Employee Ownership Trusts: A New Path for Canadian Business Succession

Updated April 2024

Business succession planning can be a daunting task for Canadian business owners. But fret not! A new and exciting option has arrived—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:

1. Trust Formation: The EOT is set up, and the employees of the target business become beneficiaries of the trust.
2. 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.
3. 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:

1. 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.
2. Qualifying Employees: The beneficiaries of the EOT must be qualifying employees, generally including individuals employed by the qualifying businesses controlled by the trust.
3. Restricted Distributions: EOTs cannot distribute shares of qualifying businesses to individual beneficiaries.
4. 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:

1. Capital Gains Exemption on EOT Sales: In the recent Federal budget, the 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). The exemption will be available when the following conditions are met:
   • Available to an individual on the sale of shares of a corporation that is not a professional corporation.
   • The sale 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 transferred shares must be exclusively owned by the individual claiming the exemption or a related person and over 50% of the fair market value of the corporation’s assets were used principally in an active business.
   • At any time prior to the 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.
   • Immediately after the transfer, at least 90% of the beneficiaries of the EOT must be resident in Canada.
   • The total exemption cannot exceed $10 million and applies per business and not per-shareholder. This means the shareholders could sell multiple businesses to EOTs and claim the $10M exemption on each sale.
   • It will be available for tax years 2024, 2025, and 2026, potentially offering the business owner over $2.6 million in tax savings.
2. No 21-Year Deemed Disposition Rule: Unlike other trusts, EOTs are exempt from the 21-year deemed disposition rule, ensuring their longevity and stability.
3. 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.
4. 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.

The Advantages of Employee Ownership

The $10 million in capital gains to be tax-free will be 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 and 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.