On EO Day 2013 HM Treasury announced that “Following the findings of the Nuttall Review and in order to support this sector, the Government has decided to introduce two tax reliefs to encourage, promote and support indirect employee ownership”. The Finance Bill (see clause 283 and schedule 33) published on 27 March 2014 contains helpful changes in response to the consultation on the original drafts of these reliefs. An earlier article on the new CGT and income tax exemptions for employee ownership trusts explained that some important amendments and clarifications were needed. The following is an explanation from HM Revenue & Customs of the changes made, as sent to those involved in the consultation (hyper-links have been added):
“…The government has today published the Finance Bill 2014. It contains legislation introducing tax reliefs for indirectly employee owned companies, a draft of which was published for technical consultation on 10 December 2013. We have made changes to the legislation reflecting views we received and I wanted to write to you to set out how those changes affect the legislation.
We received 22 responses to the technical consultation ranging from small businesses that are employee owned or considering becoming employee owned, through to big businesses with a degree of employee ownership, as well as professional advisors and representative bodies.
The general theme of the responses was that although the tax reliefs are welcome, respondents thought that some of the conditions around the reliefs and the employee ownership trust (EOT) in particular were too restrictive and would result in companies having to set up another trust or trusts to ensure that, while they were able to claim the tax reliefs, they could retain a degree of flexibility in dealing with their remaining shares.
What has changed?
Structure of the Employee Ownership Trust (EOT)
1. We recognise that many trusts that were set up for employee ownership before the publication of our draft clauses will have been set up as employee benefit trusts (EBTs). While compliant with the existing legislation that gives an IHT exemption, such trusts may have been incapable of meeting the stricter EOT conditions without amendment to their trust deeds.
2. It is not our intention to require that companies whose trusts have been operating quite genuinely for the benefit of all of their employees and which already held a significant shareholding on 10 December 2013 should have to incur costs in amending their trust deeds (or, in some cases, setting up an entirely new trust) in order to meet the all-employee benefit requirement and hence qualify as an EOT.
3. The amended legislation therefore introduces an alternative way for certain pre-existing trusts to qualify for the tax reliefs: the “behaviour requirement”. The behaviour requirement looks at the actions of the trustees to see if they would meet the intentions of the EOT legislation over a specified period of time. If the actions of the trust meet the criteria then the trust is deemed to meet the all-employee benefit requirement, and may be treated as an EOT subject to the other relevant requirements.
4. A number of respondents have told us that, even with the behaviour requirement, their structures will not qualify for the tax reliefs and suggested the criteria be made less restrictive. In particular, several companies are partly owned by trusts which operate at least in part for the benefit of charitable organisations rather than their employees. The set-up is such that the structure will not qualify as an EOT e.g. because a single trust will never hold more than 50% of the company shares with the necessary voting rights (so the controlling interest requirement is not met). While we are sympathetic to the businesses that are affected, and recognise that these structures were set up prior to the EOT legislation and have been operating in a way similar to employee trust owned companies, we have decided not to accommodate these structures. To do so would add a great deal of complexity to the legislation.
5. Respondents told us that the legislation was not flexible enough to accommodate hybrid models of direct and indirect ownership because the EOT will not be able to be used for warehousing shares that the company intends to use for plans that award shares directly to employees. For example they suggest if an EOT holds 71% of the company’s shares, then the trust should be permitted to use say 20% of those shares for direct share ownership plans, as long as a more than 50% of the shares remain in the trust.
6. We propose to facilitate the role of the EOT in the conduct of share schemes operated by the company. In order to do this, we have amended the legislation so that shares to which the new CGT relief applied when they were acquired by the trustees will be pooled separately from other shares of the same class, and when they make a disposal the trustees will be able to specify from which pool the disposal occurs. We have not provided a specific tax relief for shares warehoused in the EOT that are transferred into share schemes; in order to meet the all employee benefit requirement the trust will have to dispose of the shares to the share scheme at market value. However, the pooling arrangements will prevent the trustees’ gains on the disposal of shares to a share scheme being inflated by the deemed acquisition cost of shares to which the CGT relief applied.
7. We were also told that the deeds of most trusts created for the purpose of employee ownership require the trustees to waive their right to receive dividends in relation to the company shares they hold. This is because it is more tax-efficient for the trust to be funded as necessary by gifts or loans from the company rather than pay tax on dividend income. Such a waiver was prohibited under the draft legislation because it prevented the trustee from being entitled to profits available for distribution. We have amended the legislation to ensure that the requirement to waive dividends will not disqualify the trust from being an EOT. And we have gone further by ensuring that where there is no compulsory dividend waiver, but the trustees voluntarily waive a dividend, this will also not be a disqualifying event.
8. Trustees may use their shares in the company which they control as security for a loan. We are content that such security arrangements should not constitute arrangements whereby the trustees may cease to have a controlling interest in the company. We have amended the legislation to ensure that the mere existence of such arrangements will not result in the trustees failing to meet the controlling interest requirement. However, if the trustees actually lose control of the shares e.g. because they default on the loan under such an agreement then they will cease to meet the controlling interest requirement.
9. To prevent potential unfairness and difficulties on cessation of the business or disposal by the trustees of all their shares, we have amended the legislation so that in these circumstances the eligible employees to whom distributions may be made by the trustees must include employees who ceased employment in the preceding 24 months.
10. A further issue that has been raised by respondents as causing concern is that where a controlling interest in a company is held by an EOT (with a corporate trustee) the company may not be able to operate a Share Incentive Plan (SIP) or other tax advantaged share scheme. SIPs are widely used by companies as they represent a tax-advantaged way to remunerate employees with shares; they facilitate direct employee share ownership rather than the indirect employee ownership that the EOT represents.
11. The draft legislation has been amended to confirm that a company owned indirectly by its employees through an EOT (with a corporate trustee) can also operate one of the tax advantaged share schemes. We have amended the legislation relating to the tax-advantaged share schemes (SIP, SAYE, CSOP and EMI) to allow a company controlled by a corporate trustee of an EOT to operate such schemes, subject to the other relevant conditions being met. As the EMI scheme is a notified State Aid, the change will only take effect once any necessary clearance is obtained from the EU Commission.
12. Concerns have been raised about the fact that the EOT is not permitted to transfer any settled property into another trust. This restriction is intended to prevent the trust getting round the EOT conditions by creating new trusts on different, less stringent, terms and transferring property to them. However, we accept that without amendment this might unduly restrict the transfer of trust assets to a new EOT where that is desirable or necessary for bona fide commercial reasons including those related to the expiry of the 125 perpetuity period under UK trust law. The Department of Business Innovation and Skills is currently consulting on the perpetuity rules and one of their proposals is to abolish them so that trusts would be able to continue indefinitely. We cannot be sure of the outcome of that consultation and have decided to amend our legislation to accommodate transfers from one EOT to another.
13. We have also clarified that the EOT conditions will be met where the EOT gives the trustees power to amend the terms of the trust such that the assets are held on trusts which continue to meet the conditions in the future.
14. We have decided to make a further change in relation to office-holders. The change will require trustees to make payments to office-holders as eligible employees to the extent that the trust deeds permit them to do so. Where such payments are made they must be made to all persons (including office-holders) on the same terms. We recognise that many existing trusts specifically exclude office-holders from being beneficiaries and so this change will be permissive – that is to say it will only apply if the trust deeds enable the trusts to make such payments. Where no such provision exists, the equality requirement will not be breached if office-holders are excluded.
Capital gains tax (CGT) relief
15. Stakeholders have provided us with feedback that the limited participation requirement, which seeks to deny CGT relief in some cases where the ratio of participators to employees who benefit from the EOT is greater than 2/5, is too restrictive. Stakeholders were concerned that actions which were outside the control of the trustees (for example, an employee resigning), could in some circumstances result in a CGT charge on the trustees. We have therefore amended the legislation to ensure that the EOT is allowed a ‘grace period’. If the participation fraction test is failed for six months or less, and for reasons beyond the control of the trustees, then the trust can continue to be treated as an EOT and no CGT charge will arise.
16. There was concern that some provisions of the equality requirement appeared to work against one another. For instance, a distribution of settled property by trustees based on employees’ salaries might be permitted by one part of the legislation, but could have results which suggest another part of the legislation would prohibit it. We have amended the legislation to remove any contradiction.
Exemption from income tax on bonus payment
17. We have amended the legislation to provide flexibility when an employee dies or is asked to leave their employment. There will be circumstances when the company wants to pay a bonus to a former employee and circumstances when they don’t want to do so. We think it is right to give employers some discretion and have amended the legislation so that either making or not making a bonus payment to somebody who was an employee in the last 12 months doesn’t disqualify the bonus payments made to the rest of their employees from the income tax exemption. Some stakeholders have suggested extending this to employees who have left in the last 24 months, but we consider that a 12 months period should capture all or most of the former employees a company might wish to reward.
18. We have considered the treatment when an employee is subject to disciplinary proceedings. There will be occasions when a person remains in employment having had a finding of gross misconduct made against them. We do not want our legislation to require that bonus payments are made to the employee in those circumstances. Where the finding of gross misconduct has been made within the previous 12 months of the award being determined, or the employee is subject to disciplinary proceedings for gross misconduct at that time and is not subsequently cleared, the participation requirement will not be infringed by their being excluded from the award. However, if the outcome of the disciplinary proceedings is that the employee is cleared, the employer must pay the bonus on the same terms as other employees within a reasonable timeframe.
19. Similarly, stakeholders have suggested that there are occasions when they will want to exclude an employee from benefiting from a bonus payment. This might be the case for an employee who has been made bankrupt. We do not think it would be right for government legislation to support not making funds available for creditors of a bankrupt employee and have not therefore amended the legislation to permit this.
20. We think there may be a risk from small companies being set up in an EOT structure to benefit from the income tax exemption, where the only employees are also the office holders (directors). We have introduced a further requirement that the proportion of directors and office holders to other employees must be less than a certain fraction in order for the exemption to be claimed. If we take an example of a qualifying company where there are two directors and six employees, one of whom is connected to a director, the ratio of directors and connected persons to unconnected employees is less than 2/5 so the employer is able to pay tax-exempt bonuses.
21. However, we acknowledge that in small companies the loss of one employee could have a significant impact. To ensure that these restrictions don’t have too harsh an affect we would allow companies a grace period to remedy inadvertent breach of this new requirement.
22. Stakeholders have requested greater flexibility for employers to differentiate between individual employees or between particular units of the organisation. While we are happy to accommodate arrangements which don’t pay an equal sum to all employees, we don’t think that performance related pay (whether that be the performance of the individual or of a specific part of the business) particularly fits with the policy rationale, which is to allow companies to reward their employees in their role as owners of the business. We therefore do not intend to accommodate this.
Inheritance tax relief
23. We have made only minor consequential changes to the inheritance tax parts of the legislation, but the legislation has been substantially restructured to make it easier to understand.”
Explanatory notes on Schedule 33 to the Finance Bill as published on 27 March 2014 are available. Full background materials on these tax exemptions are listed (with hyper-links) in the article “Nuttall Review of Employee Ownership – quick guide to source materials“