Employee Ownership Trusts (EOTs): are funding contributions taxable?

Some payments that EOTs receive from companies they control could, based on current rates, potentially be subject to income tax at 39.35 percent. This article summarises the conditions that must be met for EOTs to qualify for a targeted new relief from such charges, and what steps trustees and the companies they control could take to determine whether tax charges might have arisen in the past.

An EOT is a special type of trust that holds a controlling interest in a company for the benefit of that company’s employees.

EOTs offer significant tax advantages to encourage indirect employee ownership.For example, provided certain conditions are met, a sale of shares to an EOT in the tax year in which it acquires its controlling interest in the company is free of capital gains tax (CGT).

EOTs don’t usually have funds to pay for the shares they acquire from exiting shareholders, in full, on acquisition. EOT share acquisitions are therefore often on deferred payment terms, financed by third party loans, or funded by a combination of these two methods, with payment of the outstanding purchase price and/or the loan funded over time by payments to the EOT from the company it controls.

Obtaining comfort that such payments to an EOT would not be subject to income tax in the trustees’ hands as distributions (i.e. like dividends) has been the subject of routine applications to HMRC for non-statutory business clearance, given the significance of such payments to the success of EOT transitions.

However, following their consultation on EOT taxation, HMRC stated that “the Government now recognises that the better reading of the legislation is that [such] payments [to EOTs] are distributions”, and so potentially subject to income tax in the trustees’ hands at the dividend trust rate (currently 39.35 percent).

In practice, where income tax charges arise in an EOT, these would need to be funded by the company it controls, potentially increasing the cost of moving to indirect employee ownership through EOTs.

To avoid these potential income tax charges discouraging the use of EOTs, the Finance Bill will introduce a targeted new tax relief for EOT trustees. Representations have been made in respect of the new relief, but its introduction to “ensure that income tax is not charged on such contributions as distributions” is welcome, especially as it should remove the need for clearance in most cases involving such funding of EOTs.

Provided certain conditions are met, when calculating their income tax liabilities trustees can deduct the following amounts from payments made to EOTs on or after 30 October 2024 that would otherwise potentially be taxed as distributions:

• The consideration paid to acquire the EOT’s shares (including the repayment of any loans obtained to fund the acquisition);
• Any associated Stamp Duty or Stamp Duty Reserve Tax;
• Any reasonable interest payable to the vendors in respect of deferred payment for the shares;
• The cost of any valuation exercise undertaken; and
• Any other reasonable expenses incurred by the EOT directly connected with the acquisition (but not the subsequent ownership) of the shares.

The conditions for this relief include that the sale of the relevant shares to the EOT met the requirements to be a CGT free disposal for the vendors. For disposals to an EOT on or after 30 October 2024, these requirements include that the trustees took all reasonable steps to secure that the price they paid did not exceed the shares’ market value, and that any interest payable to the vendors is reasonable.

Trustees must make a claim for the new income tax relief in their tax return (i.e. relief is not automatic where the conditions are met).

Before they clarified their view that relevant payments to an EOT are taxable as distributions, HMRC routinely gave non-statutory business clearances that such payments would not be taxed. HMRC have confirmed they will honour any such clearances (presumably subject to the usual caveats that the disclosures in the clearance application must have been complete and correct, and that the arrangements were implemented as described).

HMRC have also stated that they will not pursue income tax on relevant payments to EOTs before 30 October 2024 which were not covered by an HMRC clearance if:

• The payments were to be used to meet ‘corresponding liabilities’ on the acquisition of the relevant shares; and
• The consideration paid for the shares did not exceed their market value.

Some uncertainties remain concerning how the new income tax relief will operate, for example:

• What will HMRC regard as ‘other reasonable expenses’ that are eligible for relief as ‘directly connected’ with the share acquisition?; and
• How can trustees evidence that they took all reasonable steps to ensure they have not overpaid for the relevant shares?

However, HMRC are expected to publish new guidance over the coming months on how the new income tax relief – and other changes to the EOT legislation announced at the Autumn Budget – will work in practice. EOT trustees and companies should consider HMRC’s guidance on publication to confirm what impact, if any, the new rules will have for the trustees’ income tax liabilities and the overall cost of funding the EOT.

In the meantime, EOT trustees and companies should review their current funding arrangements – particularly any payments to EOTs before 30 October 2024 – to confirm whether any payments could give rise to unexpected income tax changes. Specific points to consider include how, if required, EOT trustees might satisfy HMRC that the price paid for the relevant shares did not exceed their market value (as the new relief includes a specific deduction for valuation costs HMRC might expect trustees to take independent specialist advice) and that any interest paid to vendors is reasonable. The coverage of any HMRC clearances obtained before the new relief was introduced should also be considered.

KPMG’s multidisciplinary team of tax, legal, and valuation professionals can advise vendor shareholders and trustees on all aspects of transitioning a company to employee ownership through an EOT. Please contact the authors or your usual KPMG in the UK contact, to talk through what these changes might mean for you.

For further information please contact:

• Hannah Barraclough
• Paula Hargaden