Sale of a company by an EOT

As part of a guest blog series with J Gadd Associates, our Partner, Andrew Evans, shared what the team found out when they were asked to research the implications of selling an EOT. Read Andrew’s guest post below.

In this briefing we look at the tax consequences should an EOT decide to sell the trading company (and end the EOT). EOTs are normally set up to hold shares in the trading company on a long term basis. However, there may be circumstances where the trustees of the EOT decide to sell the shares in the trading company to a third party.

Sale to another EOT

The transfer of the shares to another EOT should not have any adverse tax consequences. The transfer will be treated as a gift of the shares to the EOT buyer and the shares will transfer on a no gain no loss basis. The selling EOT has to submit an election to HMRC to claim the relief from chargeable gains on the transfer of the shares. A transfer of shares in this way will mean that the employees of the selling EOT receive nothing for their indirect interest in the shares. The employees do obtain an indirect ownership in a larger group.

Tax consequences of selling the trading company and ending the EOT

We were asked to pitch for a piece of work advising the EOT trustees on the sale of the shares in the trading company after the management team received an attractive offer from a third party buyer. This caused us to look at more detail into the tax consequences of a sale of the shares and even we were surprised at the high amount of tax that would be payable.

The sellers are at risk of paying CGT on the sale if the EOT breaches the qualifying conditions by the end of the tax year following the tax year in which the disposal takes place (in simple terms, a maximum 2 year period). The sale of the shares held by the EOT would be a breach on the basis that the EOT no longer controlled the trading company.

Once the sellers’ risk period has ended, the CGT risk passes to the trustees of the EOT. The EOT is treated as taking over the base cost of the shares in the company from the sellers. In many cases this could be the nominal amount paid for the shares on incorporation of the company. On a sale of the shares by the EOT, the whole of the increase in value of the shares is taxed as a chargeable gain in hands of the trustee because the trustee is deemed to have sold and reacquired the shares at their current market value. No deduction is given for any deferred consideration due to the sellers. The current rate of CGT for a trust is 20%. The EOT will then be left with a cash lump sum from which it has to pay any deferred consideration. The balance of any money has to be paid to the beneficiaries (the employees) and the payment will be taxed in the same way as a cash bonus, so subject to income tax and National Insurance Contributions, a further 63.75% tax for the highest rate taxpayers. The effective rate of tax could be 71%, so for every £100 received on a sale up to £71 is paid in tax.

Example

A company is sold to an EOT 4 years ago, so the tax risk lies with the EOT trustee. The sellers are still owed £8m in deferred consideration. The management team (which includes some of the sellers) receive an offer of £12m for the company which they wish to accept and recommend to the EOT trustee.

The EOT trustee pays tax at 20% CGT on the £12m due to the deemed sale and reacquisition rule, so pays £2.4m in tax.

The sellers receive the £8m deferred consideration (still paid with no CGT).

The EOT trustee is left with £1.6m out of which it has to pay the costs of the sale (say £100,000), so £1,500,000 is left to be paid to the employees. If there are 50 employees, they would each receive £30,000 (gross). After basic rate tax and NICs, they would be left with around £15,400 each which is not a brilliant return on the sale of the shares for £12m.

Conclusion

The trustee of an EOT needs to carefully consider any sale and particularly the tax consequences where there is a substantial amount of deferred consideration outstanding. The trustee must also consider the wider interests of the beneficiaries to satisfy its fiduciary obligations and act in the best interests of the employees. Even if the EOT deed does not require a vote by the employees in favour of the sale, the trustee may wish to consider holding a vote to ensure consultation (and approval) by the beneficiaries, or in the last resort, obtain a ruling from the Chancery Division of the High Court (which decides on trust issues).

Any decision may be made easier, the larger the potential pay-out to the employees. A “lottery” sized pay-out, even after tax, may be sufficient compensation for the employees at risk of losing any job security. However, the trustee directors must ensure they satisfy their fiduciary duties in reaching any decision.