Is financial recovery enough to kick-start the "John Lewis economy"?

John Lewis

While most people agreed that the outcome of employee-owned businesses was desirable, there was less clarity on how these ownership structures could be created. This is where Schedule 33 comes in. With effect from 6 April this year, there is a complete exemption from capital gains tax for the sale of a controlling interest in a company into a qualifying employee ownership structure (known as an “employee-ownership trust”, or “EOT”).

The essential elements of an EOT are that it must:
• own at least 50% of the equity in the company; and
• distribute benefits on an egalitarian basis, e.g. equally to all employees or in proportion to salary.

Schedule 33 will also allow EOTs to pay limited tax-free bonuses to employees from October this year, but in this article we are focusing on the CGT relief that is targeted at individuals who own private companies. Typically, these might be owner-managers who have built up the business and are now looking at succession issues and the need to create financial security for their family and/or retirement. The question is whether the 100% CGT exemption is enough to make a sale to an EOT a viable option.

The Government recognises that a sale to an EOT probably won’t achieve the same price as a sale to the highest bidder, but hopes the CGT exemption will make up the difference. That might be realistic for individuals who expect to pay CGT at the higher rate of 28%, but most people who might sell shares to an EOT would qualify for the entrepreneurs’ relief rate of CGT of 10%.

Part of the problem is that it would be very difficult to finance an outright sale of a company to an EOT. The only collateral that could be offered would be the company’s own assets and that would be unlikely to be sufficient to borrow an amount equal to the full value of the business. The owner/manager could make up the difference by effectively deferring part of the purchase price, but that would somewhat defeat the original objective of creating financial security and trigger some of the anti-tax avoidance rules in Schedule 33. In any case, attempting to finance the acquisition of control by an EOT would result in the ownership structure becoming highly geared – hardly the sort of outcome that promotes stability for the company and its employees.

These difficulties mean that EOTs are unlikely to become a mainstream exit strategy for owner/managers. However, they will certainly be of interest where an owner/manager already has considerable wealth and has a strong desire to benefit and empower the company’s workforce.

The conclusion that the new CGT relief will have a limited impact may sound disappointing, but the Government is minding the pennies and has a very limited budget for its employee ownership initiatives. Indeed, the new relief may be withdrawn if it becomes too expensive. In the meantime, the Government is promoting its underlying policy of creating employee-owned businesses through a more realistic route, focusing on employee-owned spin-outs from public sector employers.

Meanwhile, in the private sector we may see a more gradual approach to introducing employee ownership, involving a combination of sales of shares into an employee ownership structure combined with more targeted equity incentives for the senior management. The new CGT relief might still be used in this scenario, but would only cover part of the overall process. This approach will be attractive to owner/managers who want to avoid the finality of a trade sale or private equity-backed management buy-out, but still want to plan for the future. However, in the past HMRC has often applied anti-tax avoidance legislation to controlling shareholders who sell their shares a few at a time, so careful planning is needed, and it remains to be seen how accommodating HMRC will now be to this approach.

Lawrence Green is a consultant advising on employee share ownership at global law firm Squire Sanders.

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