The 0% Capital Gains Tax (CGT) relief available on qualifying Employee Ownership Trust (EOT) transactions represents one of the most attractive tax incentives currently available to UK business owners. However, this significant benefit comes with strict qualifying conditions that must be met not only at the point of sale but maintained for a considerable period thereafter. Following the October 2024 Budget, several changes have been introduced that business owners should consider when planning an EOT transition. Importantly, these changes represent a modest tightening of rules that will only affect a tiny percentage of EOTs which were pushing the boundaries of the relief. In fact, the preservation of the core EOT tax benefits in the Budget demonstrates the long-term, cross-party commitment to employee ownership in the UK. This article examines the key requirements for EOT qualification, highlights the recent legislative refinements, and outlines practical strategies to ensure your transaction remains compliant.
Understanding the EOT Tax Relief Framework: October 2024 Budget Updates
The EOT legislation introduced in the Finance Act 2014 offers business owners the opportunity to sell their shares free from CGT. While the 0% CGT rate for qualifying EOT disposals survived the October 2024 Budget intact (despite increases in CGT rates elsewhere), Chancellor Rachel Reeves introduced several refinements that take effect for EOT disposals on or after 30th October 2024.
The core qualifying conditions remain unchanged:
- The company must be a trading company or the parent company of a trading group
- The EOT must acquire a controlling interest (more than 50%) in the company
- The EOT must benefit all eligible employees on an equal basis
- The number of continuing shareholders who are directors or employees (and connected persons) must not exceed 40% of the total employees (the “Limited Participation Requirement”)
- The EOT must be established for the benefit of all employees
The new requirements largely codify existing best practice and will primarily affect only those arrangements that were pushing at the boundaries of the relief:
1. Trustee Independence Requirement Only a minority of EOT trustees can now be former owners or persons connected with them. This prevents sellers from controlling the EOT either directly or indirectly after the sale. Most well-structured EOTs already follow this approach to ensure genuine employee ownership.
2. UK Residency Requirement The trustees of an EOT must be UK resident. This has always been best practice (particularly to allow UK employees representation on the trustee board) and simply formalises what the vast majority of EOTs already do.
3. Extended Clawback Period Previously, if the EOT sold the business after one full tax year had elapsed since the original sale, no clawback of CGT relief would apply to the original sellers. The new rules extend this clawback period to four full tax years. This change targets quick “flip” transactions that weren’t aligned with the spirit of creating sustained employee ownership.
4. Formal Valuation Requirement Trustees must now take “reasonable steps” to ensure that the consideration paid for the company’s shares does not exceed market value. This effectively mandates obtaining a formal valuation from an adviser with relevant expertise, which reputable EOT advisers have always recommended.
5. Enhanced Self-Assessment Reporting For sales from 6th April 2024, sellers must provide additional information in their tax returns, including details of the sale proceeds and the number of company employees at the time of the EOT disposal. This represents a modest administrative change rather than a substantive restriction.
These measured adjustments demonstrate the government’s commitment to preserving the EOT regime while ensuring it operates as intended. For businesses approaching employee ownership in the right spirit, these changes will have minimal practical impact.
Critical Qualification Pitfalls and How to Avoid Them
The Trading Company Requirement
HMRC defines a trading company as one that carries on trading activities and does not carry on non-trading activities to a substantial extent. “Substantial” in this context generally means more than 20% of the company’s activities.
Potential Pitfall: Companies with significant property holdings, large cash reserves, or investment activities may fail this test.
Safeguarding Strategy:
- Conduct a pre-transaction review of the company’s balance sheet and activities
- Consider demerging non-trading assets before the EOT transaction
- Document the business rationale for significant cash holdings
- Implement a treasury policy that aligns with trading requirements
The Controlling Interest Requirement
The EOT must acquire a controlling interest in the company, which means more than 50% of the ordinary share capital and voting rights, and a right to more than 50% of profits available for distribution and assets on winding up.
Potential Pitfall: Complex share structures with multiple share classes can inadvertently prevent the EOT from acquiring the necessary controlling interest.
Safeguarding Strategy:
- Undertake a comprehensive review of the company’s articles and any shareholders’ agreements
- Simplify the share structure before the EOT transaction if necessary
- Ensure voting rights align with economic rights
- Consider the impact of any retained shares by selling shareholders
The All-Employee Benefit Requirement
The EOT must benefit all eligible employees on the same terms, although benefits can be varied according to remuneration, length of service, and hours worked.
Potential Pitfall: Excluding certain categories of employees or creating preferential benefits for management.
Safeguarding Strategy:
- Clearly define “eligible employees” in the trust deed
- Ensure any differentiation in benefits is based only on the permitted factors
- Document the rationale for any employee exclusions (e.g., minimum service requirements)
- Establish clear policies for benefit distributions
The Limited Participation Requirement
Perhaps the most complex condition, this requires that the number of “participators” (broadly, 5%+ shareholders) and persons connected to them who are directors or employees must not exceed 40% of the total employees.
Potential Pitfall: Family businesses often fall foul of this requirement due to the wide definition of “connected persons,” which includes spouses, civil partners, children, parents, and even more distant relatives in certain circumstances.
Safeguarding Strategy:
- Maintain detailed records of family relationships within the business
- Consider the impact of any planned recruitment, particularly of family members
- Regularly monitor the participator fraction, especially after the transaction
- Structure share ownership pre-transaction to minimize the number of participators
Post-Transaction Compliance: Maintaining Qualification
Securing tax relief at the point of sale is only half the battle. The conditions must continue to be met during a specified period after the transaction to avoid a clawback of the tax relief.
The Critical Post-Sale Period
Following the October 2024 Budget changes, the period during which conditions must be maintained has been significantly extended.
Pre-Budget Position: For transactions completed before 30th October 2024, the EOT must continue to meet the qualifying conditions until the end of the tax year following the tax year in which the disposal occurred.
Post-Budget Position: For transactions completed on or after 30th October 2024, the clawback period is extended to four full tax years instead of one.
Practical Example:
- A company completing an EOT transaction in November 2024 (tax year 2024/25) must maintain qualifying conditions until 5 April 2029 (the end of the 2028/29 tax year).
- This represents a substantial extension of the compliance period and necessitates more robust long-term planning.
It’s worth noting that even after this extended period, EOT trustees will be liable for CGT on any subsequent sale of the business, but the original sellers will retain their relief.
Key Compliance Strategies
- Regular Monitoring of the Participator Fraction
- Schedule quarterly reviews of the employee population
- Assess the impact of any staff changes on the participator fraction
- Document compliance at each review point
- Trading Status Protection
- Implement investment policies that align with trading requirements
- Regularly review balance sheet composition
- Document the business purpose of significant cash holdings
- Share Scheme Design
- Carefully design any post-transaction share incentives
- Consider the impact of option grants on the participator fraction
- Avoid creating new share classes that could undermine EOT control
- Governance Structures
- Establish a trustee board with appropriate expertise
- Create clear reporting processes between the company and trustee
- Implement compliance checklists for key decision points
