Martin Cooper, Partner at RSM, sets out the lessons to be learnt for those for those exploring employee ownership models.
With a rise in enquiries as the number of employee-owned companies more than doubled to 1,300 in the three-year period to December 2022, Martin also highlights the key areas for HMRC to consider as part of their review of the legislation.
The John Lewis Partnership, as the UK’s largest employee-owned businesses with around 80,000 employee owners, has for many years been the standard-bearer of employee ownership, with its success serving to encourage others to explore and, in some cases, adopt a similar model for their own businesses.
The recent news that it is considering raising investment that could potentially cause it to no longer be 100% employee-owned has drawn a varied response, but it highlights an important point of interest for others exploring an employee ownership model.
The difficulty in accessing equity funding, as its management believes is now required given recent trading performance, is at the heart of the challenge for not only John Lewis, but some other employee-owned businesses in similar situations now and in the future. For companies structured in such a way to meet the 2014 legislation offering tax incentives for owners of businesses becoming employee-owned, the ‘controlling interest’ requirement means that the employee ownership trust (EOT) needs to maintain a majority equity stake in the company (>50%) at all times to avoid adverse tax consequences.
Whilst a minority equity investment is a possibility, and some EOT-controlled companies have gone down this route, the fact that this cannot be a majority stake (without triggering tax charges) limits the range of potential investors. Most UK equity investors have a relatively short investment horizon (typically three to five years) with high expectations in terms of their return on equity, and this can be difficult to align with the objective of long-term employee ownership. Patient capital, investing on a much longer time horizon for an expectation of dividend income and/or steady growth, is relatively scarce. For these reasons, whilst debt finance is common in employee-owned businesses (but may be restricted due to the nature of that ownership), equity finance is much less widespread.
Whilst John Lewis has of course been owned by its employees for many years, this does highlight some circumstances where selling to an EOT may not be the most suitable form of transaction for shareholders considering an exit. In the right circumstances, employee ownership can bring continuity, protect the position of employees, provide the facility for employees to share in the fruits of their efforts and protect the legacy created by the founding shareholders. An EOT may not always, however, provide the capital investment that some companies need to grow (or even survive) and therefore is more likely to suit cash-generative and profitable businesses than those in need of investment in the short or medium term.
It should also be accepted that a company’s circumstances can change over time and, for some employee-owned companies, an alternative form of ownership may, at some point, become the right solution for the business and its employees. This could be the result of strong performance, which may result in the trustees deciding that it is in the best interests of beneficiaries to realise value for their shares, or less favourable circumstances which mean that the company needs to take on board an investor holding a majority equity stake.
Many companies have thrived and will continue to thrive under an EOT structure, and it remains an excellent model of ownership for those and many other companies, as well as a suitable succession solution for many shareholders. However, in some circumstances, an EOT may not be the right ownership structure; choosing a succession strategy and ownership model is a significant decision and should not be driven by tax factors alone.
Employee ownership enquiries on the rise
The employee ownership trust (EOT) legislation is now nearly nine years old so it seems sensible that HMRC has announced it will be reviewing how it works again. This legislation appears to have vastly extended employee ownership in the UK with the number of employee-owned companies more than doubling to 1,300 in the three-year period to December 2022. But, there is always scope for improvement.
Briefly, shareholders selling to an EOT don’t pay capital gains tax (CGT), but the taxable gain is effectively passed on to the EOT trustees, deferred until a sale. The other tax break is that employees could have a tax free (but not NIC free) bonus up to £3,600 each tax year. Both benefits are subject to some tight rules.
It’s clear from recent activity that HMRC is now checking compliance with those rules. We have seen increased enquiries about the transactions giving relief and requesting supporting documentation. It should come as no surprise that HMRC is keen to ensure the relief is claimed correctly. But given this is not an exemption but effectively a deferral, is there an actual loss to the Treasury?
As well as checking the facts of a deal, what areas could be looked at to help tighten up the rules? One place HMRC might start is CIOT’s representations to the government in 2021:
- Prohibiting offshore trustees. The current legislation allows EOT trustees to be resident abroad. That means the EOT may be outside the scope of UK capital gains tax in the future. While this is rare in our experience, there are certainly examples of companies that have taken this route. EOT relief, whilst often portrayed as “0% CGT”, ordinarily defers the CGT liability from the vendors to the trustee on a future sale, rather than exempting the liability entirely. Therefore, the offshore trust planning may result in a loss of UK CGT currently at the rate of 20%.
On the other hand, where UK employees receive pay outs following a sale, the tax and NIC rate can be over 60%, a healthy rate for the UK.
- Reduce freedoms on choice of trustee board. Many EOTs have a company as trustee, and the legislation does not specify the board structure. Typically, trustee boards are recruited from the vendors, trading company directors, employees and independents. The CIOT recommended either (i) a majority of trustee directors are not connected with the vendors or (ii) requirements are imposed on how the board is made up from these typical groups. In our view, greater employee participation through trustee board representation and independence would be worthwhile. However, for the diverse range of companies (size, business, location) that seek employee ownership, excessive bureaucracy and cost will ultimately discourage employee engagement.
What else the consultation may focus on is less clear.
- Concerns have long existed that unscrupulous vendors may seek to sell their shares to an EOT for more than market value, effectively converting future income into tax free capital gains. Actively requiring sale prices to be vetted by HMRC will increase the admin and cost for HMRC. Well advised clients already know the legislation already exists to impose an income tax and national insurance contributions charge on the excess above market value.
- The EOT legislation could be tightened to restrict the EOT tax relief. That is likely to lead to more complexity which could deter those exploring employee ownership. It should also be noted that EOT sales under the existing criteria can help boost other tax receipts as:
- future distributions to UK employees from the EOT could be taxed at high effective tax rates;
- stamp duty at 0.5% is a low rate but arises on sales to and from the EOT trustee;
- selling shareholders may benefit from CGT relief at up to 20%, but typically lose inheritance tax relief on their shares at 40%.
The EOT legislation has been enormously successful in increasing the number of employee-owned companies in the UK, and we see many success stories of the transformational difference employee ownership can make. Making some relatively modest reforms to the legislation could further enhance the policy objective of encouraging successful employee ownership whilst ensuring that all EOT transactions are done for the right reasons and minimising the potential for abuse.