Budget 2023 proposes to introduce “employee ownership trusts” (EOTs) to encourage employee ownership of a business and facilitate the transition of privately owned businesses to employees. The EOT structure was influenced by similar approaches in the United Kingdom and the United States. The proposed amendments have an effective date of Jan. 1, 2024.

This Tax Alert describes the new EOT rules as proposed, along with some commentary. The new rules are very restrictive, which will likely limit the appeal of EOTs. It is hoped the federal government will amend these rules to encourage greater use.

EOT tax advantages

An EOT offers certain tax advantages to facilitate the acquisition and ownership of qualifying businesses, including:

• New shareholder loan exception ⁠–⁠ An EOT can borrow from a qualifying business to facilitate a qualifying business transfer as long as bona fide arrangements were made for repayment of the loan or debt within 15 years of the qualifying business transfer;
• Extended capital gain reserve time period – The maximum length of time a capital gain reserve may be claimed is increased from five to ten years if the shares were disposed of to an EOT pursuant to a qualifying business transfer; and
• Exemption from 21‑year rule ⁠–⁠ The 21‑year rule, which deems many inter vivos personal trusts to have disposed of all capital property every 21 years, does not apply to EOTs.

Qualifying business transfers

The tax advantages will only be available where there has been a “qualifying business transfer” to an EOT. A qualifying business transfer is a disposition by a taxpayer of shares of the capital stock of a corporation (“subject corporation”) to the EOT, or to a Canadian‑controlled private corporation (CCPC) controlled and wholly owned by the EOT (“purchaser corporation”) where the following conditions are met:

• Immediately before disposition, all or substantially all of the fair market value (FMV) of the assets of the subject corporation are attributable to assets (other than an interest in a partnership) used principally in an active business carried on primarily in Canada by the subject corporation or a corporation controlled and wholly owned by the subject corporation;
• At the time of disposition, the taxpayer deals at arm’s length with the EOT and any purchaser corporation, the EOT acquires control of the subject corporation and all beneficiaries of the EOT are employed in the business;
• At all times after the disposition, the taxpayer deals at arm’s length with the subject corporation, the EOT and any purchaser corporation, and the taxpayer does not retain any right or influence that, if exercised, would allow the taxpayer (whether alone or together with any person or partnership related to or affiliated with the taxpayer) to exercise de facto control over the subject corporation, the EOT or any purchaser corporation.

The definition of qualifying business transfer is restrictive, likely limiting the use of EOTs in many cases. Unless all eligible employees can fund the purchase of the qualifying business, the EOT will likely require financing from the vendor. The rules seem to prevent a vendor from reacquiring the shares from the EOT if the EOT defaults on a vendor takeback. In a typical share deal, the vendor would want to control the corporation or at least have the right to regain the shares post‑acquisition should the purchase price not be paid.

The definition may also prevent an EOT from acquiring a business with significant foreign operations, due to the requirement in the first bullet above. It may be possible to restructure a business with significant foreign operations to meet the conditions, but this may not be practical or desired for business reasons.

EOT requirements

There are numerous requirements for EOT eligibility, ranging from residency rules to beneficiary and governance stipulations. The following highlights the key elements mandated by the proposed EOT legislation.

Trust residence

An EOT must be factually resident in Canada. Factual residence is based on the location of central management and control.

Trust property

All or substantially all (i.e., 90 per cent or more, according to the Canada Revenue Agency) of the FMV of the EOT’s property must be attributable to shares of the capital stock of one or more qualifying businesses over which the EOT exercises direct or indirect control, and by which all beneficiaries of the EOT are employed. This requirement may not be met if the EOT accumulates other assets with a FMV of greater than 10 per cent of the FMV of all of the EOT’s assets, or if one or more investments cease to be a qualifying business. Notably, this may prevent the EOT from holding significant debt receivable from one or more qualifying businesses.

A qualifying business is a corporation controlled by the EOT where the following conditions are met:

• The corporation is a CCPC, of which all or substantially all (i.e., 90 per cent or more) of the FMV of the assets is attributable to assets (other than an interest in a partnership) used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation the particular corporation controls;
• Not more than 40 per cent of the corporation’s directors have owned, directly or indirectly, together with certain related persons, 50 per cent or more of the FMV of the shares of the capital stock or indebtedness of the corporation immediately before the time the EOT acquired control of the corporation; and
• The corporation deals at arm’s length with, and is not affiliated with, any person or partnership that owned 50 per cent or more of the FMV of the shares of the capital stock or indebtedness of the corporation immediately before the time the EOT acquired control of it.

A corporation may cease to be a qualifying business if it accumulates assets other than shares in one or more qualifying businesses with a FMV of greater than 10 per cent of all the corporation’s assets. This rule appears overly restrictive and will require continuous monitoring to ensure each qualifying business remains onside. This rule could also prevent a corporation owned by an EOT from expanding internationally.

It appears a shareholder loan by a qualifying business to the EOT to purchase the shares could result in the qualifying business being offside of the “all or substantially all” (i.e., 90 per cent) requirement, depending on the amounts. The legislation would need to be amended to clarify the value of such a loan would be disregarded. Until then, this shortcoming may limit an EOT’s ability to finance the acquisition of a purchase of a qualifying business, further limiting the use of EOTs in practice.

Trust beneficiaries

Beneficiaries of an EOT must consist entirely of all individuals employed by one or more qualifying businesses controlled by the EOT, excluding the following:

• Employees who have not completed a reasonable probationary period of up to 12 months;
• Employees who own, directly or indirectly (other than through the EOT), 10 per cent or more of the FMV of any class of shares of the capital stock of a qualifying business controlled, directly or indirectly, by the EOT;
• Employees who own, directly or indirectly, together with any person or partnership related to or affiliated with the employee, 50 per cent or more of the FMV of any class of shares of the capital stock of a qualifying business controlled, directly or indirectly, by the EOT; and
• Employees who owned, directly or indirectly, together with any person or partnership related to or affiliated with the individual, 50 per cent or more of the FMV of the shares of the capital stock and indebtedness of a qualifying business immediately before the time of the qualifying business transfer to the EOT.

Interests of beneficiaries

The interest of each beneficiary of the EOT must be determined in the same manner, and be based solely on a reasonable application of any combination of (i) total hours of employment service provided to the qualifying business, (ii) total salary, wages and other remuneration paid or payable to the beneficiary by the qualifying business, and (iii) total period of employment service the beneficiary has provided to the qualifying business.

EOTs cannot distribute shares of the capital stock of a qualifying business to any beneficiary. It is also unclear if an EOT can purchase the interest of a retiring employee.

Trust governance

Trustees are elected by beneficiaries who must be at least 18 years of age at the time of the vote, for a term not to exceed five years. Each beneficiary is entitled to an equal vote in the conduct of EOT affairs.

Each EOT trustee must either be an individual or a corporation resident in Canada that is licensed or otherwise authorized under federal or provincial law to carry on the business of trustee services. No more than 40 per cent of the trustees of the EOT can be individuals who, directly or indirectly, together with any person or partnership related to or affiliated with the individual, owned 50 per cent or more of the FMV of the shares of the capital stock or indebtedness of a qualifying business immediately before the time the EOT acquired control, or corporations where more than 40 per cent of members of the board of directors comprise such individuals.

Finally, the EOT is prohibited from acting in the interest of one beneficiary or group of beneficiaries to the prejudice of others.

Conclusion

The EOT represents another option for business owners to consider when succession planning. As noted earlier, EOT rules are restrictive and some uncertainties remain. Despite this, EOTs can be a viable alternative to transition a business to employees and, where an EOT is not feasible, other options may be available to business owners. Contact your Baker Tilly advisor to learn more.