Employee Ownership Trusts: How to navigate the HMRC tax clearance process

From a tax perspective, the EOT clearance process remains an important step, but it should now be considered within the context of a changing legislative environment. While historically EOTs have been associated with highly favourable capital gains outcomes, recent changes mean that transactions are no longer automatically structured around full CGT exemption. As a result, HMRC scrutiny of the commercial rationale is expected to increase.

In our experience, HMRC clearance can still be obtained within 3-4 weeks, assuming the structure is clear and the underlying objectives are robust. However, the clearance process is only one element; the more complex work typically involves aligning management, shareholders and employees on the structure and purpose of the EOT well in advance of submission.

Key things to agree on before the tax clearance application: 

What is the commercial purpose of an EOT? 

• What proportion of the company’s shares will the EOT acquire? 51%, 100% or somewhere between, if you’re seeking capital gains tax exemption for the sellers? 
• Who will be managing the EOT as Trustees? 
• What is the value of shares to be sold? 
• What is the market value of the company? 
• How will the share purchase be funded? 
• How many years will it take to repay? 

While tax remains a key consideration, structuring a transaction primarily around tax outcome, particularly in light of the evolving CGT treatment, carries increased execution risk.

When thinking about these questions, don’t forget: 

• An independent valuation report will help to establish the market value and avoid any tax complications on the sale of the shares for the shareholder
• A robust financial model provides comfort that the business will be able to finance the purchase obligations entered into by the EOT
• The EOT structure is crucial to avoid any personal liabilities falling on the trustees of the EOT.

For a tax clearance, the most important question is what is the primary motivation for the EOT? This is something the owners of the company and the advisers need to be clear about.

The lawyers and the accountants will be on hand to help with an independent valuation of the company, financial models, legal documentation and other supporting documentation. Still, the business owner needs to decide why they are doing this and how involved they would like to be in the business once the controlling interest is sold to an EOT. The driving reason for the EOT establishment will make or break an HMRC tax clearance application. 

What is the anti-avoidance provision that clearance is sought for, and why is it so important for an EOT? 

The anti-avoidance provision that applies here is called ‘transaction in securities’, and it potentially applies as the share sale by the shareholder(s) can be seen as a “disguised distribution”. Thus, getting clearance for an EOT transaction is important to ensure the provision doesn’t apply. 

Why is it important? 

It is important as it avoids any potential argument over the profit and loss account reserves, which could otherwise have been paid as a dividend.

For example, if a company with small retail shops has recently sold 9 out of 10 shops, and with the one remaining trading shop applied for clearance to sell shares to an EOT, it would probably not get clearance because the profit made on the sale of the shops could have been distributed as dividends rather than to finance an EOT, with an objective to get 0% CGT. HMRC could see this as an example of tax avoidance that has no main benefit for the company or its employees. 

Whilst the Government encourages companies and their shareholders to consider setting up an EOT through the application of significant tax benefits, advance clearance is recommended before setting up an EOT to ensure the success of the scheme and benefits of the tax reliefs.