Updated: June 21, 2024
With three out of four small business owners in Canada expecting to exit their business within the next ten years, the employee ownership trust (EOTs) rules provide a new succession planning opportunity.
An EOT is a Canadian-resident trust that holds shares of qualifying businesses for the benefit of employees to facilitate succession and promote employee ownership of small and medium-sized businesses. The EOT rules allow employees to borrow from the business to finance a buy-out with an extended repayment period and a longer capital gains deferral period for the retiring owners, where certain conditions are met. This is intended to help employees overcome the challenge of having to finance the acquisition from their personal savings.
The EOT rules, including a temporary tax exemption on up to $10 million in capital gains realized on a sale to an EOT for the 2024 to 2026 tax years (if certain conditions are met), were enacted on June 20, 2024. The $10 million exemption must be shared in an agreed-upon manner where multiple owners disposing of their shares to an EOT as part of a qualifying business transfer meet the exemption conditions.
What is a qualifying business?
A qualifying business is a Canadian-controlled private corporation (CCPC) controlled by a trust, where:
- No more than 40% of its directors owned 50% (or more) of the CCPC’s debt or fair market value (FMV) of any class of shares (whether directly or indirectly, or together with any related or affiliated persons or partnerships) before the CCPC became controlled by the trust; and
- The CCPC deals at arm’s length and is not affiliated with any persons or partnerships who owned half or more of the CCPC’s debt or FMV of shares before it became controlled by the trust.
Note that certain individuals, corporations, partnerships, and trusts may generally be considered “related” or “affiliated” with each other for tax purposes when there’s a controlling interest between them.
What qualifies as an EOT?
A trust is generally considered an EOT if it’s an irrevocable trust resident in Canada and meets the following requirements:
Trust Property: The trust must hold a controlling interest in the shares of one or more qualifying businesses and the shares must account for 90% or more of the FMV of the property of the trust. Note that more than 50% of current employee beneficiaries must approve certain fundamental changes to the trust property, such as ceasing control of a qualifying business.
Beneficiaries: The trust must be set up exclusively for beneficiaries that are either current or certain former employees of the qualifying businesses, who don’t own:
- 10% or more of the FMV of any class of shares of the qualifying businesses (directly or indirectly).
- 50% or more of the FMV of any class of shares of the qualifying businesses (alone or together with any related or affiliated persons or partnerships).
- 50% or more of the FMV of the shares or indebtedness of the qualifying business (alone or together with any related or affiliated persons or partnerships) immediately before the time the trust gained control of the qualifying businesses.
In addition, the capital and income interests of all beneficiaries must be calculated using a reasonable and equitable method based solely on any combination of their length of service, remuneration, and hours worked. An EOT can provide different distribution formulas for current versus former employees, for each of their income and capital interests in the trust.
Trustees: Each trustee must be a Canadian resident individual, or a Canadian corporation licensed or authorized to serve as a trustee and must all have equal voting rights related to the trust. At least one-third of the trustees must be beneficiaries who are current employees of the qualifying business. Generally, all trustees must be elected within the past five years by certain current employees of the qualifying business; otherwise, at least 60% of all trustees must be at arm’s length with anyone who sold shares of the qualifying business to the EOT. Furthermore, the group of trustees must also not be comprised of individuals or corporate directors that held 50% or more of the FMV of the debt or shares of the qualifying businesses (alone or together with any related or affiliated persons or partnerships) before the time the qualifying businesses became controlled by the trust.
What are the benefits of EOTs?
The EOT rules offer tax advantages to both the former owners and purchasing employees of a qualifying business. Even though EOTs are generally taxed like other personal trusts whose undistributed income is taxed at the top personal marginal tax rate, they would offer the following benefits:
- Temporary $10 million capital gain exemption: The first $10 million in capital gains realized on the sale of a qualifying business to an EOT would be tax-exempt for the 2024 to 2026 tax years, subject to certain conditions. The qualifying business transfer must meet these conditions during the two years leading up to the sale, and at the time of the sale, and can’t have a disqualifying event after the sale. This exemption must be shared (in an agreed-upon manner) if multiple owners dispose of their shares to an EOT and meet the conditions.
- Doubled deferral period for capital gains: When proceeds from a sale are received over several years, the retiring owner has up to 10 years (instead of five) to claim the capital gains reserve resulting from a qualifying business transfer. Note that a qualifying business transfer occurs when a taxpayer disposes of shares to an EOT for no more than FMV.
- Extended shareholder loan repayment period: A qualifying business can lend funds to an EOT to purchase shares with a repayment period of up to 15 years. Currently, the borrower must include the shareholder loan in their income if not repaid by the end of the following calendar.
- Deemed interest benefit rule exemption: EOTs are exempt from the deemed interest benefit rules if it receives a low or non-interest-bearing loan from a qualifying business to purchase shares and the loan is repaid within 15 years. Currently, a shareholder is deemed to have received a benefit if the interest rate charged on a loan received from their corporation is lower than the prescribed interest rate.
- 21-year rule exemption: EOTs are exempt from the 21-year ‘deemed disposition’ rule to avoid getting taxed on a deemed disposition of all trust assets every 21 years; however, if the trust no longer satisfies the EOT conditions, the 21-year rule would be reinstated until the trust qualifies as an EOT again.
Takeaways
While the government has tightened the intergenerational business transfer rules, the EOT rules present another succession planning opportunity. Selling to employees can be a great option if the owner is unable to find or doesn’t wish to sell to a third-party buyer, and when family members are uninterested in taking over the business.
If you’re planning to exit your business in the near future, we can help with your succession planning. For more information on whether you and your business can benefit from employee ownership trusts, contact your local advisor or reach out to us here.
Disclaimer
The information contained herein is general in nature and is based on proposals that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice or an opinion provided by Doane Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, specific circumstances or needs and may require consideration of other factors not described herein.
