future income into tax free capital gains. Actively requiring sale prices to be vetted by HMRC will increase the admin and cost for HMRC. Well advised clients already know the legislation already exists to impose an income tax and national insurance contributions charge on the excess above market value.
- The EOT legislation could be tightened to restrict the EOT tax relief. That is likely to lead to more complexity which could deter those exploring employee ownership. It should also be noted that EOT sales under the existing criteria can help boost other tax receipts as:
- future distributions to UK employees from the EOT could be taxed at high effective tax rates;
- stamp duty at 0.5% is a low rate but arises on sales to and from the EOT trustee;
- selling shareholders may benefit from CGT relief at up to 20%, but typically lose inheritance tax relief on their shares at 40%.
The EOT legislation has been enormously successful in increasing the number of employee-owned companies in the UK, and we see many success stories of the transformational difference employee ownership can make. Making some relatively modest reforms to the legislation could further enhance the policy objective of encouraging successful employee ownership whilst ensuring that all EOT transactions are done for the right reasons and minimising the potential for abuse.