Finance Act 2014 provides, for two new exemptions from tax relating to a company of which a 51% controlling interest is acquired within a single tax year by an ‘employee-ownership trust’ which satisfies certain restrictive requirements (“an EOT”):
(a) a complete exemption from capital gains tax on a sale of shares to the trustee in that tax year; and
(b) exemption from income tax on bonuses of up to £3,600 per tax year paid by a company owned by such an EOT to all qualifying employees on a ‘same terms’ basis.
The new exemptions were outlined in the Winter 2013 Bulletin and are described below.
The capital gains tax exemption takes effect in relation to qualifying disposals by persons other than a company made to an EOT on and after 6 April 2014, the income tax relief takes effect in relation to bonus payments made on and after 1 October 2014.
Notwithstanding that, if the trust has a corporate trustee, the company would fail the “independence requirement” for granting EMI options, making share awards under a SIP, or granting CSOP or SAYE share options, that test will, from 1 October 2014 (or possibly sooner in the case of EMI options), be deemed to be satisfied if the company is owned as to 51%, and controlled, by such an EOT. It follows that a company owned by an EOT may grant EMI, CSOP or SAYE share options, or award shares under a SIP, albeit only over shares not comprised in the trustees’ 51% controlling interest.
An EOT must be drafted so as to provide that the dispositive powers of the trustees can never be exercised so as to apply the trust property (a) otherwise than for the benefit of all eligible employees on the same terms; or (b) by creating a trust, transferring property to another settlement or (c) making loans.
Can existing trusts qualify?
A ‘section 86 IHTA 1984’ employees’ trust existing prior to 10 December 2013 which holds at least a 10% interest in the company may still qualify to meet the all-employee benefit requirement (not withstanding that it has not, until amended, restricted the application of benefits to all employees) if in fact it has, within the 12 months preceding the date of disposal to the trust, applied trust property, if at all, only in a manner which satisfies the ‘equality of treatment’ requirement.
If an existing employees’ trust (for example) exercises a power of resettlement so as to declare that shares comprising ordinary share capital in a company be held on the more restrictive trusts of an EOT, in order to allow vendor(s) to qualify for the relief from CGT in respect of subsequent sales to what is then a qualifying EOT, no charge to CGT will arise upon the deemed disposal by the trustees of the newly created EOT become absolutely entitled to the trust property as against the trustees of the original trust. This allows an existing employee trusts to ‘convert’ into an EOT, but the new trustees must make a claim for this relief.
Of the shares acquired by the EOT trust, the trustees must (to avoid any ‘clawback’ charge) retain on an ongoing basis at least a 51% controlling interest in the company (“the controlling interest requirement”).
The trusts of the EOT must restrict the application of benefits at all times to a distribution on the same terms to all eligible employees (the ‘all employee benefit requirement’).
The limited participation test
The number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% (2/5ths) of the total number of employees of the company or group (“the limited participation test”). This test must be satisfied both throughout the year preceding the disposal and at all times thereafter. Subject to that requirement the vendor(s) may retain interests totalling up to a non-controlling 49% shareholding.
Care is needed if the EOT-owned company is to grant share options or award shares to employees under a Share Incentive Plan. It is understood to be intended that the trust deed of an EOT may be drafted in such a manner as will permit the trustees, in the exercise of an ‘investment power’, to sell shares (being shares held in excess of the 51% minimum threshold level of ownership) for a consideration which is not less than their ‘market value’ at the time of sale. This would allow, for example, the sale of shares acquired as ‘partnership shares’, or a sale at market value to the SIP trustee with the intention that such shares be awarded as ‘free’ or ‘matching’ shares. If, however, the shares are to be acquired by employees pursuant to the exercise of EMI, CSOP, SAYE or unapproved share options, the shares must first be sold (at their market value) to another employees’ trust which will then hold them pending sale to employees who exercise such options. A direct sale of shares at an undervalue to employee optionholders would be the exercise of a ‘dispositive power’ on terms which (except in very exceptional circumstances) would fail to satisfy the ‘same terms’ requirement applicable to any dispositive application of the trust fund.
An EOT may waive its entitlement to dividends on the shares acquired without the ‘51% controlling interest requirement’ thereby being infringed. This will lead to interesting arguments as to the market value of the shares sold to the EOT. The price paid to acquire the shares intended to qualify for the relief must not exceed their market value as this would be a provision of benefit in breach of trust. Such a waiver does mean that profits of the company can be distributed by way of dividend to all other shareholders (which could include the vendors – subject to the limited participation requirement) and/or employees.
The ‘equality of treatment’ requirement
The trusts of the EOT must provide that the trust assets cannot be applied at any time otherwise than for the benefit of all eligible employees (including directors, unless they are excluded – see below) of members of the same 75% group of which the company concerned is the principal member, on the same terms (the ‘equality of treatment’ requirement). Further, they must not permit the trust assets to be applied at any time by the creation of any sub-trust or a transfer to any other trust (other than another EOT), or in the making of loans to beneficiaries.
For these purposes, “eligible employee” excludes any 5% ‘participator’ in the company or any group company or who has been a participator in the past 10 years or has made a transfer of value to the trust (and any person connected with any such participator), whether or not the company is a close company. In essence therefore, the vendors and their connected persons must be excluded altogether from any benefit under the EOT.
The trusts of an EOT may permit :
(a) trust property to be applied as if a surviving spouse, partner or dependant of a deceased employee were themselves an eligible employee for a period of up to 12 months after the death of an eligible employee;
(b) the exclusion from participating in an application of trust property by an eligible employee who has made a written request to be excluded;
(c) the exclusion of employees with a qualifying period of continuous employment set at no more than 12 months;
(d) the exclusion of directors and other officeholders;
(e) the application of trust property on terms that differentiate between eligible employees according to their levels of remuneration, length of service or hours worked (applying each factor separately), provided that, in the event of any such application of trust property, every qualifying eligible employee receives some benefit; and
(f) the application of trust property for charitable purposes.
A clawback charge to CGT will arise, on the part of the trustees of the EOT (not the vendors who benefited from the relief) who are then treated as disposing and reacquiring the shares in respect of which the relief was given on sale (or resettlement) of shares to the EOT for a consideration equal to their market value at the time of the disqualifying event.
A “disqualifying event” occurs if :
(a) the company ceases to meet the ‘trading requirement’;
(b) the EOT ceases to satisfy the controlling interest requirement, i.e. ceases to hold a 51% controlling interest;
(c) the EOT ceases to satisfy the ‘all-employee benefit requirement’;
(d) the limited participation test is not met; or
(e) the trustee acts in breach of trust so as to offend the ‘all-employee benefit requirement’.
If, however such a disqualifying event occurs in the tax year next following that in which the vendor’s disposal is made, any claim for CGT relief on the part of the vendor is revoked.
If the EOT trustees hold shares in respect of which some, but not all, have been the subject of an exemption from CGT on sale (or resettlement) of shares to the EOT (“EOT exempt shares”), they are treated for CGT pooling purposes as being of a different class of share from other shares of the same class acquired by the trustees. But, if some shares of the same class are later sold for market value, or applied in accordance with the ‘all-employee benefit requirement’, by the trustee (but not so as to result in a disqualifying event, because – for example – the EOT still retains a 51% controlling interest), the trustees may nevertheless determine what proportion of the shares so disposed of are to be treated as EOT exempt shares. This ensures that, upon a CGT disposal by the trustees of shares (i.e. of shares in excess of the 51% controlling interest), shares with a higher base cost may be treated as disposed of in preference to EOT exempt shares which will (presumably) have a lower base cost.
The controlling interest requirement is not infringed by reason only of the existence of terms under a loan by the trustees from an unconnected third party (e.g. a bank), or a charge to secure such a loan, under which the lender may acquire rights over the trust property in the event of default.
As drafted, the legislation leaves open the possibility that, if the trustees are offshore, and the trust is properly to be treated as outside the scope of the charge to UK CGT, a clawback charge cannot arise – although it is likely that, if the company were sold by the trustees, any subsequent attempt to distribute the proceeds to employees would give rise to charges to income tax and NICs under the ‘disguised remuneration’ rules (and possibly also charges to CGT under s87 TCGA 1992.)
Inheritance tax reliefs
A contribution of cash or other assets by a close company to an EOT to enable the trustees to buy shares in the company is not a ‘transfer of value’ for the purposes of inheritance tax (per new s 13A IHTA 1984). Likewise, a gift of shares in the company by an individual to an EOT is an exempt transfer for inheritance tax purposes and a transfer or resettlement of shares from an existing employees’ trust to an EOT will not trigger an ‘exit charge’ under s65 IHTA.
Other points to bear in mind
The exemption from CGT on a sale of shares to an EOT must be claimed by the vendor.
Any clawback charge falls to the trustees to be funded out of the trust property, and not on the vendors who have taken the benefit of the CGT exemption. Careful consideration must be given to the terms of purchase by the trustees and the extent to which the trustees should seek indemnities from the vendors against losses arising from a clawback charge. Equally, the vendors would then want assurances that neither the company nor the trustees will do anything which would give rise to a clawback charge (e.g. by an issue of shares to another person so as to dilute the trust’s controlling interest).
There are no exemptions from the charges to tax on ‘loans to participators’ (in s455 CTA 2010), nor from the ‘disguised remuneration’ rules. A close company will need to consider carefully how to put an EOT in funds to enable the shares to be purchased from the vendor taxpayers. In practice, if the company has insufficient reserves available to make contributions to the EOT to fund the share purchases, it is unlikely that the trustees could raise funding from a bank, even on a secured basis, without onerous guarantees and securities being given by the company itself.
Quite apart from the desire of existing individual proprietors to take advantage of the CGT exemption on a sale of shares to the EOT, trustees of existing employee trusts holding, or in a position to acquire, a 51% controlling interest in the company might wish to convert to EOT status in order to allow the company to take advantage of the other new relief : relief from income tax on bonus payments to employees of a company owned and controlled by an EOT.
Tax-free bonuses for all employees of a company owned by an EOT
From 1st October 2014, cash bonuses of not more than £3,600 may be paid, to all qualifying eligible employees of a company owned and controlled by an Employee Ownership Trust, free of income tax (but not National Insurance contributions).
To qualify for the exemption, the bonus must not consist of regular salary or wages and must be awarded under a ‘scheme’ which meets the requirements of new s312C ITEPA 2003 (the ‘participation’ and ‘equality’ requirements).
The company making the payment must be the employer company, and must meet the ‘trading requirement test and the ‘indirect employee-ownership requirement’ throughout the 12 months ending with the date of the payment (or, if shorter, throughout the period since those requirements were first met). It must also meet the ‘office-holder requirement’ when the payment is made and on at least such number of the days falling within the past 12 months as is as reduced by 90 (or, if the period since the all-employee benefit and indirect-ownership requirements were first met was shorter, as reduced by a corresponding fraction of 90). It must not be a ‘service company’ (see below).
To qualify, a bonus payment must not be paid under any form of ‘salary-sacrifice’ arrangement and, if paid to a former employee, must, if it is to qualify for the exemption, be paid within 12 months after the employment ceased.
The indirect employee-ownership requirement
The company must be owned and controlled by an Employee-Ownership Trust of the type described in our note on the new relief from CGT for sales of shares to an EOT. In short, the trust must hold a 51% controlling interest in the company for the benefit of all eligible employees with a qualifying period of continuous employment of up to 12 months, must exclude from benefit certain participators and connected persons, must prohibit the making of loans or creation of sub-trusts, and must restrict the disposition of benefits at any time to a distribution to all qualifying employees on a ‘same-terms’ basis (subject only to differentiation according to remuneration, length of service or hours worked).
The participation and equality requirements
All qualifying employees (i.e. those with at least 12 months continuous service) must be eligible to participate in the bonus. But an employee may be excluded from participation if he or she has been the subject of proceedings for gross misconduct or is found to have been guilty of gross misconduct or has been summarily dismissed.
Every employee who does participate must do so on the same terms save that individual entitlement can be varied by reference to the employee’s level of remuneration, length of service or hours worked. Further, the scheme must not have, or be likely to have, the effect of conferring benefits wholly or mainly on directors, the highest paid, or employees in a particular part of the business or carrying on particular activities.
The trading requirement
The employer must be a trading company or member of a trading group. For this purpose, the activities of members of a group are to be treated as one business (disregarding intra-group activities), and a business carried on in partnership with another person is not treated as a trading activity.
The office-holder requirement
[Note that this is different from the ‘limited participation’ requirement for the CGT exemption.]
This is that the number of persons who are directors of the employer company (or other office-holders), and/or persons connected with such a director (or office-holder), must not exceed 40% of the aggregate number of employees and office-holders of the company.
The employer must not be a service company
The employer must not be a ‘managed service company’, per s 61B ITEPA 2003, nor a company providing the services of its employees to persons outside the group but who, alone or together with others, has, or has in the past had, direct or indirect control of the employer or which formerly employed the employees.