When a company is employee owned (as set out in this article Employee Ownership Legal Advice | Succession & EOT Experts) via an employee ownership trust (EOT) it can pay a tax-free profit share to its employees if certain criteria are met. The document that sets out the process for determining an individual’s profit share is called a Profit Share Policy.
The policy:
- Operates at the level of the trading company, not the trust itself.
- Is usually designed to meet the statutory criteria for income tax relief on certain employee bonus payments.
The key incentive for employees of an employee-owned company is that employees can receive qualifying bonuses of up to £3,600 per tax year free of income tax.
However:
- These bonuses remain subject to National Insurance Contributions (NICs) for both employees and employers.
- They must be paid out of profits of the company.
Main conditions for Income Tax Relief
The main criteria for a payment to qualify for the EOT bonus exemption under Part 6 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) (ITEPA 2003) are:
- the payment must not comprise regular salary or wages;
- it must not be in place of employment income;
- the payment must be paid under a written profit share policy that meets the participation requirement, the equality requirement, the trading requirement and the indirect ownership requirement.
What is the Participation Requirement?
This is where all employees (including any former shareholders who are employed in the employee-owned business) are eligible.
What is the Equality Requirement?
Payments must be on the same terms (this does not mean each employee receives the same amount). Differentiation is permitted based on:
- Renumeration.
- Length of service.
- Hours worked.
The above factors can be applied separately but not together.
Most importantly, the agreed structure must not favour senior staff disproportionately. It is possible to disregard the above factors and pay a set figure for all eligible employees (i.e. £3,600 per eligible employee) – this is by far the simplest and safest approach.
What is the Trading Requirement?
The company must be a trading company.
What is the Indirect Ownership Requirement?
The trading company must be controlled by an EOT at the time of payment and the employees must all be beneficiaries of the EOT.
Why is it important to get the Profit Share Policy right?
If the Profit Share Policy fails to meet the ITEPA 2003 requirements, any bonus paid to employees will be taxed as ordinary earnings.
If the Profit Share Policy is incorrectly implemented, this could have significant tax consequences for the original sellers and/or the EOT.
For example, if the Profit Share Policy undermines the principle of All-Employee Benefit by unfairly benefiting certain individuals more than others, it could trigger a breach under the Equality Requirement which in turn would mean a disqualifying event has occurred.
If a disqualifying event occurs, one of the key risks for the EOT and the original sellers is losing the Capital Gains Tax relief on the EOT sale. The time a disqualifying event occurs is crucial.
If it occurs:
- before the end of the fourth tax year following the tax year in which the sale to the EOT took place – the CGT relief is revoked and HMRC can claw it back from the sellers;
- after the above period – the sale to the EOT will be treated as if the EOT re-acquired the shares in respect of which the relief was claimed for and would cause a CGT charge on the market value of the shares less the seller’s base cost. The EOT will be responsible for paying this charge to HMRC.
Avoid unnecessary risk
Our advice would always be that if an employee owned business would like to implement a Profit Share Policy, they should seek specialised legal and tax advice. By doing so they minimise the possibility of a disqualifying event occurring which can have significant tax implications.
Common errors in policies implemented without specialised legal advice include:
- Breaching the Equality Requirement – weighting profit shares towards senior staff;
- Excluding employees without justification – only limited disqualification allowed;
- Using salary sacrifice arrangements – this is not allowed;
- Not having a policy in writing.
Are you an Employee Owned Business?
If you are considering adopting a Profit Share Policy, or would like to review an existing arrangement, specialist advice can help you avoid common pitfalls and reduce the risk of unintended tax consequences.
Our Employee Ownership team advises businesses at every stage of the employee ownership journey and can help you put in place arrangements that are both practical and compliant.