HMRC launched a consultation into the taxation of Employee Ownership Trusts (EOTs) and Employee Benefit Trusts (EBTs) on 18 July which closed on 25 September. The consultation invited views on proposals to reform the tax treatment of EOTs and EBTs. The aim of the consultation was to ensure that the tax regime for EOTs (and EBTs) remain focused on the targeted objectives of rewarding employees and encouraging employee ownership while preventing tax advantages being obtained through the use of these trusts outside of the intended purposes. Claritas submitted a response to the consultation to share our views on the proposals included, given our extensive experience in implanting EOT transactions over the last few years.
EOT tax reliefs were introduced in Finance Act 2014, nearly 10 years ago. Broadly, if a controlling interest i.e. more than 50% is sold to an EOT the selling shareholders are exempt from Capital Gains Tax on the sale, subject to there being no disqualifying events within 2 years of this sale. There are also other tax benefits including the availability of £3,600 bonuses to be paid to employees from the EOT which are free from income tax but not NICs.
Unfortunately, the reality is that this oversimplifies what are a very complex set of provisions. Our view is that the EOT rules and legislation are extremely difficult to navigate such that it is easy to make errors inadvertently which have draconian and unintended consequences that contradict the policy objectives. Any changes to the provisions which would simplify the rules would be welcomed. Sales to EOTs have become more popular in recent and we believe there is a case to be made to rewrite the legislation into its own sub-set of tax laws.
The overall policy objectives of the EOT tax reliefs introduced in Finance Act 2014 were to encourage indirect employee ownership, so as to enhance employee engagement. The effect of the rules, however, is that the employees are not taxed as employee owners. Our view is that the only incentive for the employees to grow the business is the £3,600 bonus which can be received without a charge to PAYE, in our opinion this is not adequate to encourage employee ownership, so this questions whether the policy objective is being met.
The EOT’s version of indirect employee ownership falls most short of true employee ownership where an EOT disposes of its shares in the underlying company. Although the legislation does not make the point explicitly, our understanding is that HMRC consider that a distribution of consideration made by an EOT on a sale of the shares should also be subject to PAYE and NIC (this is, of course, after the EOT has paid CGT on any capital gain). Therefore, the current rules do not provide for a form of employee ownership or incentive that is comparable to that which is afforded to direct shareholders, who would typically be subject to CGT on a disposal of their shareholdings.
In our view, the overriding policy objective to give the employees a meaningful stake in the business in which they work to make the company’s success their success is not achieved. The rules appear to instead have the effect of providing tax relief for the company owners selling a controlling stake in the company to the EOT rather than incentivizing the employees who are taking on indirect ownership via the EOT. This is ultimately leading to the misalignment of the intended policy objective against providing the vendors with a tax driven incentive but no real incentive for the employees over the long term.
Many of the proposals suggested in the consultation are sensible in our view including:-
- Prohibiting former owners and connected persons from retaining control of the EOT-owned company post-sale, so that there is a genuine transition in ownership to the EOT for the benefit of the employees;
- Focusing on the UK residence status of EOT trustees to prevent the abuse of offshore trustee arrangements, whereby disqualifying events are structured to take place after the end of the tax year following the season so that the Trustees are deemed to have disposed of and reacquired the shares at their market value. The effect of the Trustees being offshore is for the gain not to be subject to UK CGT;
- Confirming the treatment of contributions made from the company to the EOT to prevent taxpayers having to apply for non-statutory clearance on issues that HMRC usually give clearance on as a matter of course; and
- Looking at simplifying the EOT bonus rules which create unintended administrative challenges and inequality – for example, a single error affecting one employee can disqualify the bonus arrangements for all employees. There are also seems to be no rationale in providing an exemption from PAYE but not from NIC.
Our strong view is that the EOT tax regime does not currently sufficiently support employee ownership because the beneficiaries of the EOT i.e. the employees are not treated or taxed as employee owners under the current regulations. Our view is that the distribution to employees after the sale of the EOT should be a capital event and that the distribution to employees after a dividend to the EOT should be subject to income tax as a dividend at dividend rates. We also sought more clarification on the legislative provisions impacting EOT arrangements that are not clear enough in the current drafting.
It will be interesting to see the outcome of the proposals and what changes are made. The overriding takeaway point here is that EOT tax reliefs are being reviewed and the future tax landscape for them is likely to be subject to change. Watch this space!
