Employee Ownership Trusts and the Entrepreneur

Tax exemption and employee participation

Which entrepreneur wouldn’t want to sell his or her company at full value, tax free? And even better, without having to find the buyer and negotiate a deal? That is the tantalising prospect if you consider selling your company to an employee-ownership trust (EOT). I recently completed Excello Law’s latest such deal for CDY Ceiling and Partitions Ltd, based in Hull.

The special tax rules were introduced in 2014 to encourage employee ownership, on the John Lewis model. Previous tax reliefs helped business owners to give their company to employees, but there were not many owners willing and able to be so generous. Now the rules allow a sale to an EOT at a full price, funded from the assets and future cashflow of the company. The seller pays no capital gains tax at all on the sale.

What’s not to like? Some of the advantages of selling to an EOT are:

• The CGT exemption.
• The ability to set the price, so long as it is not more than market value, based on valuation.
• No hard-nosed negotiation with a trade buyer or institutional investor over price or warranties and indemnities, saving time and professional costs.
• Deferred payment to match the company’s free cashflow.
• The sellers can stay as directors and keep management control while they are paid out.
• The sellers can retain shares, so long as the EOT has control.
• Employees do not own shares directly and do not have to be paid out if they leave. They do not have to be given a voice in management.
• Improved engagement and incentives for the workforce.
• Income tax free bonuses can be paid to employees of EOT-owned companies of up to £3,600 per person per tax year.
• An EOT can suit even small companies with modest workforces.

There are some possible downsides, depending on circumstances:

• The need to find trustees for the EOT. If professional trustees are used, they will need to be paid and can be costly. Trustees have heavy legal responsibilities and should usually have liability insurance.
• Trustees have to act in the interests of the employees. They may want to negotiate the terms of the sale, even if it is funded entirely by the company. Trustees should have separate legal advice. There may be tensions between the sellers, the trustees, the management and the workforce. There can be conflicts of interests and each group needs to understand its legal responsibilities.
• If the trust is UK resident, the trustees will pay capital gains tax on any future sale of the company, calculated on the original sellers’ base cost. So the tax on the gain has only been deferred, not avoided. Worse, if the sellers would have qualified for business asset disposal relief (the 10% effective rate of CGT) the trustees will be paying CGT at a much higher rate. If it likely that the trustees will eventually seek an exit, an offshore trust should be used – but that may be much more expensive than UK resident trustees.
• Management succession and long-term strategy may suffer. The sellers may be primarily focussed on paying out the deferred price for their shares, and may then retire, or lose interest. External funding may be harder to obtain through borrowing or equity investment.
• If the price is set high, the trustees may struggle to justify the EOT as benefitting employees, or to deliver any actual benefit to them. At least in the early years, any money available is likely to go to fund the purchase price.
• The sellers depend on the future prosperity of the company to enable it to fund the instalments of the sale price. If it does not perform, they could lose their money or have to extend the payment schedule.
• If the sellers retain a shareholding, or management are given equity, they may not be able to realise its full value if the EOT does not want an exit, and the EOT is the only possible buyer for the minority stake.

My 40 years of legal experience acting both on corporate sales and employee share incentives makes me ideally qualified to advise on EOTs. They provide an attractive alternative to a trade sale, an MBO  or an exchange of equity for debt.

US stock option plans subject to English law?

Courts clash on jurisdiction over employees 

It will come as a great surprise to many international employers that their US stock option plans are subject to the exclusive jurisdiction of European courts, as the plans apply to employees in Europe.

Many American companies offer stock option plans or other share incentives on a global basis, with employees having conditional rights to receive stock in the US holding company, or stock issued by a vehicle created for the purpose in the USA. The stock option plan will be established in a state of the USA and subject to its laws, and may or may not be tailored through sub-plans to meet tax requirements in other countries, such as the Enterprise Management Incentive Scheme in the UK.
Rights are granted under a contract direct between the American entity and the employee. 

The Brussels Regulation (recast) governs the jurisdiction of all courts in the EU to hear cases, and says that an employer may bring proceedings only in the courts of the Member State in which the employee is domiciled. At first glance, the stock plan is not an "individual contract of employment" and the US entity is not the employer, so the special rules for contracts of employment in would not apply. As an English lawyer I have no difficulty with the concept of a separate contract with a third party dealing with stock options or incentives, and I would not consider it to be a contract of employment, or the incentive provider to be an employer. Indeed, in English law it has been held that a share option is not a term of the contract of employment: Micklefield v SAC Technology Ltd [1990] 1 W.L.R. 1002. 

But Samengo-Turner v J & H Marsh & McLennan (Services) Ltd held that words used in EU legislation must be given an autonomous (European) meaning so that each Member State will apply it consistently and not interpret it in accordance with its own national law. The terms of the Brussels Regulation are essentially an employment protection measure, to stop employees being sued anywhere other than than their own home jurisdiction, and the English courts would give effect to that: not only by including any contract relating to employment as an "individual contract of employment" and the benefits provider as an employer, but also by granting an anti-suit injunction preventing the foreign company from taking proceedings in its own country.

In the recent case Petter v EMC Europe Ltd the English Court of Appeal became engaged in an unseemly scramble to establish jurisdiction either in England or in Massachusetts, with both courts being asked to grant injunctions preventing a party from continuing proceedings in the other place. Courts of different countries usually try to respect each other and not fight over jurisdiction, but in this case the Court of Appeal decided it had to grant an injunction effectively overturning the decision of the Massachusetts court, in order to protect the employment rights of UK employees.

A fight over the choice of court is not the end of the matter: an English court will still apply foreign law if that is the law chosen in the contract: the Rome I Regulation on the law applicable to contractual obligations allows the parties to choose the applicable law, even for a contract of employment, and an English court can apply foreign law if presented with evidence of what the foreign law is. However, this is subject to the application of mandatory rules of local law. Whilst the courts of England and Massachusetts should theoretically apply the same laws in reaching their decision, a court in England is likely to give far greater weight to English employment rules such as the duty of trust and confidence between employer and employee, principles of English law banning contractual penalties and granting relief from forfeiture of assets, restrictions on deductions from pay and the requirements for non-compete restrictions not to be unreasonable restrains of trade. The legal environment in the UK is far more friendly to the employee than in the USA, so employees may be very keen indeed to have any litigation heard here.

Another EMI options tax break

Is this the most generous tax relief we have?

Another big boost for EMI share options: the Treasury has relented and will now extend entrepreneurs' relief - the effective 10% rate of CGT - to almost all EMI options. Previously they had said that the employee would have to hold the shares for at least a year - difficult in many schemes.  From April 2013, the relief will be available if the option (rather than the shares) has been held for a year, and the employee has remained employed for that time.

EMI options are almost ludicrously tax-efficient, with an effective negative tax rate. Any company that could be using them probably should be.

Frequently asked questions:

Why was it hard to get the relief previously? Until the 2012 Budget, entrepreneurs' relief was not available unless the employee had held shares amounting to 5% of the company for at least 12 months. Few EMI options amounted to 5%, so most were excluded on that ground alone. But the 2012 budget removed the 5% requirement for EMI options. The 12 month rule remained.

Why was that a problem? Most EMI options are exercised (converted from an option to real shares) only immediately before the shares are sold. There are a number of reasons for this:

• The employee doesn’t have to find or borrow the money to pay the exercise price
• The employee is not at risk of losing money if the value of the shares falls or the company fails
• If there is tax to pay on exercise (usually only if the exercise price was set at below market value at the date of grant) the employee has the money to pay the tax if he has sold the shares – otherwise he may have it deducted from pay under PAYE
• Option exercise can remain subject to conditions being met. Most popular is condition making options exercisable only when the company is sold – which ruled out holding the shares for 12 months
• The company has not issued real shares until shortly before sale, removing all the issues surrounding small employee holdings in private companies – how to buy the shares back if someone leaves, upsetting voting balance, inhibiting owners remunerating themselves by way of dividends…
• Corporation tax relief is maximised: it continues to accrue on the rising value of the shares until the moment before the shares are sold

Until this change, in order to benefit from entrepreneurs’ relief, the employee would have had to exercise his option and get real shares at least a year before sale. If sale was going to be on sale of the company, that meant accurately predicting an exit a year in advance!

Why is there a negative tax rate?

On options granted at market value, there is normally no income tax (or NICs) payable on grant of the option , exercise of the option or sale of the shares. The only tax paid by the employee is CGT on the gain on sale of the shares, to the extent that it exceeds the annual CGT allowance – and the CGT will now usually be at 10%. But the company gets corporation tax relief on the gain[1], even though it has not incurred any cash cost. As the rate of corporation tax is higher than the employee’s effective rate of CGT, the Treasury is paying you!
 

I have been advising companies on employee share incentives for 30 years. If I can help with EMI options or any other kind of share scheme, do get in touch.








Published December 2012
Updated February 2013

 

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[1] Assuming exercise of the option and sale of the shares are at the same value. All tax reliefs mentioned are subject to conditions, and the tax position described is the usual one, but there could be exceptions; always take proper professional advice, ideally from me!

 

 

Trading shares for rights

How will George Osborne’s new share scheme work?

"Workers will be asked to surrender employment rights in return for shares in their company under plans to boost enterprise announced by George Osborne. People who accept the shares will have to waive their rights to redundancy or to sue for unfair dismissal and will not be able to request flexible working hours. The Treasury will not levy capital gains tax when workers sell their shares, which can be worth between £2,000 and £50,000." - Daily Telegraph

 

I don’t wish to enter the political debate on whether employees in small businesses should be able to opt for reduced employment rights, or whether they should have full rights at all. But how would this proposal work on the shares side? I strongly suspect that if it ever sees the light of day, this will be one of those schemes that languishes largely unused – unless it becomes a bonanza for tax avoidance.

 

Of course there are few details available beyond what George Osborne said in his Conference speech. A Government press release adds a couple of points, and promises a consultation, so the promise to “rush through” legislation to be in force by April 2013 looks unlikely to be fulfilled.

So what are the issues that would have to be addressed?

 

·         Under present legislation, the value of the shares (between £2,000 and £50,000 we are told, assuming this means value when they are given) would be immediately charged to income tax, and usually national insurance, when the shares were given. But the new “owner-employee” would have no money to pay the tax, other than his other earnings. Mr Osborne says there will be an exemption from CGT, but doesn’t mention income tax. Will there be an exemption?

 

·         If so, HMRC has been tightening up on employers finding was to confer tax-free benefits on employees, including through employee shares, and this could blow a hole in their strategy. What will stop a senior employee waiving his bonus (and his employment rights) and instead receiving £50,000 in tax-free shares, which he then sells back tax free?

 

·         Further income tax charges can arise if the shares are subject to restrictions or risks of forfeiture. If these rules are waived, further tax planning opportunities open up.

 

·         If the company buys back its own shares within five years of their issue, the gain made by the employee is normally charged to income tax and not CGT, so the promised exemption from CGT looks a bit hollow.

 

·         Most small businesses are very reluctant to part with equity in the company. Minority shareholdings can be a significant brake on the development of the business, especially if they remain after an owner-employee has left and ceases to contribute. But an open-ended commitment to buy shares for cash if an employee leaves would be unaffordable as well as unacceptable. Where is the cash going to come from? Most successful private companies could not easily fund an obligation to buy a significant proportion of their own share value.

 

·         In a start-up micro business the shares are worth very little, so you get an awful lot of shares to make up a minimum market value of £2,000. Entrepreneurs could find they have given away equity that becomes extremely valuable once the business takes off.

 

·         It is an important part of employee share scheme planning to avoid creating incentives for employees to leave. The press release makes it clear that owner-employees must be entitled to full value for their shares and cannot forfeit them as “bad leavers”. This is one of the many attractions of employee management incentive scheme (EMI) options: the employee does not get the shares until their value has been earned.

 

·         Unless a small business is looking for an exit through sale, there will be no visible route for owner-employees to realise their shares except by selling them back to the employer at a valuation. Companies are reluctant to commit to buying shares at someone’s opinion of value. Employee shares can become negative incentives if they fail to grow in value, or if there is no realistic prospect of selling them.

 

 

EMI share options boost

By far the most tax-efficient incentive

EMI share options (the Enterprise Management Incentive scheme) were given a huge boost in the 2012 Budget, and they are by far the most tax-effective incentive available to unquoted companies to reward and incentivise employees. Most importantly for the majority of participants, Entrepreneur’s Relief – an effective 10% rate of capital gains tax – will now apply to options exercised after 6 April 2012. That restores the attractions of the EMI scheme before the abolition of taper relief a few years back. Participants with no other relevant gains could receive up to £10m of gains at a 10% tax rate. The overall tax rate is actually negative: the corporation tax relief, at (say) 22%, exceeds the tax the employee pays at 10%. So the Treasury is actually subsidising the benefit.

The limit on the value of options that can be granted to any one employee is also to be more than doubled, from £120,000 to £250,000. The limit applies to the value of the shares at the date of grant of the option. This change is not yet in force, because it requires EU approval as “state aid”.

As a reminder, EMI options give an employee a right to acquire shares at a future date at a fixed price, often the current market value. The right can be conditional: it can be exercisable only on sale of the company, so that the owners do not lose and control or suffer dilution until an exit. Or it can depend on meeting performance targets. The usual tax treatment will be:

·         No tax of any kind on grant of the option

·         No income tax or NI (including employer’s NI) on exercise of the option, if the option is granted at market value

·         The company gets corporation tax relief (say 22%) on the notional gain made by the employee at the date of exercise, even though the company has paid nothing out

·         When the employee sells the shares he or she pays 10% CGT on the gain above the annual CGT exemption (with Entrepreneur’s Relief).

In most cases exercise of the option, issue of the shares and sale of the shares are more or less simultaneous.

The Office of Tax Simplification recently published recommendations for simplifying employee share schemes, including merger of the CSOP into EMI and the introduction of self-certification instead of HMRC prior approval of scheme rules (which is already the process in EMI schemes, greatly reducing cost). But merging the two could bring restrictions on the current freedom of EMI, so it may be wise grant EMI options before that happens.

With private company share values still low in a depressed M&A market, there has never been a better time to grant EMI options. Anyone about to exercise an option should consider deferring until after 6 April. If your company has granted unapproved options to key staff because you had used the £120,000 EMI limit, it may be worth considering cancelling the unapproved option and re-granting it within EMI, especially if the share price has not increased much – but only after the new rules come into force.

I have been advising on employee share schemes for 30 years. If I can help with EMI schemes, give me a call.

Stephen Hester’s bonus: how not to structure exec remuneration

Tax and bonuses in shares

Sorry if you’re expecting a polemic about the level of bankers’ bonuses. There’s been far too much of that in my view: I have the old-fashioned view that if the Government negotiates a contract it’s probably not a good thing for it to renege on it.

What I wanted to tell you about is the tax treatment of such a bonus, and how smaller companies can do much better. This is an area in which those poor oppressed bankers really have been losing out.

The Government has been keen to see bonuses paid in shares rather than cash, but it has made no tax concessions to encourage it. An employee receiving free shares as a bonus is taxed on their value as if they were cash. Listed company shares are “readily-convertible assets” so the tax has to be paid through the PAYE system, and national insurance is payable. Mr Hester is not allowed to sell his shares, so he will have to find over £500,000 out of his net salary to pay the tax on his £963,000 bonus. On his reported salary of £1.2 million, that will leave him with about £85,000 net [1]. The taxpayer-controlled bank will have to pay national insurance contributions of almost £300,000. So in total for 20011-12 Stephen Hester gets £85,000 and George Osborne gets £1.425 million! RBS does get a corporation tax deduction for the salary, the value of the shares and employer’s NIC (if RBS makes a profit) but the Exchequer still gets £785,000 net.

The position changes, of course, when the shares are eventually sold. If they go down in value, there is no tax to pay, but no credit for the tax already paid. If they halved in value, Mr Hester would make a net of tax loss (the tax paid would be more than the proceeds of sale). If the shares go up, there is no tax on the first £963,000 (on which he has paid tax already) but the profit will be chargeable to capital gains tax. But of course the taxpayer loses out through dilution of the Treasury’s shareholding: if the shares double in value, the bonus will have cost the shareholders twice as much as if they had paid the bonus in cash.

Mr Hester may be able to afford to pay £520,000 of tax and NIC out of other salary and resources, but most employees are not likely to be grateful for a bonus in shares they can’t sell, which lands them with a large tax bill they can’t pay. This makes bonuses in shares very unattractive.

Fortunately private companies have a much better route available to them. We can thank the LibDems (in the 1970’s [2] for starting a range of tax-approved employee share schemes. Best of these now is the Enterprise Management Incentive (EMI) Scheme [3]. Its tax advantages remain amongst the best of any tax relief. Complete exemption of gains from tax or NIC and a full corporation tax deduction for the value of the shares mean the net tax rate is often actually negative!

I have been setting up EMI schemes for private companies for many years. They are wonderfully flexible, and can be structured to avoid diluting owners’ equity until the company is sold. If you would like more details please contact me.

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[1] assuming he uses his allowances and basic rate tax band elsewhere

[2] actually they were still Liberals then

[3] under Schedule 5 of ITEPA 2003