Employee Ownership Trust (EOT) tax rules: HMRC consultation objectives and key talking points revealed

Background

In April 2023, HMRC indicated that it would be launching a consultation on the EOT tax rules with the aim of examining “the use and effectiveness of the Employee Ownership Trust (EOT) tax regime”. This announcement prompted widespread speculation around potential changes to the rules. In our experience, the potential rule changes also prompted some anxiety amongst business owners who were in the process of selling to an EOT, as well as those who were considering the possibility; an understandable reaction given the amount of tax at stake in most cases.

On 18 July 2023, HMRC officially launched the consultation on the reform of the Employee Ownership Trust tax regime, which means that we now have more detail, including the areas of focus for HMRC. The purpose of a consultation is for HMRC and government to set out the issues they are interested in and seek input from other stakeholders in respect of them. Do not expect to see any immediate changes arising as a result of it (it closes 25 September 2023), however, any conclusions reached will help to shape future legislation.

Summary of our view on the consultation

Our overriding message to our clients, and to anyone who is considering a sale to an EOT, is one of reassurance; there are no frightening surprises contained in the consultation. In reality, the areas of focus which are set out below, signal a clear desire from HMRC and the government to provide clarity and show a commitment to the original policy objective of promoting employee ownership. It looks like EOTs are here to stay, and it is business as usual from our perspective.

EOT consultation focus areas

1. Trustee appointment:

Currently there are no specific tax rules contained in the EOT legislation governing who may be appointed as a trustee of the trust. This is problematic because it essentially means that the business owner(s) can continue to control the company post sale, by ensuring that they make up a majority of the trustees. The consultation seeks to prevent previous owners from continuing to control the company in this way post sale. In our experience, the consensus amongst advisors was that, whilst previous owners could, and should, have a presence amongst the EOT trustees, best practice was that they should not make up the majority. An extract from the consultation shows that this is exactly how HMRC view it: “This restriction would not prevent former owners and connected persons from acting as trustees of the EOT, provided that they do not constitute a majority of the trustees.”

Our view on trustee appointment? From a policy point of view, the change makes sense; it should ensure greater employee participation in the running of the company. From a tax and deal structuring point of view; definitive rules on this point included in the legislation will help to make decision making easier, in respect of who should be a trustee. 

2. Trustee tax residency:

The lack of rules around who can be a trustee introduce a second issue; it is possible to set up the trust such that it is not UK tax resident by appointing solely non-UK tax resident trustees. From HMRC’s point of view, the problem with this,is that it can result in no UK tax take whatsoever on the disposal of the shares, because the trust would not be subject to UK tax on its eventual disposal of them. The consultation proposes that the legislation is amended to prevent the trust from being non-UK tax resident. 

Our view on trustee tax residency? The way the regime works at the moment makes it clear that HMRC never intended to miss out on collecting any tax on the increase in value of the companies being sold to EOTs.

Firstly, if the EOT disposes of the company shares in the future, it pays tax on the whole uplift in value of the company shares from when the previous owners acquired them, to the EOT sale. 

Secondly, if various conditions cease to be met one year or more after the sale to an EOT, there is a tax charge on the EOT, based on the value of the company at the time that the conditions cease to be met. 

In that context, it is reasonable that HMRC are seeking to prevent taxpayers from avoiding paying tax by structuring the trust as non-UK tax resident. In our experience, there is little appetite from business owners to exploit this loophole and when asked we have advised against it. Most business owners should not be impacted in any way by the proposals; for us it is reassuring that the rules are being tightened to be in line with the best practice that we have been advising our clients about.

3. Funding issues, income tax on payments to the EOT:

In an EOT arrangement, in most cases the funds to acquire company shares are sourced by the trust from the company and payments are required from the company to the EOT post sale to fund the deferred element of the consideration. This poses a technical tax issue in that the EOT is potentially subject to income tax on the receipts as shareholder of the company. Currently, it is routine to seek clearance from HMRC that the EOT will not be subject to income tax. The consultation suggests that government will legislate to remove any uncertainty in this area, eliminating the need to seek clearance on the point.

Our view on the income tax clarification? This can only be a good thing. It will reduce unnecessary work associated with EOT arrangements, as well as reducing uncertainty.

4. Funding issues, anti-avoidance in respect of payments to the EOT:

The payments to the EOT raise a second potential issue on which advisors commonly seek tax clearance; that anti-avoidance legislation at CTA10 s.464A will apply to them. This anti-avoidance legislation has a similar effect to the widely known ‘s.455 tax’ on loans to participators in a close company AKA ‘director’s loans’ and is potentially in point in respect of EOT arrangements, but only if there is an avoidance motive. The consultation addresses the fact that advisors seek clearance on this point and signals HMRC’s intention to stop providing it, simply stating that if there is no tax avoidance motive, there is no risk of the legislation applying.

Our view on not giving clearance for CTA10 s.464A risks? In almost all cases, an EOT is not being entered into with a tax avoidance motive and therefore the legislation should not be in point. It seems reasonable that HMRC will stop giving clearance on this point and the fact that they have gone public with their views will reduce unnecessary work associated with EOT transactions.

5. Income tax free bonuses:

As it stands, there are detailed and restrictive rules governing the payment of bonuses to the employees of the EOT owned group, if they are to be able to benefit from the income tax exemption. The consultation identifies one particular issue that HMRC are considering a remedy for: the interaction of the participation requirement with the office holder requirement can mean that some EOT companies cannot make qualifying income tax-free payments, despite the fact that their activities are in line with the policy aims of the legislation. The example used by HMRC is as follows: 

“When a group has overseas companies with one employee who is a director, the office holder requirement may not be met which would mean no tax-free bonuses can be awarded to any employee of the group.”

In other words, if one company in the EOT owned group fails the office holder requirement, that can scupper the income tax free bonus for all employees across the group. The reason that this happens is that the participation requirement mandates that all ‘eligible employees’ must be able to participate in the payment, this includes all employees across the whole group, not just the employees of the company making the payment. 

If there is a company in the group that fails the office holder requirement, it’s possible that its employees will not be able to receive a qualifying payment and the participation requirement will be failed.  The office holder requirement is that the ratio of office holders to employees must not exceed 2:5 (including the office holders as employees also). So, if a company has three employees, one of whom is a director, the office holder requirement is not failed, but if the company only had two employees, it would be. HMRC has recognised that this could lead to unfair outcomes and so proposes a change to the rules so that directors can be excluded as an ‘eligible employee’.

Our view on the relaxation of the income tax free payment rules? This issue is probably less niche than HMRC think, and with the increasing uptake of the EOT structure, it is only likely to grow. Therefore, it is positive that HMRC have identified this issue and we believe that their proposed remedy is a sensible one, albeit probably still limiting. Allowing directors to be excluded as eligible employees will mean that having a very small, director led subsidiary will not result in the issue identified.

Perhaps HMRC could go further though and apply the office holder test on a group wide basis, as well as the eligible employee test. This would still achieve the policy aim of preventing payments being made to a small group of select employees (by ensuring all employees across the group are able to participate), whilst allowing groups with subsidiaries that employ very few staff to continue to reward their employees and adopt a corporate structure uninfluenced by the EOT rules.

Conclusion

The are two overriding messages here:

1. HMRC is looking to reduce taxpayer behaviours linked with EOTs that are either abusive (non-resident trusts), or are not fully in the spirit of the policy objective (founders keeping control through trustee status), and
    
2. HMRC and the government are committed to employee ownership, and EOTs as a mechanism for achieving that. They are seeking to remove uncertainties and ensure the legislation does not unfairly remove the tax advantages of the EOT structure.

The proposed changes to trustee appointment (1 and 2 above): to prevent the selling shareholders from making up a majority of the EOT trustees; and to prevent an EOT being non-UK tax resident; are sensible and are in line with adopted best practice in our experience. Having the rules set out in legislation will be helpful and should make the EOT structuring process more efficient in most cases.

The clarification and proposed change in respect of the EOT funding (3 and 4 above) is welcomed. Both points here are tax technical and have created an administrative burden for tax advisors on EOT transactions in the past, removal of the uncertainty will make future transactions more efficient.

Finally, the relaxation of the rules governing income tax free payments would be welcome, although HMRC’s proposal to allow the exclusion of directors may be a little narrow. We would recommend applying the office holder requirement on a group wide basis, rather than applying it to each employer company.

If you have any questions regarding the HMRC consultation in respect of EOTs, or you are considering a sale of your company shares to an EOT, please feel free to get in touch. We are passionate about employee ownership and are always keen to work on new projects and assist with the tax technical issues associated with this ownership structure; they can become very complex!