Employee Benefit Trusts - Triple tax benefits
Following on from our article on Share buy-backs last month we now look at how Employee Benefit Trusts (EBTs) can be used to help shareholders realise value for their shares before an exit.
If the shareholder sells back to the company this may result in the whole of the value of the shares in excess of their nominal value being treated as a taxable dividend instead of a Capital Gain. This may happen if the shares have been held for less than five years, if the reduction in shareholding does not meet certain tests, or if HMRC suspects tax avoidance. For shareholdings in excess of 5% this can mean the difference between a tax rate of just 10% (with the benefit of Entrepreneurs' Relief) or as much as 42.5%.
In private companies, shareholders are often members of the management team. When shareholder directors step down, there are usually new managers to take their place and it may well be appropriate for them to be incentivised through an interest in the company's share capital. But typically, these executives cannot afford to purchase significant shareholdings, and if the shares are gifted to them they will pay income tax on the whole value.
A trust-based solution
A viable solution can often be found using an employee benefit trust. In outline this works as follows:
- The company provides funds to the trustees. Alternatively, if the company is non-close it can underwrite borrowing by the trust from a bank or other third party.
- The trustees use these funds to acquire shares from the retiring shareholder on arms' length terms. The selling shareholder should be liable only to capital gains tax on the sale of the shares. Capital Gains Tax (CGT) rates are much more favourable than income tax or dividend rates. And for shareholdings of more than 5% (carrying at least 5% of the vote) the effective rate is only 10% on the first £10m of gains.
- The shares can then be used for the purposes of an employee share scheme. If established under a government sponsored scheme such as the Enterprise Management Incentive (EMI) or the Share Incentive Plan (SIP), the incentives will themselves be taxed at low rates (or possibly escape tax altogether).
Triple tax benefits
In the right circumstances, these arrangements can produce three-fold tax benefits. A tax-efficient result is achieved for the selling shareholder, since the proceeds should attract favourable capital gains tax treatment. The employees will benefit from favourable tax treatment on the gains realised from their equity incentives. And the company will also receive full Corporation Tax Relief on the employee benefits when these are crystallised.
Entire companies can be transferred into employee ownership over time. Although whole-company transfers are still rare, they can be attractive to proprietors who seek genuine continuity in the business whilst receiving value for their shareholdings.
A sale of shares into trust should take place on arm's length terms since otherwise some of the tax benefits may be lost. HM Revenue & Customs generally attaches much lower values to private company shares than to quoted shares on the grounds that private company shares cannot be traded. If the sale has taken place at a price higher than HM Revenue & Customs consider fair they may seek to assess the difference to income tax. However if an employee trust has been established this can also be used to create an internal market in the shares that is, the opportunity for employees to realise value for their shares in the same way as the selling shareholder. The existence of an internal market removes part of the justification for discounting the value of private company shares and can therefore result in a higher value to the selling shareholder.
New legislation brought in by the Finance Act 2011 has placed some restrictions on Employee Benefit Trusts. In general, however, these restrictions are designed to reduce tax avoidance and the arrangements described above, if properly implemented, should not be affected. And the use of employee trusts is not limited to internal share transfers. They can also play a valuable part in planning equity incentives following a trade sale or management buy-out.
To discuss anything in this article further please call us on 020 8949 5522 and ask for Liz Hunter.