Misunderstanding the Employee Benefit Trust
Many of our private company clients operate Employee Benefit Trusts (EBTs) as these can be a very useful way of warehousing shares for use in employee share schemes. An EBT can also provide an internal marketplace, particularly for leavers to sell shares back to the EBT for “recycling”.
However, care needs to be taken when establishing or operating EBTs, as demonstrated in a recent case that looked at three separate EBT arrangements, all with similar issues.
The cases referred to companies using EBT arrangements before significant changes in the tax legislation relating to EBTs, but many of the principles discussed remain relevant.
Issue 1: Consider who will benefit under the EBT
It’s not strictly true that a discretionary EBT can only benefit employees – but if the EBT is used to benefit certain people that don’t fall into the usual class of beneficiaries, the outcome may not be what was initially expected, particularly from a tax perspective.
Praze Consultants Limited (“Praze”) established an EBT in November 1999, supposedly to operate a “commercial executive incentive program”. The EBT was intended to benefit employees and consultants of the Company. The Company’s two founder shareholders were excluded from benefiting under the EBT. In total, Praze contributed over £2.5m to the EBT and distributed around £77,000 to employees and consultants.
In March 2000, two subtrusts were established. Each was for the benefit of the widows and surviving children of one of the founders. The subtrusts together were entitled to 100% of the original trust fund.
Not unreasonably, the judge concluded that contributions made to the EBT by the Company were “ostensibly not available to provide benefits to employees … generally”, given that 100% of the trust property was earmarked for the original directors’ families and descendants.
The outcome was that no corporation tax deduction was available for the contributions made to the EBT by the Company (other than the £77,000 noted above).
Issue 2: Consider the purpose of payments to the EBT
The companies in question were seeking a corporation tax deduction for payments made to the EBT. This was at the time permissible, provided that the payments were made “wholly and exclusively for the purposes of [the Company’s] trade”.
Always Sheet Metal Ltd established an EBT in 1998. Two founder shareholders held 50% each of the Company’s shares, and both were excluded from benefiting under the EBT. Shortly after the EBT was set up, two further sub-trusts were created, each relating to 45% of the trust fund, and each established for the benefit of family members of one of the shareholders. Only 10% of the trust fund, therefore, could ever have been used to benefit employees of the Company.
The founders argued that the EBT was established to promote employee loyalty and thus to benefit the Company’ s trade. The judge, however, thought that the difference between the amounts paid out to the sub-trusts (a total of £490,000), and those made for the benefit of employees (a total of £7,620) was “simply too large to be credible”- he could not accept that the company would have made such large payments simply to obtain a “nebulous benefit in the form of possible increased employee loyalty”. In any case, 90% of the amounts contributed to the EBT could not have been used to benefit the employees anyway.
The judge concluded that the payments made to the EBT were not exclusively for the Company’s trade, but that the Company had additional objects in mind – specifically, the obtaining of a tax benefit.
The Company was permitted to obtain a corporation tax deduction in relation to payments made for the benefit of employees, but not for the remaining amount.
Issue 3: Accurately recording the arrangements
In all of the cases, the Company directors seem, not unreasonably, to have relied on the guidance given to them by their advisors. However, in some cases there seems to have been a limited understanding of the arrangements being entered into.
Unfortunately, particularly when entering into arrangements where tax advantages may be obtained, it is crucial that company directors understand the purpose and intention behind such arrangements. This includes reviewing and checking the formal documentation, including board minutes, which should accurately reflect the true purpose behind the Company’s actions.
For example, when making payments to the EBT, J C McCahill Limited (JCM) recorded its decision and the reason for its decision in Board minutes, which typically included the following wording:
“The Chairman noted that the establishment of the Scheme and past bonus receipts from it appeared to be promoting employee loyalty to the Company and that the trade of the Company is thereby being benefited."
The judge had previously concluded that the purpose of the trust was not wholly and exclusively for the Company’s trade, but that additional objects lay behind the establishment of the trust (i.e., the obtaining of a tax benefit). His view was that the board minutes had therefore been drafted to give “a misleading impression” of the Company’s true objects.
JCM argued that they had been using standard board minutes provided by their advisors. The judge recognised that it is perfectly valid for advisors to prepare board minutes for their clients in this way but also noted that, once the directors had signed the minutes, they adopted them “as their own”. The board minutes could not be relied upon as a demonstration of the Company’s true purpose.
EBTs and employee share schemes
The EBTs noted above were, in the opinion of the Tribunal Judge, established not to benefit employees but to obtain a tax advantage. It should not be assumed that EBTs are always established with this in mind, and changes in tax legislation have gone a long way to shut down such arrangements. RM2 can assist companies in establishing EBTs as part of legitimate employee share scheme arrangements, including tax-advantaged Share Incentive Plan trusts, if we believe that the existence of a trust is appropriate for your requirements. We can also act as an independent trustee to ensure that the trust is used for its correct purpose and all actions taken by the trust are valid, given appropriate consideration and recorded appropriately.
For more information about our trustee services, please contact firstname.lastname@example.org or call to speak to one of our advisers on 020 8949 5522.