HMRC Plans Restrictions on IHT Benefits of Trusts for UK Employees
HMRC has this summer published proposed measures to limit the use of employee ownership trusts (EOTs) and employee benefit trusts (EBTs) to avoid capital gains tax (CGT) and inheritance tax (IHT).
His Majesty's Revenue & Customs: the national taxing authority of the United Kingdom that collects all direct and indirect taxes and administers benefits and tax credit payments to residents.
Employee Ownership Trust
Employee Benefit Trust
Capital Gains Tax
EOTs and EBTs explained
EBTs are set up for the benefit of employees or officeholders of a company or group of companies. EOTs are a specific type of EBT whereby the trustees own and control the company for the benefit of all of the employees. Both receive favourable tax treatment. HMRC says its proposals are designed to ensure that these advantages will continue to be available when the trusts are being used for their intended policy purpose of encouraging employee engagement in business. The government introduced EOT tax benefits in Finance Act 2014, as a result of the independent Nuttall Review of Employee Ownership, which found that employee-owned companies perform better, are more resilient and open to change and have more committed and engaged employees.
Business owners who dispose of their shares to the trustees of an EOT pay no CGT on the disposal, provided the EOT trustees hold a controlling interest in the company as a result.
Instead, the taxable gain is effectively passed on to the EOT trustees and the charge is deferred until a later sale. Moreover, no IHT charge arises on the transfer of shares to an EOT and the EOT itself is exempt from the IHT relevant property regime.
HMRC says these reliefs have succeeded in encouraging the creation of EOTs. It is understood that the number of employee-owned companies more than doubled to 1,300 in the three-year period to December 2022. It would appear from recent activity that HMRC is now checking compliance.
Trustees concerns and proposals
One of HMRC's concerns is the appointment of trustees. At present, no restrictions are placed on trustee appointments and it is common for company owners to retain some degree of involvement in the company post-sale by appointing themselves as one of the trustees of the EOT. In some cases, they appoint themselves or their associates as the sole or majority trustees of the EOT so that in effect they retain control of the company. HMRC says it is 'questionable' whether such an arrangement delivers meaningful change for the employees of the company.
It is therefore proposing that former owners and persons connected to them should be prevented from retaining control of the EOT, by requiring that they represent less than half of
the trustees of the EOT. Any breach of these conditions after disposal would be a disqualifying event and lead to an immediate CGT charge to the trustees or to the former owner, if within the first year following disposal.
Furthermore, the issue of trustee tax residency is to be addressed. Again, there are currently no conditions regarding the residency status of EOT trustees, so it is possible to establish a non-resident EOT by appointing non-UK-resident trustees, even if the former owner, company and employees are all located in the UK. The trustees of such a trust would not be liable to pay CGT on any subsequent disposal of the target company shares, nor on a deemed disposal were a disqualifying event to occur.
This arrangement could be used to reduce tax, perhaps as part of a predetermined arrangement to dispose of the company to a third party without suffering the CGT that would otherwise be due.
HMRC accepts there may be legitimate reasons for an EOT to have non-UK-resident trustees, but it is proposing to introduce a requirement that the trustees of an EOT be UK-resident as a single body of persons as defined at s.69 of the Taxation of Chargeable Gains Act 1992. This would require that either the trustees of the EOT all be UK-resident or that the trustees be a mix of UK-resident and non-UK-resident and that the former owner was UK-resident or domiciled at the date the shares were disposed of to the EOT. A breach of this condition at any time after the disposal such that a UK-resident EOT becomes non-UK-resident would result in a CGT exit charge under existing provisions.
IHT concerns and proposals
A further proposed measure concerns the IHT treatment of EBTs. An EBT that meets the conditions set out in s.86 of the Inheritance Tax Act 1984 will get relief from IHT relevant property trust charges of up to 6 per cent at each ten year anniversary of the EBT being set up and exit charges on capital distributions from the EBT. Additionally, transfers into an EBT that meet conditions set out at s.28 of the 1984 Act will be exempt from IHT where there is a transfer of shares or securities in a company by an individual. There are similar provisions where the transfer is by a close company and in relation to relevant property trusts. The conditions are intended to ensure that EBTs set up to benefit only those people who are shareholders (participator) in the company, or people connected with those shareholders, do not qualify for this preferential treatment.
However, HMRC has concerns that some EBTs are being used in ways that are not in line with the policy objective: to encourage the use of EBTs in a way that incentivises a wider class of employees. HMRC has seen arrangements where EBTs are set up to meet the conditions set out in the 1984 Act but little or no capital is given to the wider class of employees. These EBTs are set up so that participators or their family members can benefit from income earned by the EBT. The government is consulting on reforming the exemptions to protect against this behaviour and to ensure the tax treatment of EBTs is in line with the original policy intent.
HMRC also considers that individuals connected to a participator cannot benefit for the lifetime of the EBT. However, it has seen cases where the trust deed allows individuals connected to a participator to benefit after the participator's death. It proposes to make it explicit that restrictions on persons connected to the participator benefitting from EBT must apply for the lifetime of the EBT.
Another new anti-avoidance measure would address the case where an individual can set up a company, immediately make a transfer of shares to an EBT and obtain the IHT exemption. The government proposes introducing a rule where the settlor needs to have held the shares for two years prior to settlement into an EBT in order to gain this exemption.
The consultation process closed on 25 September 2023 and we await HMRC’s conclusions and legislation changes recommendations.
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