Dispelling Some Common Misconceptions Regarding Sales of Shares to an Employee Ownership Trust (EOT)

At Alvarez & Marsal we are pleased to be celebrating EO Day today to help raise awareness of Employee Ownership. Whilst the general understanding of Employee Ownership and sales to Employee Ownership Trusts (EOTs) continues to improve, there remain some potential misconceptions regarding sales of shares to an EOT which we dispel in this article.

“If I sell my business to an Employee Ownership Trust, I am passing control of my business to the employees.”

No. Following a controlling sale of shares to an employee owned trust, the trustees of the EOT will become the majority shareholder of the company/group. This means they will have the usual suite of majority shareholder powers and under English law they will control the board of the Company as the shareholders can remove a director by passing an ordinary resolution.

In addition, the trustee, in its capacity as trustee of the EOT, has an overarching duty under the trust deed which constitutes the trust to deal with the trust property (i.e. the shares it holds in the EOT company) in the best interests of the beneficiaries who are the employees of the employee owned company.

However, the management and operation of the employee owned company remains the responsibility of the Board. There is no requirement to re-constitute the Board following a sale to an EOT although this may present an opportunity to appoint new Board members. It will be important to consider the composition of the Board and appointment and removal powers of Board directors once the company becomes employee owned.

Therefore, whilst the sale of a business to an EOT aligns the interests of the “members” and the employees, the employees only hold an indirect interest in the employee owned company as beneficiaries of the EOT.

“If I sell my business to an EOT, the business will be unable to raise new equity capital to support growth going forward.”

No. It is a condition of a sale to an EOT that following the sale, the EOT trustee must hold more than 50% of the ordinary share capital and must be entitled to more than 50% of voting rights and income and capital rights conferred by the company’s share capital. In addition, there must be no provision in any agreement whereby this condition would cease to be met without trustee consent.

This means that an employee owned company can divest a minority equity interest to a new investor without breaching this requirement. If the employee owned company needed to raise more significant equity finance, the trustees will need to determine whether this is in the best interests of the beneficiaries particularly as if the trustee ceases to hold a controlling interest in the employee owned company, this will be a disqualifying event under the EOT tax regime which will give rise to a dry tax charge for a UK resident trustee.

Therefore, it will be important to consider the company’s future finance raising requirements and the timing of a sale to an EOT in the company’s life cycle.

“If I sell to an EOT, I will not benefit from as good a valuation as if I sold to a third party.”

No. A sale to an EOT is a market value transaction and it will be essential for an independent valuation to be prepared to support the transaction. This is important both to the trustee and the company to demonstrate the agreed sale value is equivalent to an arm’s length negotiated transaction value. From the sellers’ perspective, this is also important for tax purposes to demonstrate the company has not been overvalued and in order that the seller’s return may benefit in full from the capital gains tax relief for sales to an EOT. If less than 100% of the equity is sold to the EOT, it will be important to consider whether any minority discounts to the valuation are appropriate.

“A sale to an EOT will preclude the future operation of other share-based remuneration schemes.”

No. There is no restriction on operating other share-based remuneration schemes outside the EOT following a sale to an EOT. It is possible to implement any of the HMRC tax-advantaged share plans alongside an EOT.

As mentioned above, the EOT trustee must hold a controlling interest in the ordinary share capital in the employee owned company, and therefore the shares to supply other share-based remuneration plans would need to be sourced from the remaining 49% of the company’s share capital.

It will also be essential to consider the timing of implementation of any additional share schemes post sale to an EOT and the proportion of the share capital which is being optioned to any individual. This may be particularly relevant under an enterprise management incentive scheme which has an individual limit of up to £250,000 of shares which may be optioned to an employee under the scheme (this is the most generous limit of all the HMRC tax-advantaged schemes).

This is in order not to breach the requirements of the EOT tax reliefs which may be restricted where the number of shareholders/option holders holding at least 5% of the share capital of the company is significant (as calculated under a statutory fraction), as compared to the overall number of employees of the company or its group.

In addition, employees holding 5% of any class of shares or rights to acquire 5% of any class of shares in the company cannot be beneficiaries of the EOT trust.

“Aren’t employee benefit trusts synonymous with aggressive tax planning?”

Not necessarily. An EOT benefits from specific reliefs laid down in tax legislation. This structure should not be confused with some of the more aggressive tax planning arrangements which have been marketed in the past using employee benefit trusts.

In conclusion, whilst there are a number of complexities to navigate to structure a sale to an EOT, many of these challenges can be overcome with the benefit of specialist advice.

How can A&M Tax help?

The team at A&M Tax would be happy to talk through the considerations of implementing an Employee Ownership Trust with you and how we can help you structure a sale to an EOT.

https://www.alvarezandmarsal.com/insights/eot-misconceptions