The 2023 Federal Budget proposed tax rules to facilitate the creation of employee ownership trusts ("EOTs"), vehicles which can facilitate the purchase of a business by its employees. The initial proposal contained in Budget 2023 included certain tax incentives primarily targeting the EOT buyer, however, notably missing was a tax incentive for the vendor such as an enhanced capital gains exemption.
The 2023 Fall Economic Statement addressed this perceived incentive gap by proposing to exempt from taxation the first $10 million in capital gains realized on the sale of a business to an EOT, subject to certain conditions.
The 2024 Federal Budget provided further details on the proposed $10 million exemption and on May 2, 2024, Bill C-69, Budget Implementation Act, 2024, No. 1 ("Bill C-69") containing draft legislation implementing these rules was introduced in Parliament. The House of Commons has recently completed its second reading of the bill.
In light of proposed changes to the capital gains inclusion rate and alternative minimum tax regime under the 2024 Federal Budget (if enacted), the new EOT capital gains exemption would provide an additional incentive for Canadian business owners to consider in their succession and/or exit planning.
This bulletin provides a brief overview of EOTs and outlines qualifying and disqualifying conditions in relation to the establishment of an EOT and the new $10M capital gains exemption.
What is an Employee Ownership Trust?
EOTs, originally introduced in the United States and United Kingdom, aim to facilitate increased employee ownership of privately held businesses.
An EOT is a trust that holds a corporation's shares on behalf of and for the benefit of the corporation's employees. Under the traditional EOT structure, a corporation loans funds to the EOT, and the EOT uses such funds to acquire an interest in the corporation. The loan is re-paid out of the corporation's earnings, enabling employees to purchase an interest in the corporation without paying directly for shares.
Employee Ownership Trust – Qualifying Conditions
To qualify as an EOT, a trust must be resident in Canada and have only two purposes: i) to hold shares of a "qualifying business" (a Canadian controlled private corporation (CCPC), 90% or more of the fair market value of the assets of which is attributable to assets used principally in an active business immediately before the sale to the EOT) for the benefit of employees; and (ii) to make distributions (whether capital and/or income) to beneficiaries based solely on pay, hours worked, or duration of employment, or a combination of these factors. Additionally, all or substantially all (generally 90% or more) of the fair market value of the EOT's property must be attributable to shares of qualifying businesses.
After the disposition of shares of the capital stock of a qualifying business to an EOT or a CCPC that is controlled and wholly-owned by an EOT, subject to prescribed conditions (a "qualifying business transfer"), the former controlling vendor(s) cannot maintain control of the business. Additionally, following the qualifying business transfer, the vendors cannot represent more than 40% of (i) the directors of the business, or (ii) the trustees of the EOT.
Measures to Incentivize Establishment of EOTs
To encourage the establishment of EOTs, draft legislation proposes to:
- extend a vendor's capital gains reserve pursuant to a qualifying business transfer from 5 years to a maximum of 10 years;
- create an exception to subsection 15(2) of the Income Tax Act, permitting a shareholder loan to an EOT from a qualifying business to be repaid over a period of 15 years;
- create an exception to the 21-year deemed disposition rule generally applicable to trusts.
In addition to these initial measures, Bill C-69 proposes to implement a $10M capital gains exemption for proceeds realized on the sale of a qualifying business to an EOT.
Capital Gains Exemption – Qualifying Conditions
The $10 million capital gains exemption is available to an individual (other than a trust) on the sale of shares to an EOT, if all of the following conditions are met:
- the individual disposes of shares of a corporation (that is not a professional corporation) to a trust or a corporation wholly owned by a trust;
- the transaction is a qualifying business transfer in which the trust acquiring the shares is not already an EOT or a similar trust with employee beneficiaries;
- the qualifying business transfer occurs between January 1, 2024 and December 31, 2026;
- throughout the 24 months immediately prior to the qualifying
business transfer:
- the transferred shares were exclusively owned by the individual claiming the exemption, a related person, or a partnership in which the individual is a member; and
- more than 50 per cent of the fair market value of the target corporation's assets were used principally in an active business.
- at any time prior to the qualifying business transfer, the individual (or their spouse or common-law partner) has been actively engaged in the qualifying business on a regular and continuous basis for a minimum period of 24 months; and
- immediately after the qualifying business transfer, at least 75% of the beneficiaries of the EOT must be resident in Canada.
Additionally, an individual (and any related individuals) seeking to claim the capital gains exemption cannot be a beneficiary under the EOT.
If certain "disqualifying events" occur within 24 months of the qualifying business transfer, the capital gains exemption will be retroactively denied to the vendor. If a disqualifying event occurs after 24 months, the EOT will be assessed a capital gain equal to the amount of the exemption claimed by the vendor. Note that the EOT will be jointly and severally liable along with the vendor for any tax arising as a result of the exemption being denied due to a disqualifying event occurring within the first 24 months. After 24 months, the EOT will be solely liable.
Therefore, the vendor should take care when entering into this type of transaction to ensure they have sufficient protections in case of this eventuality.
Exemption from Alternative minimum tax (AMT)
The draft legislation also proposes to exempt EOTs from the application of Alternative Minimum Tax (AMT), a parallel tax regime under which taxpayers (individuals and most trusts) pay the higher of their "regular" tax or their AMT, effective for taxation years that begin after December 31, 2023. Furthermore, the draft legislation also exempts from the AMT calculation the amount of the vendor's exempted capital gain on the sale of the business to the EOT.
This is a significant incentive because AMT normally applies to vendors claiming the regular lifetime capital gains exemption.
Takeaways
The $10M capital gains exemption is especially attractive given the recent budget proposal to increase the capital gains inclusion rate from one-half to two-thirds for gains realized on or after June 25, 2024.
As mentioned above, this $10M capital gains exemption is time limited and is currently set to expire at the end of 2026. Vendors considering a sale of their business should act promptly and review their succession planning. Members of the Tax and Business Law Groups at Fogler, Rubinoff LLP would be pleased to discuss how the establishment of an EOT may be suitable for your business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.