In her statement last month, the Chancellor, Rachel Reeves, restated Labour’s commitment that Labour would not raise the rates of VAT, income tax or NICs whilst, at the same time, highlighting a black hole in the public finances.
There is wide consensus that Labour’s strategy for filling the black hole could include an increase in Capital Gains Tax (CGT).
Figures suggest that if CGT were to be aligned with income tax rates, an extra £14 billion in tax revenues could be raised.
For business-owners who are currently considering a sale, there is one fairly obvious (if impractical) ‘solution’; sell now to avoid the risk of a rate change.
However, even for those lucky enough to have buyers on tap, only a seller with a strong bargaining position will be able to control the timeline.
This is because most of the work on an M&A transaction (securing and agreeing finance terms, due diligence and negotiating share purchase protections) is driven by the buyer.
With less than three months to go, many sellers may need to make some form of sacrifice (increased risk or reduced sale price) to achieve an abridged deal timetable, and this ‘cost’ must be factored to the benefit of a quick sale.
For the right type of business, there is another option to avoid the increase. Introduced back in 2014, a sale to an Employee Ownership Trusts (EOT) will, if certain qualifying conditions are met, enable business owners to sell their business for market value whilst applying full Capital Gains Tax relief (0% CGT).
Could a rise in Capital Gains Tax persuade some business owners (who were maybe on the fence), to pursue the route of an EOT, rather than a trade or Private Equity sale?
Whilst the Capital Gains Tax saving should never be the principal reason for selling to an Employee Ownership Trust, an increased volume of EOT sales is very possible should there be a rise in the rate of CGT.
Labour has thus far shown its support for employee-owned business. Ideologically, it’s consistent with the foundations of the party. It confers a fiduciary duty on the ultimate controller of the business (the trustee/s) that is consistent with principles of raising and maintaining employee standards, staff engagement and productivity.
It also cleverly seeks to ensure that future rewards paid to those that continue to lead, build and work in businesses sold to EOTs are subject to income tax and NICs.
For now, we await confirmation that Labour will continue to support the current EOT regime (notably its generous tax reliefs) in the October budget.
How does an Employee Ownership Trust (EOT) work?
In very brief terms, if a trading business has a motivated, engaged workforce and an able, committed management team (well placed to step into the sellers’ roles), an EOT sale could be a good option.
It can also help traditional business owners who are worried about selling to trade competitors or Private Equity and who want to ensure succession and culture preservation for the staff. It’s not right for every business and we do always recommend some initial feasibility guidance.
Broadly speaking, whilst the rules don’t require a minimum number of staff for a sale to an EOT, they do include a “limited participation” requirement.
This means that sellers who hold more than 5% of the shares in the business (and their connected persons, such as spouses and other family members), who are employed in the businesses, must not comprise more than 40% of the staff in the 12 months prior to the sale. They also must not exceed 40% before the end of the tax year in which the sale takes place.
There are other qualifying conditions to meet but, if they are all met, in summary the steps for an EOT transition are broadly as follows:
- The trading company/group is valued and pre-clearance is obtained from HMRC under the TIS legislation (an additional non-statutory clearance may also be submitted).
- The trustee/s of the EOT will need to be established. Often this is a single corporate trustee with a board of directors/members that includes a professional trustee, a seller representative and an employee representative (although there are many options here).
- The trading company settles the trust (the EOT) for the benefit of all of the employees using a detailed and carefully drafted Trust Deed that ensures that all employees benefit equally (subject to some permitted exceptions under the legislation).
- The shareholders will then sell a controlling interest (often 100%) of the company to the EOT and the EOT will be gifted the reserves held by the company to fund the initial purchase price, with further gifts being made from the company’s profits over time so that the EOT can repay deferred payment to the sellers.
Putting in place (or enhancing) employee engagement will be important. However, for the right business, a well organised EOT transition, supported by carefully drafted documents, is an effective exit option.
If structured correctly, the result could be a transfer of the business for full value funded by the retained and future profits of the business with a zero Capital Gains Tax liability.
Frequently Asked Questions on Employee Ownership Trusts
Some initial questions we often get asked are:
Q1. If I’ve sold the business and given control to the trust, how can I ensure that the business will be run effectively so that my deferred consideration is paid?
An EOT seller will typically have a number of protections in place whilst any deferred payments remain outstanding.
These can include rights to an enduring place on the board, veto matters on certain operational decisions, information rights regarding the business and it finances and contractual undertakings from the EOT and the company.
These must be very carefully drafted so as to avoid not breaching the qualifying condition that the sellers must transfer a “controlling interest”.
In fact, with regard to board appointments, very often, the sellers will stay on the board of the target for the time being as the trustees will take the view that they continue to be best placed to operate the business.
Q2. Do the employees now own the shares?
No, an EOT is a form of indirect ownership. The shares in the company have been sold to the EOT to hold for the benefit of the employees of the company (present and future). It’s a form of discretionary trust and no particular employee can lay claim to any particular shares.
Instead, the employees reap the rewards of being a ‘beneficiary’ of the EOT once the sellers have been paid the balance of the purchase price. This is mainly through profit shares (think John Lewis) but it can also be through enhancing the employees’ working experience.
Q3. If the trust needs to pay out the remainder of my deferred consideration, won’t it be 5 years or so before the employees see any benefit? Will this not dampen the initial enthusiasm of employee ownership and a more engaged workforce?
In most cases the employees will see an immediate benefit. This is because, in addition to the promise of profit shares going forward, the EOT legislation provides for the payment of tax-free bonuses by an employee-owned company of up to £3,600 per employee each year.
These cannot be made by way of salary sacrifice and so are often a very tangible and immediate benefit to staff.
Furthermore, properly managed employee engagement, including a voice at the very top of the structure (and/or through an employee council) can ensure that the staff feel the step change.
How can Morr & Co help?
Greg Vincent and the Corporate & Commercial team at Morr & Co acted on EOT transactions valued at over £100M in deal value in 2023-2024 and are highly experienced in this area.
We also have a detailed Employee Ownership Guide that we would be delighted to share on request.
To make an enquiry or to request your copy of our Employee Ownership Guide, please contact Greg Vincent directly at [email protected]. Alternatively you can email [email protected] or call 01737 854500.