Employee Ownership: Value beyond tax benefits

In our final instalment in our series of insights exploring why Employee Ownership (“EO”) should be considered, we look at the other benefits of Employee Ownership Trusts (“EOTs”) and new changes post-Budget.

EOTs offer a unique alternative to traditional business sales, providing not only tax advantages but also a host of operational and cultural benefits. While tax considerations often play a role in motivating a transition to EO, as explored earlier in this series, they should not overshadow the broader advantages. From reduced due diligence to enhanced employee engagement and legacy preservation, EOTs bring flexibility and long-term value to both the business and its stakeholders. We delve into the many benefits of EOTs, the recent changes introduced in the Budget, and the importance of expert guidance to navigate this evolving landscape.

As already mentioned, a transition to EO should not be purely tax driven. There are many other benefits to consider with an EOT.

Invasive and expensive due diligence is largely avoided with an EOT where only a modest level of due diligence work is usually considered necessary.

The current shareholder(s) can also largely design the EOT deal themselves (although as discussed further below, great care is needed in determining consideration) and remain as involved as they wish. After the sale, vendors cannot retain control, but they can remain influential and be remunerated for future work (in addition to exit proceeds), and potentially retain or obtain some shares.

Employees should become more galvanised, provided they are properly engaged with EO and the opportunities it provides them and the business. The culture of the business and the founder’s legacy may be better preserved, with the founder’s “spirit” often continuing after their exit.

The business may also become more successful because of greater employee retention, motivation, and ideas.

After a sale to an EOT, HM Revenue & Customs (“HMRC”) appear to accept that the value of the company for the purposes of tax employee equity plans (such as the tax favoured discretionary and Enterprise Management Incentive share option plan, or all employee plans like the Save As You Earn plan) will be suppressed by any debt owed to vendors, such that it can be a very attractive time to provide employees with options/shares. Former owners and family are not usually prohibited from partaking.

Of course, this is not an exhaustive list and there are also potential pitfalls to navigate. For example, care is needed to ensure the company can fund the exit proceeds and that all the EOT conditions are met at the date of sale and into the future. However, the key message here is that there is great flexibility with an EOT that may not be available with a management buy-in or buy-out or a sale to a third party.

What has changed for EOTs?

The Budget saw various new EOT rules introduced. More coverage on these changes can be found here.

Although the new rules add to the conditions that must be met to secure the tax-advantaged status of EOTs, they are generally considered to be positive changes, as they are designed to help protect the spirit of EO and to ensure a sale to an EOT is not unduly driven by the tax advantages. After all, the tax advantages were only put in place to fan the flame of EO.

EOTs can no longer be resident outside the UK, to close a perceived loophole. As well as adding to the risk of “double tax” where an EOT later sells the business, due to there being Capital Gains Tax “(“CGT”) for the trustees and PAYE and NIC for the employees, this change will also add demand for UK based trustees - which creates the risk of opportunistic organisations seeking to exploit that demand, without necessarily having the suitable skills and experience that the existing population of offshore trustee companies in Jersey, Guernsey etc already has.

Under the new rules, it becomes critical to seek support from suitably experienced and qualified accountants, legal advisors, and valuation experts when considering an EOT—not least because the Budget has made it a requirement that trustees take “reasonable steps” to ensure that what they pay to the vendors does not exceed the shares’ market value, and that any interest charged on deferred consideration is at a reasonable commercial rate.

In practice, this may mean an expectation from HMRC for vendors to engage with reputable independent trustees (who may become harder to pick out from an increasing crowd, given the new rules mentioned above on blocking non-resident EOTs) and for those trustees to obtain formal valuations from independent valuers to evidence the new requirements on value has been met. Evidencing a commercial rate of interest may also demand greater engagement with professionals.

Some good news is the reduced need for non-statutory clearance applications to HMRC, due to them legislating on what was the rather grey area of the tax treatment of funds contributed from the company to the EOT. However, this change does not eliminate the need to apply for the relevant clearances to HMRC on many other points that arise during an EOT transaction. Rather, the new rules increase the need for careful tax planning and clearance applications to HMRC, to help manage the increased number of conditions and associated risks.