Company owning individuals selling their shares upon retirement can generally expect to pay capital gains tax (CGT) at 28% (for 2014/15) unless entrepreneurs’ relief is available, in which case the CGT rate is only 10% (on the first £10 million of chargeable gains).
Of course, the retiring shareholders would probably prefer to sell their shares and pay no CGT at all. The good news is that this is possible in some cases. Does it involve a tax avoidance scheme, which may be attacked by HM Revenue & Customs? No; in fact, there is a way to sell the company without paying any CGT – with the government’s blessing!
Furthermore, it is not necessary for the company owner to find a buyer for the business. The company need not be sold to complete strangers. In fact, the new owners will be quite familiar – the company’s employees! To be more precise, the shares are held by a trust on the employees’ behalf. Indirect ownership through a trust may be particularly helpful where the employees could not afford to pay for the shares personally.
The ‘employee ownership trust’ (EOT) rules were introduced in Finance Act 2014. An EOT is broadly a legal structure, which allows business continuity and succession by providing for trading company ownership through a particular type of trust for the benefit of employees.
Tax-advantaged share schemes for employees are nothing new. However, the EOT is a separate arrangement. It builds upon the ‘John Lewis model’, whereby a company is held collectively (in this case, through a trust) with its employees as beneficiaries (John Lewis being the popular department store; its employees are ‘partners’ and the partnership shares are held in trust, in which the beneficiaries are those partners).
Company ownership by an EOT has potential tax benefits not only for shareholders disposing of the business, but also for the employees and the company itself.
A claim for CGT relief can be made on the disposal of ordinary share capital to the trustees of an EOT, where the relief requirements are met. The EOT should therefore be seen as a long-term (or perhaps indefinite) shareholding vehicle.
The effect of the relief is that the disposal is treated for CGT purposes as being made on a ‘no gain, no loss’ basis. Note that the disposal is not exempt from CGT; in effect, the disposing shareholder’s capital gain is transferred to the trustees of the EOT.
There are five relief requirements in the legislation (TCGA 1992, s 236H):
(a) Trading requirement – The company must meet a ‘trading requirement’ at the time of disposal, and throughout the remainder of that tax year. In broad terms, the company must either be a trading company, or the principal company of a trading group (TCGA 1992, s 236I).
(b) All-employee benefit requirement – The trust must meet an ‘all employee benefit requirement’ at the time of disposal, and throughout the remainder of that tax year. The rules are detailed (ss 236H(5), 236J-236L), but in essence all ‘eligible employees’ (as defined) must be permitted to benefit from the trust on the same terms. In addition, the trustees are subject to certain restrictions, which prohibit the creation of sub-trusts, unauthorised transfers of trust assets, or making loans to trust beneficiaries.
(c) Controlling interest requirement – The trust does not meet a ‘controlling interest requirement’ (in s 236M, i.e. broadly by the trustees holding more than 50% of the company’s ordinary share capital, voting rights, profits available for distribution and assets available for distribution on a winding up) immediately before the start of the tax year of disposal, but meets the requirement at the end of that tax year.
(d) Limited participation requirement – This requirement (s 236N) is met broadly if there was no time during the year ending immediately after the disposal when the claimant was a ‘participator’ (e.g. a shareholder) in the company, and at that time a ‘participator fraction’ (broadly the number of participators who are employees/officer holders in the company (including certain connected persons), over the total number of employees in the company or group) exceeded the fraction 2/5. In addition, that fraction must not be exceeded between the time of disposal and the end of that tax year.
The limited participation requirement is essentially aimed at ensuring that the ratio of participators to employees does not exceed the above fraction. However, a ‘participator’ for these purposes excludes those not entitled to 5% or more of the company’s share capital and assets on a winding up. In addition, there is a grace period of up to six months during which the participator fraction may exceed 2/5 without failing the limited participation requirement, if it results from events outside the trustees’ reasonable control.
(e) Earlier disposals – The claimant (or anyone connected with him) must not have received relief (under s 236H) in an earlier year on the disposal of shares in the same company or group.
As might be expected for such a generous CGT relief, the rules (ss 236H-236U) are long and complex. Detailed consideration of them is beyond the scope of this article. Employee trusts are a specialist area; expert tax and legal advice is strongly recommended.
An added (tax-free) bonus
There is also a tax incentive for employees. A tax-free bonus of up to £3,600 per annum may be paid to employees, if certain conditions are satisfied (ITEPA 2003, ss 312A-312I).
This income tax exemption (note there is no National Insurance contributions exemption) applies to qualifying bonus payments made by an employer (not by the EOT) in the tax year to employees or former employees. A ‘qualifying bonus’ is broadly a payment that satisfies certain conditions (in ITEPA 2003, s 312B(1)). For example, the payment must not consist of regular salary or wages (i.e. it must be a genuine bonus).
The bonus scheme must meet participation and equality requirements. The ‘participation requirement’ is that all those employed by the company or group member (subject to limited exceptions) must be eligible to participate in the bonus scheme awards. The ‘equality requirement’ is that employees must participate in the bonus on the same terms. The legislation sets out circumstances in which this requirement is, and is not, infringed. For example, employees with less than 12 months’ continuous employment may be excluded; and the amount of bonus may (subject to certain conditions) be determined by reference to an employee’s earnings, length of service or hours worked.
The employer must also meet certain requirements (i.e. ‘trading’, ‘indirect employee-ownership’ and ‘office holder’) for certain specified periods, and must not be a ‘service company’ (all as defined). In addition, the payment must not be ‘excluded’, i.e. broadly there must be no arrangements involving an employee or former employee giving up employment income in return for the payment (e.g. salary sacrifice). Payments to former employees must be made within 12 months of the employment ending.
A corporation tax deduction is available for the company to the extent that a qualifying bonus payment is exempt from income tax under the above rules (CTA 2009, s 1292(6B)).
There are also inheritance tax (IHT) reliefs in relation to EOTs. For example, a transfer of shares by an individual to an ‘employee ownership trust’ is exempt from IHT broadly if the company meets a ‘trading requirement’, the trust meets an ‘all-employee benefit requirement’ and the trust does not meet a ‘controlling interest’ requirement immediately before the start of the tax year of transfer but does so at the end of that tax year (IHTA 1984, s 28A). The CGT relief rules largely apply in determining whether those requirements are met.
If shares are to be sold (as opposed to being gifted) to the EOT, stamp duty will be payable in the normal way. Some thought will also need to be given to how the EOT will pay for the shares. Whilst the EOT tax regime is generous in other respects, there are no provisions allowing the company a deduction for contributions it makes to enable the EOT to buy shares. No deduction is generally available for the company’s contributions to an EOT, because employees are unlikely to receive taxable benefits (CTA 2009, s 1290).
For long term business continuity and succession purposes, an EOT is a useful option for the existing company owners to consider. However, an EOT is designed as a permanent shareholding vehicle, so it may not be suitable in some cases.
Many company owners, such as those unable to claim entrepreneurs’ relief on a disposal of their shares for some reason, will find an EOT an attractive proposition where the conditions for claiming CGT relief are satisfied. Practitioners will also need to consider EOTs when advising their clients about business exit strategies. Finally, as mentioned earlier, expert professional advice is important.
The above article was first published by Tax Insider (www.taxinsider.co.uk).