Adapting to Change: Key updates to Employee Ownership Trusts following the consultation response

Following an anxiously awaited Autumn Budget on 30 October 2024, where the new Labour Government did not make changes to the tax relief available for disposals to Employee Ownership Trusts (EOTs) the Government also published its response to the recent consultation on EOTs and Employee Benefit Trusts (EBTs) together with the proposed draft legislation which is anticipated will be introduced in the Finance Bill 2024/25.

Whilst the new legislation is not yet in place, the changes will have effect from 30 October 2024.  Therefore, any EOTs established on and after 30 October 2024 will need to ensure they are compliant with the updated legislation. The changes will not affect EOTs established prior to 30 October 2024.  

Changes following consultation

The consultation sought views on targeted proposals in relation to the tax treatment and the structuring of the EOTs. The reforms are aimed at ensuring the favourable tax treatment remains available for those who use EOTs for the intended policy purposes.

Whilst the response published is a helpful summary of the matters considered and the changes the Government intend to make, as always, the devil is in the detail.

At first blush the changes appear to simply codify what is already considered to be “best practice” on a legislative footing. However, the legislation goes further than expected in some areas, fails to address obvious issues in others and lacks clarity in places.  Below we have set out our thoughts against the material changes brought by the draft legislation.

Seller’s risk period extended

For EOTs established on and after 30 October 2024, the ‘period within which a seller’s application for tax relief can be denied or revoked (because of a disqualifying event or a failure to meet the relief requirements) is extended. The aim of this extension is to encourage the former owners to take a long-term view as to the future success of the business.

The clawback period was previously to the end of the tax year following the disposal, whereas now it will be extended to the end of the fourth tax year following the tax year in which the disposal occurred.  This effectively increases the period from a maximum of two years to a maximum of five years, depending on when the transaction occurs.

Trustee Independence Requirement

Previously the legislation did not comment on how the trustee should (or should not) be set up or controlled. The trustee can either be a collection of individual trustees or more commonly there is a corporate trustee (Trustco) which acts via its board of directors.

Birketts’ best practice approach, followed by many reputable advisors, included a requirement for balance amongst trustees or, in the case of a corporate trustee, to have a balanced board of directors. Specifically, this would see the trustee, or the directors of a Trustco made up of an independent non-executive, and then an even balance of employees and persons appointed by the trading group, (often the former owners whilst they are owed their deferred consideration).  Some EOTs did not follow this best practice and merely had former owners controlling the trustee.

The new legislation adds a new “trustee independence requirement” to the existing relief requirements. This means that excluded participators (a complicated status but including anyone who is or was in the ten years ending on the date the EOT acquired a shareholder in the relevant company, beneficially entitled to 5% or more of either the entire share capital of the relevant company or 5% or more of any class of shares comprised in the relevant company’s share capital) are prohibited from controlling the trustee.

In practice, this will mean that excluded participators will not be able to form the majority of the trustees (if individual trustees) or the majority of the directors on the board of a Trustco. The proposals do not go as far as insisting there is an independent trustee appointed.

Whilst it is not a legislative requirement, Birketts view remains that the appointment of an independent non-executive (either as a trustee or a director on a Trustco) is best practice to enable the satisfactory navigation of conflicts of interest and to bolster the confidence of employee directors who may be less familiar with board practices and less able in reality to challenge fellow directors who could be their superiors in the hierarchy of the company.

If the trustee independence requirement is not met at the outset the EOT will fail to meet the relief requirements. If it is met at the outset but later is infringed, there will be a disqualifying event for the EOT resulting in either a loss of tax relief for sellers or a significant charge to the trust depending on the timing of the event.

Given that the adoption of best practice means that excluded participators would not usually control the trust in any event, it might appear as though the trustee independence requirement is easy enough to comply with however there is a trap for the unwary. 

There is a grace period in the draft legislation, applicable where there is a temporary breach of the trustee independence requirement, so that there isn’t an automatic and immediate disqualifying event provided balance is restored within 6 months. All good so far. However, the only circumstances in which the grace period is available is where the imbalance occurs because of the death of a trustee/director of the Trustco. A pretty narrow eventuality compared to the far more likely scenario of someone resigning to move employment. There is no allowance for breaches that might arise if, for example a trustee/director of the Trustco were to resign with immediate effect.  Therefore, careful consideration should be given as to how the trustees/directors of the Trustco are appointed and removed and how decisions are made to navigate this trap.

Trust residency

Previously the EOT could be either UK resident or non-UK resident. The advantage of a non-UK resident EOT was that if there was a subsequent disposal by the trustees, or disqualifying event, no capital gains tax (CGT) charge would arise.  

This ability to set up a non-UK resident EOT which could not be subject to CGT has been removed.  The new legislation includes a new trustee residency requirement stipulating that the trustee must be UK resident both at the time of the disposal and thereafter. Failure to adhere to this requirement will be a disqualifying event meaning CGT charges would arise.

Birketts experience is that the majority of EOTs would be set up with a UK resident EOT, so whilst this removes the opportunity to set up offshore, it is not a problematic change to comply with.

Consideration requirement

To ensure former owners are not inflating the reasonable market valuation of the company sold to an EOT, the new legislation requires that trustees have taken “all reasonable steps” to ensure that the amount paid on the acquisition does not exceed market value.

Again, best practice means that an independent valuation should always be obtained for the benefit of the trustee and the company as a minimum.  The new legislation draws into question what “all reasonable steps” requires and whether it simply aims to codify best practice or if it will require more detailed professional advice for the trustee.

The legislation also goes on to state that if the terms of the transaction include interest on deferred consideration that it should not “exceed a reasonable commercial rate”.  Again, who can reasonably take this view is something open to interpretation and query if this is an additional matter for independent professional advice. In any event it adds a further layer to the thought process that the parties should undertake when deciding whether to charge interest on any deferred consideration.  Not all EOT transactions include interest in the terms, this may deter the use of interest further.

Clearance applications

Included in the response to the consultation is the welcome confirmation that the accepted approach to funding an EOT transaction will be given legislative effect in an amendment to the Income Tax (Trading and Other Income) Act 2005.  This avoids the need for a clearance to be submitted to HMRC seeking confirmation that capital payments (often referred to as ‘gifts’) made by the employee-owned company to the EOT (thus enabling it to pay deferred consideration to the sellers) will not be taxed as a distribution in the hands of the trustee.   This is a helpful confirmation as due to the previous uncertainty on the tax treatment of such payments many had considered it standard practice to seek this clearance from HMRC on each transaction.

Bonus scheme

One of the many advantages of employee ownership via an EOT is that eligible employees can (provided that relevant criterion are met) be paid up to £3,600 in bonus payments free from income tax (but will still be subject to employer and employee national insurance contributions) in each tax year.

One of the criticisms of the legislation in this area relates to the way the office-holder requirement applies to groups, which can result in a counter intuitive outcome depending on how officers and employees are organised within the group structure.  Disappointingly this issue has not been addressed.

A practical issue arising on bonuses is that the strict rules meant the bonus could not be given to the employees without also being awarded to sellers, when in some circumstances the sellers were prepared to forgo their entitlement.  

As of 30 October 2024, when determining a tax-free bonus, directors may now be excluded from being awarded the bonus.  The draft legislation is not entirely clear on whether such an exclusion should be all of the directors or if it can just be some of the directors, which is an important distinction   since there could be some directors who are not sellers and therefore do not want to be excluded.

Not my problem?

Those who are already employee-owned via an EOT established prior to 30 October 2024 will not be subject to the changes in legislation set out above. However, Birketts recommendation is that they should review their structure and governance and consider the extent to which their structure adheres to the above and whether they should voluntarily make any changes to bring themselves in line.

Conclusion

Whilst the consultation responses and draft legislation are in the main helpful making welcome changes and codifying best practice, there are some new grey areas that will have to be approached with caution if parties do not unwittingly want to create a disqualifying event.  We look forward to the legislation being finalised and HMRC updating their guidance which may add some clarification.

If you would like more information about EOTs and whether establishing an EOT is an option for your business, please contact any member of the Birketts Employee Incentives team.