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In this article, the TLT Employee Ownership team discusses the practical implications for employee ownership trusts (EOTs) of the recent changes to the taxation of contributions made by an employee-owned company to an EOT.
An EOT is a special type of discretionary trust which is established by a trading company (or the parent company of a trading group), for the purpose of acquiring a controlling interest in that company. The trustee(s) of the EOT will hold the shares in the trading company on the terms of the trust for the employees of the company, who are the beneficiaries of the trust.
At the time when the EOT is established, and before the transition of the trading company to employee ownership, the initial trust fund is likely to consist of only a nominal cash sum. This means that the EOT does not have sufficient assets to enable it to fund the purchase price of the trading company shares.
It is typically the case that the trading company will make a contribution/gift of cash to the EOT out of the company’s trading profits so that the EOT can fund the purchase price of the shares in the trading company that it acquires from the vendors together with the associated costs of the acquisition, such as professional fees for legal and valuation advice and stamp duty payable on the transfer of shares.
In some transactions, the vendors will agree to the payment of the consideration by the EOT in instalments over a number of years following completion (typically 4 to 7 years) which may be funded by annual cash contributions from the trading company to the EOT.
HMRC have routinely confirmed to the vendors of employee-owned companies during the pre-transition planning stage, by way of HMRC advance clearance, that they would generally not treat the types of contributions referred to above as income distributions for the EOT for tax purposes. However, this position has never been set out in HMRC’s guidance on the taxation of EOTs and it is not provided for in the relevant tax legislation. A UK government consultation acknowledged the uncertainties arising from HMRC’s approach to this tax issue and proposed an amendment to the distributions legislation.
Legislation will be introduced when the Finance Bill 2025 is enacted providing a specific relief from income tax distribution treatment for contributions paid by the EOT-owned company to the trustee(s) of the EOT to fund certain costs associated with the acquisition of the shares in the company by the EOT.
As we highlighted in an article last year, when the draft legislation was originally published in October 2024, there were some notable exclusions from the list of costs to which the relief would apply, such as the cost of legal and valuation fees associated with the acquisition. This was particularly concerning as enactment of the Finance Bill will introduce a new requirement (for disposals on or after 30 October 2024) that the trustee(s) of an EOT must take all reasonable steps to ensure that the consideration paid to acquire the shares does not exceed market value at the time of the disposal. It is therefore increasingly likely that trustee(s) of EOTs will wish to obtain an independent third party valuation of the shares to satisfy the new requirement, leading to increased acquisition costs for the EOT.
It seems that there could be an issue for the EOT trustee(s). However, during the committee stage of the Finance Bill, the government introduced a number of amendments to the draft legislation including to the list of EOT acquisition costs in relation to which the income tax relief will be available. On the basis that these amendments are incorporated into the final version of the Finance Bill, the acquisition costs that will benefit from the relief will include:
the consideration payable to the vendors by the EOT for the disposal of their shares;
where some or all of the consideration for the disposal is deferred, any interest payable on the deferred consideration as long as the rate of interest does not exceed a reasonable commercial rate;
the repayment of any sums borrowed by the EOT to fund the acquisition;
any liability to stamp duty or stamp duty reserve tax on the disposal;
any valuation of the trading company carried out in connection with the acquisition; and
any other reasonable expenses which are directly connected with the acquisition.
The new legislation will take effect in relation to distributions made to an EOT on or after 30 October 2024.
Whilst we welcome the government’s intention to confirm in legislation that certain contributions paid by an EOT-owned company to the EOT will be payable free of income tax, it is our view that the legislation still does not go far enough in protecting the EOT from unwanted income tax charges.
Our concern is that the new relief is limited to the specified list of acquisition costs referred to above and specifically excludes any expenses incurred in connection with the ownership of the shares in the trading company following the acquisition, such as the fees of appointing an independent or professional trustee to the board of the EOT trustee company, the cost of arranging external finance and ongoing legal fees for advice.
The implication from the draft Finance Bill legislation is that any contributions made to an EOT by the trading company which do not fall within the specified list of acquisition costs will therefore be treated as distributions by the trading company. This means that those contributions will be taxed as a dividend in the hands of the EOT trustee(s).
As such, despite the purpose behind the new legislation, uncertainties about the tax treatment of contributions made to the EOT will remain.
TLT has been a leading firm active in the employee ownership sector for a number of years. Our specialist, and experienced, employee ownership lawyers have a diverse range of clients in England, Wales, Northern Ireland and Scotland.
We provide insightful strategic direction to employee-owned businesses at every stage of their journey and have led a number of the most high-profile employee ownership transactions within the UK.
If you are interested in discussing any of the topics covered in this article, get in touch with our employee ownership specialists below.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2025. Specific advice should be sought for specific cases. For more information see our terms and conditions.
Date published
31 January 2025
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