New Employee Ownership Trusts provide an option in succession planning, but not hoped-for tax breaks

Federal budget sets out to have EOT program in place in 2024

New Employee Ownership Trusts provide an option in succession planning, but not hoped-for tax breaks
Jill Winton, Stikeman Elliott LLP

This week’s federal budget introduces new rules to allow for the creation of Employee Ownership Trusts, but tax lawyers looking at the proposal say that while it facilitates the transfer of a business to employees, it doesn’t come with the substantial tax advantages hoped for.

Jill Winton, a tax lawyer with Stikeman Elliott LLP, says, “I don’t know if there’s much of an actual tax benefit [in what is being proposed], but these changes were designed to facilitate the structure [of EOTs].”

And some who have been lobbying for the creation of EOTs in Canada describe the program announced in the budget as a “missed opportunity” because it doesn’t provide the hoped-for tax incentives.

Jon Shell, the managing director of Social Capital Partners, a non-profit financing company in Toronto, told the media after the budget announcement that “in the absence of incentives, all of the evidence we have suggests that very few people will use it.”

He noted that the United Kingdom changed its rules around ownership trusts in In 2014, with provisions to exempt eligible sellers from paying capital gains taxes when transferring ownership to an EOT. That led to a wave of employee-owned firms.

However, the proposed Canadian legislation doesn’t come with that incentive, nor one that allows EOT employee beneficiaries to receive up to £3,600 (around $6,000) in tax-free bonuses annually.

In the United States, EOTs create incentives for lenders and preferential tax treatment for the employee-owned business, allowing employees to repay the seller faster, Shell said.

EOTs provide option in succession planning

Still, Winton and other lawyers suggest that the move will provide another option for business founders to consider when deciding what to do with the company when ready to retire. It will also allow employees to purchase their employer’s business without acquiring shares directly, to keep well-paying jobs. Selling to employees with a vested stake in the company also could help the legacy of a firm, something business owners might prefer rather than selling to private equity or a competitor.

The introduction of EOTs, expected to kick in on Jan. 1, 2024, is “welcome news to business owners as the ability to [create] a ‘qualifying business transfer” can provide an additional option for succession planning,’” says an analysis note from Osler Hoskin Harcourt LLP.

Winton says the EOT rules as they stand are not so much about a tax benefit at this point but more of a commercial incentive “why somebody might do this,” like if they couldn’t find a buyer for their business or thought it was for the good of the employees. Research also indicates that employee-owned companies perform better and can be more socially responsible.

Under the proposed rules, a Canadian EOT would be a personal trust, and, like other trusts, with taxes on undistributed trust income coming in at the highest personal marginal tax rate. Trust income distributed from an EOT to its employee beneficiaries would not be subject to tax at the trust level but at the beneficiary level.

Any distribution by the EOT of dividends received from the qualifying business would retain their character when received by employee beneficiaries and would therefore be eligible for the dividend tax credit.

A “qualifying business” under the proposed rules would be a Canadian-controlled private corporation in which all the fair market value of the assets are used in an active business in Canada and generally follow the existing requirements for “small business corporation” status under the Tax Act.

There would also be additional control and relationship test to ensure a former business owner has genuinely given up the business to the trust.

How to qualify as an Employee Ownership Trust

To qualify, an EOT must meet several conditions, Winton says. These include:

  • The trust must be a Canadian resident trust
  • The trust is exclusively for the benefit of employees of one or more “qualifying businesses” controlled by the trust and who do not hold a significant economic interest in the qualifying business;
  • The interest of each beneficiary is determined based on hours worked, length of employment, and salary paid to the beneficiary by the qualifying business;
  • The trust is prohibited from acting in the interest of one beneficiary to the prejudice of another beneficiary;
  • The trust is prohibited from distributing shares of a qualifying business to any beneficiary of the trust;
  • Trustees of the trust must be elected by the beneficiaries for a period not exceeding five years;
  • Individuals and their relations who held a significant economic interest in the business before the trust acquiring control are not entitled to make up more than 40% of the trustees of the EOT;
  • The trust must hold a controlling interest in the shares of one or more qualifying businesses; and
  • All or substantially all of the trust’s assets must be shares of qualifying businesses that the trust controls and which employ all of the beneficiaries of the trust.

Changes to tax laws to allow EOTs

Winton added that to facilitate the creation of EOTs in Canada, there will be some favourable changes to current laws. These include extending the capital gains reserve for taxpayers transferring qualifying businesses to an EOT to ten years from the current five. This means that a capital gain on the transfer of shares to an EOT can be deferred until the year proceeds are received, up to a maximum of 10 years. A minimum of 10 percent of the gain must be brought into income each year.

However, she says, “that really only is helpful if they [a seller] take their proceeds over ten years - because if they get all their proceeds in year one, there’s no reserve to be claimed.”

Another change would be an exception to the shareholder loan rules. Under existing rules of the Tax Act, a taxpayer who receives a shareholder loan must include the amount of the loan as income in the year that the loan is obtained unless it is repaid within a year.

The federal budget proposes to allow a trust EOT to borrow funds from a qualifying business to finance the purchase of shares. The loan amount would not be included in the EOT’s income, if arrangements are in place when the loan is made for the repayment of the loan within 15 years of the transfer.

In addition, an exception would be made to the 21-year-disposition rule so that the shares can be held indefinitely for the benefit of employees. The budget proposes to exempt EOTs from the rules in the Tax Act that would otherwise deem the trust to dispose of its assets every 21 years.

Winton said that a few details about EOTs need to be clarified, such as what happens to the accrued value of the business when an employee ceases to be employed by the qualifying business or dies.

“What happens to their interest? Can they get redeemed? You can’t get shares, but can you get cash? There are more details to be ironed out.” And with their expected introduction at the start of 2024, Winton notes, “there’s not a lot of time.”

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