Updated December 2023
Business succession planning can be a daunting task for Canadian business owners. But fret not! A new and exciting option is on the horizon—Employee Ownership Trusts (EOTs). These innovative trusts have been the subject of consultations in Canada for several years, and starting from January 1, 2024, they will offer a fantastic alternative for business succession planning. In this blog, we will dig into the world of EOTs, exploring how they work, the proposed rules in Canada, and the tax benefits they may offer.
What’s the buzz about employee ownership trusts?
Let’s break it down! EOTs allow businesses to transition into employee ownership by selling their shares to a trust that benefits their employees. With EOTs, employees don’t directly own shares but become beneficiaries of the trust. It’s a win-win! This unique structure simplifies the legal and administrative complexities of multiple employees participating in a buyout.
How do EOTs Work?
Here’s the scoop on how EOTs operate:
- Trust Formation: The EOT is set up, and the employees of the target business become beneficiaries of the trust.
- Negotiation and Financing: Trustees step in to negotiate the terms and conditions for purchasing the shares of the target business. Debt financing is often arranged, enabling the EOT to acquire the shares. Sometimes, the business itself provides the necessary funds.
- Repayment and Distribution: Over time, the EOT repays the debt using earnings from the business. Employees benefit from these distributions, receiving their portion of the business’s earnings as dividends through the EOT.
Federal Budget proposed EOT rules
Canada has recognized the barriers that hindered the creation of EOTs and aims to remove them through new rules. The introduction of EOTs in 2024 provides an exciting opportunity for Canadian business owners to explore an alternative path for succession planning.
Key Conditions for EOTs in Canada
To qualify as an EOT in Canada, certain conditions must be met:
- Qualifying Business Transfer: The EOT must acquire a controlling interest in one or more qualifying businesses. These businesses are Canadian-controlled private corporations, where the majority of their fair market value is derived from assets used in active businesses conducted in Canada.
- Qualifying Employees: The beneficiaries of the EOT must be qualifying employees, generally including individuals employed by the qualifying businesses controlled by the trust.
- Restricted Distributions: EOTs cannot distribute shares of qualifying businesses to individual beneficiaries.
- Trustee Appointments: Specific rules govern the appointment of trustees. All trustees of the EOT must be Canadian residents. Additionally, limitations are placed on individuals who held a significant economic interest in the business before its sale to the EOT.
Tax benefits of EOTs
The proposed EOT rules in Canada come with several tax benefits that make them even more appealing:
- No 21-Year Deemed Disposition Rule: Unlike other trusts, EOTs are exempt from the 21-year deemed disposition rule, ensuring their longevity and stability.
- Extended Shareholder Loan Repayment Period: The repayment period for shareholder loans made to an EOT is extended to 15 years, mitigating a significant tax barrier and offering greater flexibility.
- Extension of Capital Gains Reserve: The existing capital gains reserve is extended from 5 years to up to 10 years, allowing vendors to defer recognizing part of the capital gain for a longer period, aligning with other transfers.
- Capital Gains Exemption on EOT Sales: In the fall economic statement, the Federal Government proposed an exemption for the first $10 million in capital gains realized on the sale of a business to an Employee Ownership Trust (EOT). Subject to certain conditions, to be released early in the new year, this incentive aims to boost EOT utilization. It will be available for tax years 2024, 2025, and 2026, potentially offering the business owner over $2.6 million in tax savings.
The Advantages of Employee Ownership
The latest change allowing the first $10 million in capital gains to be tax free can end up being a game changer for business owners looking at selling their business. This tax incentive change now puts this program on par with similar ones in the US & UK. It should increase the number of business owners selling to an EOT.
Beyond the tax benefits, there are other advantages to consider when transitioning to an employee-owned business. One of the significant advantages is the preservation of the company’s culture and vision. Many businesses purchased by outsiders experience a loss of the original culture and see a significant turnover of employees. By giving employees a stake in the company’s success, EOTs foster a sense of ownership, motivation, and loyalty. Employees become more engaged, committed, and proactive in driving the business forward.
Furthermore, EOTs promote long-term sustainability. Employee-owned businesses tend to prioritize the well-being of employees, the community, and the environment. They have a vested interest in the company’s success and are more likely to make responsible and sustainable business decisions.
As we eagerly anticipate the implementation of EOTs in Canada, it is essential to stay informed about any updates or changes to the proposed rules. Consult with legal, financial, and tax professionals to understand how EOTs can benefit your unique business and circumstances.
The introduction of EOTs in 2024 provides an exciting opportunity for business owners to explore alternative paths for succession planning.
Remember, this blog provides general information and should not be considered as legal, financial, or tax advice. Your situation may require tailored guidance from professionals well-versed in EOTs and business succession planning.