HMRC moves to close Employee Owned Trust loopholes

As was announced in Jeremy Hunt’s March 2023 budget, HMRC published on 18 July the promised consultation document on changes they want to make to the currently very popular and tax-effective tax regime on Employee Ownership Trusts (EOTs).

The consultation document also contains some proposed changes on the Inheritance Tax regime for Employee Benefit Trusts, which I haven’t covered in this article. It is a consultation document and HMRC require responses to it by 25 September this year. It doesn't say when the legislative changes proposed in the document might pass into law, but given the changes are intended to tighten up the regime to ensure the relief on EOTs is better targeted to encourage employee ownership (as opposed to capital gains tax avoidance by owners), we should be planning for these changes to come into effect as soon as the government can manage so probably 6 April 2024. Of course, I don't know that, and these changes may not come into effect until a later date (say 6 April 2025) and some of the proposed changes may never come into effect at all or not in their current proposed form (a consultation process must have some effect, after all).

Overall, the proposed the changes are reasonable and expected but do mean the opportunities for a sale to an EOT will be more restricted for business owners and could mean employees will be worse off in certain circumstances.

So, what does the consultation document say are the changes the government intends to make on EOTs?

Trustees

At present, even though they must sell more than 50% of their company to an EOT to benefit from the EOT tax reliefs, the former owners of the company can maintain some level of control over their company by being on the EOT’s board of trustees. HMRC are concerned that owners may keep de facto control of their company if they form the majority on the EOT’s board of trustees. Therefore, HMRC are proposing that the legislation is amended to require that more than half of the EOT’s board of trustees are persons other than former owners or people connected with them. They are also going further and asking whether in fact the legislation should be amended to stipulate that some of the EOT’s trustees must be chosen from certain groups like employees or independent non-executive-director type people. Neither of these proposed changes is unexpected. Those working with EOTs had long wondered why a measure to encourage employee ownership did not require that some of the people with controlling influence over the EOT were representatives of the company’s employees. The proposal on preventing former owners from controlling the EOT’s board of trustees is an understandable tightening of the rules but in our experience of setting up EOTs, most former owners want to maintain an influence over the company by being on the board of trustees but do not want to exercise any controlling influence over the company via this route. HMRC’s proposals are not a blanket exclusion preventing former owners being appointed to the EOT’s board of trustees at all - it would still be possible for them to be appointed to the EOT’s board of trustees; it would just be that they couldn’t make up the majority of the EOT’s trustees. Also, there is no proposal to prevent former owners remaining as directors of the company sold to the EOT. Therefore, this practice can continue. However, it will be the case that these changes to the requirements on how the EOT’s board of trustees can be made up will discourage some business owners from using the EOT route who might have chosen it currently.

Tax residency of the EOT

A trust with solely non-UK trustees is treated as not tax resident in the UK. There is currently nothing in the tax legislation on EOTs which requires that the EOT to which the company is sold is UK resident (i.e. that at least some of its trustees are UK resident). This has been a generous part of the current legislation. When individuals sell their company shares to a qualifying EOT, the capital gain they make on that sale (“the held-over gain”) is essentially given to the EOT trustees. The trustees would then pay the capital gains tax (CGT) on that gain when they either sell the company on or were any of the many qualifying conditions for the CGT relief on sales to EOTs to be breached in the future. However, if the EOT is resident outside the UK when the trustees either sell the company on or when one or more of the qualifying conditions are breached, the held-over gain that the legislation had intended would be UK taxable at that point won’t be because the trustees would not be UK resident and so would be outside the UK tax net. The proposal in the consultation document is that the EOT to which the individuals sell their shares must be UK resident for the sellers to qualify for their CGT tax reliefs. This change is entirely understandable, and it has always been thought generous that there was nothing in the legislation requiring the EOT to which the company was to be sold to be UK resident. The cost of this change will, however, fall on the employee beneficiaries of the EOT not the company owners who sold their shares to the EOT. It will mean that when the trustees come to sell the company, they will have to pay UK CGT on their gains (both the held-over gain and any gains they have made since acquiring the company shares) and so out of the proceeds of sale, there will be less to distribute to the employees. It won’t have any impact on those who originally sold their company shares to the EOT.

Contributions to the EOT from the sold company

Most sales of companies to EOTs are structured such that the sale is on deferred terms. For example, a company is worth £10m. It is agreed that 100% of this company is to be sold to the EOT for £10m with £2m paid upfront and the remaining £8m to be paid over the next 5 years. The EOT has no cash or assets itself when it is first set up and so has no cash or assets to buy the shares from the company owners. Usually what happens is that what it has agreed to pay for the company is funded by voluntary contributions to the EOT from the sold company out of its built-up distributable reserves and future profits. Strictly, these contributions from the company to the EOT should be treated as dividends on which the EOT trustees would have to pay dividend income tax whether they were UK resident or not. However, to date HMRC have given concessional clearances that where the contributions made by the company to the EOT are to a qualifying EOT to fund the EOT’s purchase price of a company’s shares which qualified for the EOT CGT reliefs, the payment/s would not be treated as a taxable dividend of the EOT trustees. As had been requested by the Chartered Institute of Tax amongst others, the government is now proposing to amend the UK’s tax law such that payments made by companies to EOTs in these situations would not be treated as taxable dividends provided the price the EOT agreed to pay for the company was not more than its market value. This is good news. Advisers do not like relying on concessional tax reliefs given by HMRC which can be withdrawn at any time. Further since the situation with Mohamed Al-Fayad which came to a head in a court case in the early 2000s, HMRC has resisted giving any tax relief by concession preferring instead that any reliefs are codified in the tax legislation.

There were other minor changes that were announced too, but these three were the major ones.

As I have said, it isn’t known when the legislation will be introduced to give effect to these proposals. However, we should plan for them being introduced with effect from 6 April 2024. So, anyone who has been considering an exit plan that involves selling their company to an EOT should be planning on doing this sooner rather than later. You should certainly be aiming to get the sale to the EOT completed by March next year if you want to take advantage of the current EOT regime particularly if you are considering using offshore trustees for the EOT.