Bill C-59, Fall Economic Statement Implementation Act, 2023 includes draft legislative proposals to introduce a new set of rules for Employee Ownership Trusts (EOTs) in Canada. If enacted, the EOT regime will come into effect on January 1, 2024.
What is an EOT?
An EOT is an arrangement where a trust holds shares of a corporation for the benefit of the corporation’s employees and intended to provide an alternative business succession method for retiring business owners. The goal of parliament is to encourage more business owners to sell to an EOT.
How to qualify as an EOT?
To qualify as an EOT, a trust must have two purposes:
- Holding shares of a qualifying business for the benefit of employee beneficiaries.
- Making reasonable distributions to employees based on factors like length of service, remuneration, and hours worked. If not using this formula, all beneficiaries must be treated similarly.
Qualifying business
A qualifying business is a Canadian-controlled private corporation (CCPC) controlled by a trust, where:
- no more than 40% of its directors owned 50% (or more) of the CCPC’s debt or fair market value (FMV) of any class of shares (whether directly or indirectly, or together with any related or affiliated persons or partnerships) before the CCPC became controlled by the trust; and
- the CCPC deals at arm’s length and is not affiliated with any persons or partnerships who owned half or more of the CCPC’s debt or FMV of shares before it became controlled by the trust.
Trust Property
The trust must hold a controlling interest in the shares of one or more qualifying businesses and the shares must account for 90% or more of the FMV of the property of the trust. Note that more than 50% of current employee beneficiaries must approve certain fundamental changes to the trust property, such as ceasing control of a qualifying business.
Beneficiaries
The trust must be set up exclusively for beneficiaries that are either current or certain former employees of the qualifying businesses, who don’t own:
- 10% or more of the FMV of any class of shares of the qualifying businesses (directly or indirectly)
- 50% or more of the FMV of any class of shares of the qualifying businesses (alone or together with any related or affiliated persons or partnerships); and
- 50% or more of the FMV of the shares or indebtedness of the qualifying business (alone or together with any related or affiliated persons or partnerships) immediately before the time the trust gained control of the qualifying businesses.
In addition, the capital and income interests of all beneficiaries must be calculated using a reasonable and equitable method based solely on any combination of their length of service, remuneration, and hours worked.
Trustees
Each trustee must be a Canadian resident individual, or a Canadian corporation licensed or authorized to serve as a trustee and must all have equal voting rights related to the trust.
At least one-third of the trustees must be beneficiaries who are current employees of the qualifying business. Generally, all trustees must be elected within the past five years by certain current employees of the qualifying business; otherwise, at least 60% of all trustees must be at arm’s length with anyone who sold shares of the qualifying business to the EOT.
The group of trustees must also not be comprised of individuals or corporate directors that held 50% or more of the FMV of the debt or shares of the qualifying businesses (alone or together with any related or affiliated persons or partnerships) before the time the qualifying businesses became controlled by the trust.
EOT trustees, elected every five years, must be Canadian-resident corporations or authorized individuals. Individuals with a significant prior interest are limited to 40% of trustees. Beneficiaries must be qualifying employees, excluding significant economic interest holders and those without a completed probationary period. The EOT cannot distribute qualifying business shares to individual beneficiaries.
Tax Advantages of EOT
- Shareholder loans:
Shareholder loans received by a non-corporate shareholder are generally included in the shareholder’s income unless the loan is repaid within one year after the end of the corporation’s tax year in which the loan was made. Budget 2023 proposes rules that allow EOTs to repay certain shareholder loans over a 15-year period, without including the loan in income where the loan was made to purchase the qualifying business. This proposed rule would enable an EOT to borrow money from a qualifying business to pay for the purchase of shares of such corporation from a vendor.
- Capital gains reserve:
The capital gains reserve generally allows taxpayers to defer the recognition of a capital gain where all or part of the proceeds from a disposition are receivable after the end of the taxation year. The capital gains reserve can generally be claimed over a maximum five-year period, with at least 20 percent of the applicable gain being recognized each year. Budget 2023 proposes an extended 10-year capital gains reserve for dispositions of a qualifying business to an EOT, with at least 10 percent of the applicable gain recognized each year. This proposed rule would be beneficial for a vendor that receives proceeds from a disposition from an EOT over a period longer than the current five-year capital gains reserve, reducing the vendor’s tax burden in those years and lining up the tax with the receipt of cash proceeds.
- 21-year deemed disposition rule for trusts:
Unless an exception applies, personal trusts are generally deemed to dispose of all of their capital property every 21 years, which results in the taxation of accrued gains. Budget 2023 proposes to exempt EOTs from the 21-year rule, meaning EOTs can hold shares of the qualifying business corporation for an indefinite period without the Act deeming a taxable event every 21 years.
- Temporary tax exemption for certain capital gains:
The first $10 million in capital gains realized on the sale of a qualifying business to an EOT would be tax-exempt for the 2024 to 2026 tax years, subject to certain conditions. Further details on this measure will be provided in the coming months.
- Deemed interest benefit rule exemption:
EOTs are exempt from the deemed interest benefit rules if it receives a low or non-interest-bearing loan from a qualifying business to purchase shares and the loan is repaid within 15 years. Currently, a shareholder is deemed to have received a benefit if the interest rate charged on a loan received from their corporation is lower than the prescribed interest rate.
Disadvantages and concerns of EOT
- Owners must relinquish control
The budget mandates that an EOT must maintain a controlling interest in shares of qualifying businesses whereas the vendor is required to give up control of the qualifying business. Many business owners may not want to give up control or have the right to re-acquire control until the vendor is fully paid out over time. Most may prefer for the employees to incorporate a holding company (Employee Holdco) to buy the shares.
- Financing concerns
The proposed rules would enable EOTs to obtain shareholder loans from the qualifying business in order to facilitate a qualifying business transfer. Presumably, the repayments would have to occur with the after-tax portion of dividend payments received by the EOT from the qualifying business. Taxation for EOTs aligns with personal trust rules, with distributed income taxed at individual rates for beneficiaries and undistributed trust income taxed within the EOT at the top personal marginal tax rate. This dividend income would be subject to high marginal tax in the EOT which in many cases would exceed the beneficiaries’ tax rates.
- Sale of qualifying business by EOT
The proposed rules require that the EOT prohibit the distribution of the shares of the qualifying business to the employee beneficiaries. This would seem to leave two options for the trust vis-à-vis the qualifying business it holds: (1) the EOT must exist and hold the qualifying business perpetually, or (2) the EOT must sell its shares. This is limiting, and there should be circumstances where it would be permitted for the trustees to collapse the EOT and distribute the shares out to the beneficiaries, if desired.
