A majority of small business owners plan to exit their business over the next decade. 1 For many business owners there may not be a family successor ready and willing to take on the business. To address this impending "succession crisis", the 2023 Federal Budget, released by the Department of Finance on March 28, 2023, included new tax measures to provide for employee ownership trusts ("EOTs"). EOTs are intended to provide business owners with a succession alternative by facilitating the sale of a business to its employees, without requiring the employees to immediately or directly pay the purchase price.
Although new to Canada, EOTs have become quite popular in jurisdictions such as the United States and United Kingdom. Canada first announced its intention to explore EOTs through stakeholder engagement in the 2021 Federal Budget and the following Federal Budget then proposed to create an EOT regime. Federal Budget 2023 brought this proposal to life by including various amendments to the Income Tax Act (Canada) (the "Act") which provide the facilitating mechanisms for certain transfers of qualifying businesses to this new form of trust (the "EOT Rules").
Benefits of using an EOT
Why would a business owner want to use the EOT regime? An EOT offers an alternative means of a leveraged buy-out where there is no ready buyer for the business. The notion is that an EOT can borrow the funds to purchase the shares from a departing owner, presumably with better borrowing power than individual employees would have. The EOT could then repay the debt financing using distributed earnings from the business.
A business owner may also be motivated by some of the broader policy drivers underlying the EOT regime in connection with the legacy of their business. In particular, increasing employee ownership is positively correlated with overall business stability, employee retention and stability of employment. Community-minded business owners may also see the EOT regime as an opportunity to benefit their community by increasing employee wealth and keeping business ownership within their local community.
Limitations
The EOT Rules provide a deferral advantage to vendors by means of an extended capital gains reserve (discussed further below). However, the EOT Rules do not go as far as some advocates for a Canadian EOT regime have called for. Other jurisdictions (such as the United Kingdom) have provided more robust tax incentives to promote the use of EOTs, including capital gains exemptions for vendors and allowances for a certain amount of tax-free distribution to employees. Critics warn that the EOT Rules provide insufficient tax incentives to vendors and will therefore have low uptake.
The EOT Rules are quite restrictive and leave little room for customization. For example, for businesses that already have significant employee share ownership (e.g. key management shareholders), a succession plan involving an EOT together with key employee shareholders does not appear to be possible unless the EOT acquires a controlling interest and the significant employee shareholders are excluded from the EOT.
Tax Treatment of EOTs
The EOT regime provides for the following tax treatment and relieving measures in order to facilitate the use of EOTs as a succession alternative.
Extended capital gains reserve from 5 to 10 years: Generally, when a vendor sells capital property (including shares of a business) and proceeds are received over a period of years, the vendor can claim the capital gains reserve allowing them to defer the realization of the capital gain over a maximum period of 5 years. The EOT Rules will extend the capital gains reserve to a maximum period of 10 years for capital gains realized on a qualifying business transfer to an EOT. In other words, a qualifying business transfer may be structured with deferred payment of sale proceeds to defer the vendor's realization of the capital gain over a period of up to 10 years (realizing a minimum of 10% of the gain each year).
EOT Shareholder loan exception: Generally, any loan by a corporation to a non-corporate shareholder is required to be fully included in the loan recipient's income unless an exception applies (e.g. such as the exception for loans that are repaid within one year after the year ending in which the loan was made). The EOT Rules will provide a new exception to the shareholder loan rules so that an EOT shareholder of a qualifying business can borrow funds from the qualifying business in respect of a qualifying business transfer. Provided that the purpose of the loan is to fund the qualifying transfer and that there is a bona fide arrangement for repayment of the loan within 15 years of the transfer, the EOT will not be required to include the loan in income for tax purposes.
Exemption from 21-year Rule: EOTs will be exempt from the 21-year deemed disposition applicable to most inter vivos trusts so that shares could be held by the EOT beyond 21 years without realizing a deemed disposition.
Tax Treatment as a Trust: Other than the special rules mentioned above, an EOT will generally be taxed like other personal trusts. As such, undistributed trust income will be taxed at the top marginal rate and a deduction will be permitted for income allocated and distributed to beneficiaries. Dividend income allocated to beneficiaries would retain its character as such.
What is a qualifying business transfer?
The concepts of a "qualifying business transfer" and a "qualifying business" are fundamental to the EOT Rules. Only transfers of businesses that are "qualifying business transfers" are eligible for the benefits under the EOT regime. In addition, a transferred business must remain a "qualifying business" to retain the advantages of the EOT regime.
A "qualifying business transfer" is a disposition by a taxpayer of shares of a corporation (the "subject corporation") to a trust (or to a corporation that is wholly owned by a trust) where the subject corporation meets the following conditions:
Active business Test: Immediately prior to the disposition of shares, all or substantially all of the fair market value of the assets of the subject corporation is attributable to assets that are used principally in an active business carried on primarily in Canada by the subject corporation or by its wholly owned subsidiary.
Arm's Length Test: At the time of the disposition the taxpayer/vendor deals at arm's length with the trust/purchaser.
Control Test: At the time of the disposition the trust acquires control of the subject corporation.
Qualifying Trust: At the time of the disposition the trust is an EOT, the beneficiaries of which are employed in the business.
Ongoing Control Test: There is an ongoing requirement that the taxpayer/vendor continue to deal at arm's length with the subject corporation and the trust/purchaser. Further, the taxpayer/vendor cannot retain any right or influence that could, if exercised, amount to de facto control of the subject corporation or the trust/purchaser.
A "qualifying business" is a corporation that is controlled by a trust wherein the corporation meets certain conditions on an ongoing basis:
CCPC/Active business test: The corporation must be a Canadian controlled private corporation ("CCPC"), all or substantially all of the fair market value of the assets of which are used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation that the particular corporation controls.
Governance Requirements: At least 60% of the directors of the corporation or trustees of the trust2 must not be persons who owned "50% or more of the fair market value of the shares of the capital stock or indebtedness of the corporation" prior to the trust acquiring control (a "50%+ owner"), nor can they be persons who were related to a 50%+ owner.
Arm's Length Test: The corporation must deal at arm's length and not be affiliated with any person that was a 50%+ owner immediately before the time the trust acquired control of the corporation.
Presumably the intent of these ongoing governance and arm's length requirements is to ensure that the benefits of the EOT regime are only accessed when there is a genuine business succession in favor of employees. Notably, a person could be a 50%+ owner as a result of holding shares or debt instruments.
What are the requirements of an EOT?
In order to qualify as an EOT, a trust will need to have very specific terms and conditions, including with respect to beneficiaries, trustees, trust property and permitted distributions, as set out in the EOT Rules. EOTs will require careful drafting and will differ quite substantially from a discretionary family or business trust. An EOT will be required to meet all of the following conditions on an ongoing basis:
Canadian resident trust: The trust must be a Canadian resident trust. This is factual determination and is determined based on where the central management and control of the trust actually takes place.
Class of beneficiaries: The beneficiaries of the trust are all individuals each of whom meets all of the following criteria:
- is an employee of one or more qualifying businesses controlled by the trust (other than an employee who has not completed an applicable probationary period not exceeding 12 months);
- does not own (other than through the trust) 10% or more of the fair market value of any class of shares of a qualifying business controlled by the trust;
- does not own (alone or together with any related or affiliated person) 50% or more of the fair market value of any class of shares of a qualifying business controlled by the trust; and
- did not own (alone or together with any related or affiliated person), immediately prior to the qualifying business transfer to the trust, 50% or more of the fair market value of the shares and indebtedness of the qualifying business.
Notably, all employees of the qualifying business (other than those who are specifically excluded above) must be included in the beneficiary class.
Interests of Beneficiaries: The interests of each beneficiary must be determined in the same manner, based solely on a reasonable application of any combination of (i) hours of service; (ii) salary, wages paid or payable; and (iii) length of service (all in relation to the qualifying business). The trust is prohibited from acting in the interest of one or more beneficiaries to the prejudice or exclusion of another one or more beneficiaries.
Prohibited Distributions: The trust is prohibited from distributing the shares of the qualifying business to any beneficiary of the trust.
Trustee Requirements: Trustees of an EOT must be Canadian resident and either an individual or a licensed, corporate trustee. Trustees are elected by the beneficiaries for a term not exceeding 5 years. The trustees have equal votes in conducting the affairs of the trust (i.e. there are no principal trustees permitted).
Independent Trustee Requirements: Not more than 40% of the trustees of the EOT can be (i) individuals who were 50%+ owners of the business immediately prior to the qualifying business transfer, nor (ii) corporations with more than 40% of the directors of which were 50%+ owners.
Trust Property: All or substantially all of the fair market value of the trust property is attributable to shares of one or more qualifying businesses that the trust controls, and by which all beneficiaries are employed.
Implementation
The legislative changes supporting EOTs will take effect on January 1, 2024. There is a stakeholder consultation period in effect until the end of May 2023. It will be interesting to see whether the consultation will result in any changes to further incentivize the use of EOTs.
Footnotes
1. See https://www.cfib-fcei.ca/en/media/over-2-trillion-in-business-assets-are-at-stake-as-majority-of-small-business-owners-plan-to-exit-their-business-over-the-next-decade.
2. This condition also applies to directors of any corporate trustee of the trust.
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