Over the next decade, three-quarters of all Canadian small business owners are expected to exit their companies.
We are at the precipice of the largest transfer of wealth in Canadian history, with nearly 2 trillion dollars estimated to change hands within the next ten years. To prepare for this impending succession crisis, the federal government proposed two key tax measures as part of Budget 2023.
Firstly, they amended and strengthened the rules for intergenerational business transfers, making it easier for business owners to pass their company on to the next generation (see Part One for a detailed breakdown). Secondly, they introduced a new type of trust called an Employee Ownership Trust (EOT).
EOTs are big news for Canadian business owners as they provide an entirely new option for succession planning. Surveys have shown that two of the biggest obstacles owners face when exiting their business are finding a suitable buyer and protecting their employees. EOTs would address both issues by effectively allowing owners to sell the business to their employees.
Keep reading as we take a detailed look at the new EOT framework, from how they work to their requirements for implementation and the benefits they provide.
What is an EOT?
EOTs are a type of trust that allows employees to own a stake in the company they work for. They are different from other forms of employee ownership, such as share schemes or cooperatives, because they do not require employees to buy or sell shares individually. Instead, the shares are held in a trust on behalf of all employees, who benefit from the profits and dividends of the company.
EOTs provide business owners with a powerful tool for succession planning, allowing employees to purchase a business without having to pay directly to acquire the shares. As such, they can provide a smooth transition of ownership that preserves the company’s culture and values while rewarding and motivating the staff.
How do EOTs work?
To set up an EOT, a business owner must sell at least 51% of the shares of a qualifying business to a trust. A qualifying business is a Canadian-controlled private corporation (CCPC) that uses all or substantially all of its assets in an active business carried on in Canada. The sale can be for either cash or a loan note (which can be repaid over time from the future profits of the business), and the price must be based on an independent valuation of the business.
To be considered an EOT, the trust needs to be resident in Canada and have only two purposes: (i) holding shares of the qualifying business for the benefit of the employees; and (ii) making distributions to employee beneficiaries based on a formula that only considers their length of service, remuneration and hours worked. The EOT must hold a controlling interest in the shares of at least one qualifying business, and all or substantially all of the EOT’s assets must be shares of a qualifying business.
The EOT becomes the legal owner of the shares, but the employees become the beneficial owners. They have a say in how the business is run and receive a share of the profits as dividends or bonuses. All employees must be made beneficiaries, except those who have or had a significant economic interest in the business, probationary employees, the seller and anyone related to the seller.
EOT Governance
EOTs will be governed by trustees, who must be Canadian residents elected by the trust beneficiaries at least once every five years. To ensure independence from any prior ownership group, individuals holding a significant economic interest in the business cannot account for more than 40% of:
- The trustees of the EOT
- The directors of the board of a corporation serving as a trustee of the EOT
- The directors of any qualifying business of the EOT
EOT Tax Treatments
Under the proposed framework, EOTs would be subject to the same tax rules as personal trusts, meaning undistributed income would be taxed at the top marginal tax rate. However, income distributed to trust beneficiaries would be taxed at the recipient’s personal level, and any dividends received would be eligible for the dividend tax credit. In addition, certain tax rules would be modified to help facilitate the establishment of EOTs, including:
Ten-year capital gains reserve – For qualifying business transfers to an EOT, Budget 2023 proposed an extension to the current five-year capital gains reserve. Under this change, the seller can defer the recognition of capital gains on the sale by using a 10-year capital gains reserve. This means that only 10% of the gain on deferred proceeds must be brought into income annually, instead of the usual 20% under the five-year reserve period.
Exception to shareholder loan rules – Under current rules, taxpayers who receive a shareholder loan must repay the loan within one year to avoid paying taxes on the loaned amount. Budget 2023 proposed an exception to this rule that will extend the repayment deadline to 15 years for EOTs. This change will allow an EOT to finance the purchase using funds borrowed from the qualifying business itself and repay that loan over 15 years without adverse tax consequences.
Exception to the 21-year rule – As EOTs are intended to hold shares indefinitely, they would not be subject to the 21-year deemed disposition rule that applies to most trusts. This means that, unlike other trusts, EOTs won’t have to pay tax on any unrealized gains every 21 years.
Final Thoughts
EOTs are not a new concept. They have been successfully implemented in other countries, such as the United States and the United Kingdom, where they have been shown to improve business performance, employee well-being and social outcomes.
Their introduction in Canada presents a new avenue for business succession. They can offer significant tax benefits and non-tax benefits to both the sellers and the employees of Canadian businesses, and provide a welcome alternative to existing exit strategies.
If you are interested in learning more about the new EOT framework and whether it could be the right option for your business, reach out to our expert team today. Through personalized guidance and custom solutions, we work with you to build a tailored exit strategy that ensures success in succession for you and your business.
