“Exits” from Employee Ownership Trusts

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Fieldfisher LLP

Fieldfisher is a law firm with extensive experience in supporting organisations, and their owners and stakeholders, as they seek genuine alternatives to traditional business structures. Our work has focused particularly on creating and sustaining employee ownership solutions, and our employee ownership specialists have been at the forefront of the drive to make employee ownership mainstream in the UK and elsewhere for over 30 years.

Cwmpas

Cwmpas is a development agency working for positive change, in Wales and across the UK. Our economy and society could – and should – work in the interests of people and the planet. Established in 1982 as the Wales Co-operative Centre, at Cwmpas we’ve made it our mission to change the way our economy and society works. We have been supporting employee ownership in Wales for over 25 years.

This article is authored by Jennifer Martin with content and editing input from Mark Gearing and Professor Paul Cantrill. Jennifer is a former member of the Employee Ownership team at Fieldfisher and, until the end of 2023, was involved in advising EOT-owned companies since the “employee ownership trust” was introduced in 2014. Mark Gearing is co-head of the Fieldfisher Employee Ownership Team and Professor Paul Cantrill is a business consultant at Cwmpas, specialising in employee ownership.

Introduction

Since the introduction of "employee ownership trusts" (EOTs) to the UK in 2014, the employee ownership (EO) sector has seen exponential growth with many more company owners choosing to transfer their businesses into employee trust-ownership. As advisers to the EO community, Fieldfisher and Cwmpas have seen this growth first hand as an ever increasing number of companies approach us to support their transitions.

This article is the third in a series of articles published jointly by Fieldfisher and Cwmpas; the first covers "qualifying" bonuses for EOT-owned companies and the second focuses on hybrid structures for EOT-controlled companies.  Despite there being a variety of good reasons for a company to become EOT-owned, there are also circumstances where it is appropriate for a company to come out of EOT-ownership. This third article in our series looks at the likely role for the main parties to an EOT “exit” transaction, with the aim of ensuring that a decision to sell a company out of EOT ownership is made for the right reasons.

EOTs were introduced in 2014 with their associated tax incentives: (i) a capital gains tax (CGT) exemption on qualifying sales of shares to an EOT; and (ii) an income tax exemption for qualifying bonuses paid to employees of EOT-owned companies. These incentives were introduced by the Government to encourage companies to introduce employee ownership for the long-term; ownership by an EOT is intended to provide a stable and sustainable ownership structure which maintains the independence of the business into the future.

The statutory rules relating to EOTs are unchanged from their original iteration, although the Government has recently carried out a consultation exercise which is widely expected to result in certain changes to the current rules. The Government response to the consultation is awaited and expected to be published later this year, and we plan to comment on the outcomes once they are available.

EOTs should not be established to acquire companies where understandings or arrangements for a subsequent “reversal” of the EOT structure are already in place; however, it may be necessary for the original planning to be “unwound” later if this is necessary following a change in the company's circumstances and to preserve the longevity of the business for the benefit of the employees.

What is an EOT “exit” and what are the tax implications?

In order to qualify for the CGT relief on a sale of shares to an EOT, individual shareholders must sell a sufficient number of shares for the EOT to gain control; this can be anything from 50.01% to 100%. Typically, a corporate trustee company (the Trustee) will be established to act as trustee of the EOT and this company will have its own board of directors. If the statutory conditions for CGT relief are met, the transfer of shares from the (former) shareholders to the EOT takes place on a “no gain, no loss” basis; this means that the original base cost of the shares (which is usually low) is effectively rolled over to the EOT.

The CGT relief is only intended to be available to the original sellers, so if there is a later “exit” where the EOT sells the shares it acquired onto someone else, CGT is due in connection with that sale. If the sale/disposal takes place in the “clawback” period*, the original CGT relief for the former shareholders is not available; if the sale/disposal takes place after the end of the clawback period, the CGT liability falls to the trustee of the EOT (on the difference between the base cost in the shares it inherits from the sellers and the disposal price). This is assuming that the Trustee is a UK trustee.

The payment of CGT need not necessarily be a barrier to an EOT exit, but it does need to be properly calculated and considered as part of the decision making process, particularly by the Trustee (see further below).

*The “clawback period” ends on 5 April of the tax year following the tax year in which the transfer to EOT-ownership took place; so it is a period of up to two years. If, for example, the transaction takes place any time between 6 April 2024 and 5 April 2025, the clawback period will end on 5 April 2026. If the EOT-owned company is sold out of EOT-ownership before the end of this period, the original sellers are no longer entitled to the CGT relief claimed (or yet to be claimed). If the “exit” takes place from 6 April 2026 onwards, the CGT liability falls on the Trustee.

Why might an EOT exit be considered?

Despite the intentions of the original parties to become an EOT-owned company and remain so, there are a number of possible reasons why this situation might not be maintained forever – these include:

• offer made for the company which values the business far in excess of the original acquisition cost by the Trustee;
• market conditions change such that it becomes difficult to operate the business as an independent enterprise with limited sources of external capital;
• the business fails to thrive under EOT-ownership;
• opportunities for growth or international expansion are not available whilst the company is under EOT-ownership; or
• there are other strategic reasons to pursue an exit opportunity.

It is important to stress that the decision to sell a business out of an EOT is not a decision which should be taken lightly. However, ultimately, it may be in the best interests of the employees (as beneficiaries of the EOT) for the Trustee to sell and this decision should be taken with as much care and consideration as was no doubt given to transferring the business to EOT-ownership in the first place. This will help to ensure that it is robust, that any opportunity for challenge is minimised and, above all, that the interests of the beneficiaries of the EOT are fully considered and protected.

Parties to an EOT exit

1.          The Trustee

The Trustee, acting by its directors (the Trustee Directors), has the most important role in an exit transaction; it is the legal owner of the shares held in the EOT and so only it can make the ultimate decision to sell those shares. There are a number of important issues for the Trustee Directors to consider, including (but not limited to):

• does the Trustee require legal advice? Almost certainly the answer to this question will be yes, although retained advisers for the company may be able to switch their engagement to the Trustee;
• does the Trustee require independent tax, valuation or commercial advice? This will likely depend on the circumstances of the proposed sale and also on the expertise of the Trustee Directors and what advice the company has already received (and is able to share);
• before selling the shares in the EOT, the Trustee Directors must ultimately decide that this is in the interests of the company's employees (as beneficiaries of the EOT). The Trustee Directors must equip themselves with sufficient information to be able to consider this decision. This might include: (i) clarifying who is in the class of beneficiaries; (ii) understanding the proposed valuation for the business; (iii) understanding the identity of the buyer, together with their plans for the acquired business and its employees; and (iv) considering the pros and cons of any available alternatives to a company sale;
• what liabilities arise in connection with the proposed sale? Have these been calculated with sufficient accuracy to ensure the economics of the proposed sale have been fully considered? Liabilities could include: (i) CGT (likely from a very low base cost); (ii) remaining purchase price payments due to former shareholders; and (iii) costs of sale (e.g. professional fees);
• what are the terms on which the shares are sold? Will the Trustee be required to give warranties to the buyer as part of the transaction? Will the Trustee receive all the sale proceeds on completion, or will some be deferred or subject to an earn-out?
• if, following the sale and after payments of liabilities, there is likely to be excess cash available in the EOT, how will this be distributed in accordance with the terms of the EOT;
• in accordance with the constitutional documents relating to the EOT and the company, are any consents required (e.g. from employees) or is there any consultation process to be followed? Are there any barriers to sale in any relevant documents?; and
• consider and confirm any “post-completion” obligations of the Trustee, including agreeing with the Buyer who the Trustee Directors will comprise and agreeing who will have responsibility for ensuring that the EOT is wound down after all liabilities are paid.

If (as we would always recommend), the Trustee Directors comprise a mix of former owners/management, employees and an independent individual, the views of each constituency potentially affected by the exit will be better represented. The role of the independent Trustee Director plays a particularly key role in an exit scenario because that individual will often be the only Trustee Director who does not have a personal interest in the outcome of the proposed transaction.

The Trustee will be heavily reliant on both the company and the prospective buyer entity to provide all relevant information required for the decision making process; with the benefit of appropriate professional advice, the Trustee Directors should ensure that they gather all necessary information to ensure that they each comply with both: (i) their statutory duties as directors of the Trustee; and (ii) their fiduciary duties under trust law. It will be vital to document the decision-making process in detail, including any decisions with respect to distributions from the EOT, in order to ensure that all relevant duties are discharged and documented. This should be done with the benefit of independent professional advice.

2.          The Company

The role of the “target” company, acting by its directors, will depend to some extent on how the exit opportunity has come about. As for a public company takeover, the proposal to exit may have been initiated by the board and taken to its shareholder(s) (i.e. the EOT and any other individual shareholders). In particular if this is the case, the main role of the company board will be to:

• assist with any due diligence exercise carried out by the proposed buyer;
• ensure that the Trustee has sufficient information in order to be able to fully consider the proposed sale and ultimately decide whether or not to sell the company out of the EOT;
• liaise with the Trustee to assist with proposing any distribution mechanism for excess sale proceeds (in particular in relation to employee details such as salary and length of service); and
• assist with any practical obligations such as ensuring that any employer’s national insurance contribution liabilities arising in connection with any employee distributions from the EOT are paid.

3.          The Buyer

The proposed buyer of an EOT-owned business will want to ensure that:

• there are no potential income tax liabilities associated with the payment of historic income tax free bonuses;
• a decision is taken as to who will have responsibility for ensuring the EOT settles its liabilities and is wound down after completion; and
• it has input into the methodology for making any distributions from the EOT to employees.

The identity of the proposed buyer is also likely to have a bearing on the process and outcome of a proposed EOT-exit transaction. If, for example, the buyer is itself an EOT-owned company, it will have different considerations than a privately owned trade buyer, a corporate group company or a private equity buyer. A full discussion on these considerations is outside of the scope of this article, although where two EOT-owned companies are looking at some kind of acquisition or “merger” it would be sensible for both companies and their advisors to consider together how best to “combine” both entities, taking into account their respective ownership structures, business attributes and possible tax liabilities.

Ultimately, the sale of a company out of an EOT may be the best commercial outcome for the parties and in many ways such a transaction will play out in the same way as any other corporate sale/acquisition. However, it is also important to understand the unique issues and challenges for a sale transaction involving an EOT.

For more information on how Fieldfisher and Cwmpas can assist with the sale of companies out of an EOT or any other proposed re-structuring or proposed transaction involving an EOT, please get in touch using the contact details below.

Note: The information contained in this article is not intended to, nor does it, constitute legal, tax or other professional advice or services. The contents of this article is provided on an information basis only and should not be relied upon. If you need advice or services on a specific matter, please contact us.