Charting a new course for corporate succession: Employee ownership trusts (EOT)

We recently published an article on the Employee Share Purchase Tax Credit in Manitoba, implemented by the Government of Manitoba to encourage, address and facilitate succession planning for Manitoba small businesses.

While this may be an appropriate avenue for some Manitoba companies, for other companies, employee ownership trusts (EOT) offer an effective solution for succession planning. This article sets out how to qualify as an EOT and take advantage of the tax incentives and other benefits, including up to a $10-million capital gains exemption.

Exit sign for business owners

As recently reported by the Canadian Federation of Independent Business, succession planning is a top of mind issue for Canadian business owners:

• Approximately three out of every four Canadian business owners are planning to exit their business within the next 10 years.
• Nearly one in four business owners plan to exit by passing the reigns to employees; an additional 24% are looking to their family members.

What is an EOT?

An EOT is an irrevocable trust created to acquire and hold equity shares of a Qualifying Business (as defined below) from a business owner, for the benefit of the corporation’s employees as part of an exit or succession plan of the business owner.

How does a trust qualify as an EOT?

To qualify as an EOT, a trust must at all times meet the following conditions with respect to residency, structure and composition:

• The trust must be resident in Canada determined without reference to certain rules of the Income Tax Act (Canada) (the Tax Act) that deem certain trusts to be resident in Canada;
• The beneficiaries of the trust must consist exclusively of individuals who are current employees (and/or former employees, if desired);
• The trust’s beneficiaries cannot include employees who also have a significant ownership stake in the business outside the EOT, employees related to or affiliated with significant owners, or employees who were part of, or are related to or affiliated with, the vendor ownership group;
• The interest of each beneficiary is determined equally and in a manner which only factors in hours worked, remuneration and length of service;
• The trustees must be restricted in exercising their powers to act in the interest of certain beneficiaries to the detriment of other beneficiaries;
• Each trustee must be a Canadian licensed trust company or an individual with an equal vote in the conduct of the trust’s affairs;
• At least one-third of the trustees must be active employee beneficiaries;
• If any trustees of the EOT are to be appointed instead of elected, at least 60% of all trustees must deal at arm’s length with members of the vendor ownership group;
• More than half of the active employee beneficiaries must approve reductions in the business’s workforce greater than 25% and any wind up, amalgamation, or merger of the business with non-affiliates; and
• 90% or more of the fair market value of the trust’s property must be attributable to shares in Qualifying Businesses (discussed below) controlled by the EOT.

What are Qualifying Businesses?

An EOT can only own and hold shares in a corporation that meets the following criteria (a Qualifying Business):

• The corporation must be a Canadian Controlled Private Corporation (CCPC) (as defined in the Tax Act);
• No more than 40% of the corporation’s directors own 50% or more of the fair market value of the equity or debt of the corporation at the time immediately before the EOT acquires control; and
• The corporation deals at arm’s length and is not affiliated with any person or partnership that owned, directly or indirectly, 50% or more of the fair market value of the equity or debt of the corporation immediately before the time the EOT acquired control of the corporation.

What is a Qualifying Business Transfer?

A “Qualifying Business Transfer” is a sale of equity shares from a Qualifying Business to an EOT, or to a CCPC that is controlled and wholly-owned by an EOT, that meets the following requirements:

• Immediately before the transfer, 90% or more of the fair market value of the assets of the corporation must be attributable to assets (other than an interest in a partnership) that are used principally (more than 50%) in an active business carried on by the Qualifying Business or a wholly-owned subsidiary of the Qualifying Business;
• At the time of the transfer, the vendor deals at arm’s length with the EOT and any affiliated corporation of the EOT;
• The EOT must acquire control of the corporation upon the share transfer;
• The beneficiaries of the EOT must be employed in the business of the corporation at the time of the share transfer; and
• At all times after the transfer, the transferor must: (i) deal at arm’s length with the corporation, the EOT and any affiliated corporation of the EOT and (ii) must not retain the ability to exercise legal or de facto control over the corporation, the EOT or any affiliated corporation.

Access up to a $10-million capital gains exemption

For Qualifying Business Transfer occurring in the 2024, 2025 or 2026 tax year(s), EOTs may allow the business owners of a Qualifying Business to access up to a $10-million shared capital gains exemption (the “EOT Capital Gains Exemption”).

To qualify for the EOT Capital Gains Exemption, several conditions must be met:

• The individual claiming the exemption must be at least 18 years old;
• The deduction must not have previously been claimed by any person in respect of the transfer of shares that derived their value from the same Qualifying Business;
• During the 24 months immediately before the Qualifying Business Transfer:
  • The shares must not have been owned by anyone other than the individual claiming the deduction, or a person or partnership related to that individual, and
  • More than 50% of the fair market value of the shares must have been derived from assets used principally in an active business;
• The trust acquiring the shares must not already be an EOT or a similar trust with employee beneficiaries of a different Qualifying Business;
• Neither the Qualifying Business, nor any of its affiliated corporations, can be professional corporations;
• 75% or more of the EOT beneficiaries must be resident in Canada at the time of the Qualifying Business Transfer;
• The individual claiming the deduction or their spouse or common-law partner must have been actively engaged in the business on a regular and continuous basis for at least 24 months at any time prior to the Qualifying Business Transfer; and
• The EOT, any of its affiliated corporations, and any individuals claiming the deduction must jointly elect for the deduction on or before the EOT’s filing due date for the tax year in which the Qualifying Business Transfer occurred (all eligible individuals and/or entities must agree on an allocation for the deduction, which cannot exceed $10 million in total).

Disqualifying events and consequences

If the trust ceases to be an EOT or if less than 50% of the fair market value of the Qualifying Business’s shares is attributable to assets used principally in the active business there will be a disqualifying event that will disqualify an EOT’s eligibility for the EOT Capital Gains Exemption after the Qualifying Business Transfer.

If a disqualifying event occurs within 24 months of the Qualifying Business Transfer, the EOT Capital Gains Exemption becomes void.

Other restrictions

EOTs are also subject to additional conditions that restrict their eligibility for the EOT Capital Gains Exemption. Readers should consult their own financial and legal advisers for more details.

Other advantages and considerations

In addition to up to a $10-million capital gains exemption, EOTs are afforded attractive benefits with respect to borrowing power and deferral of capital gains. When borrowing money from a Qualifying Business to fund the purchase of shares, EOTs benefit from an extended repayment period of 15 years. Furthermore, unlike some other borrowers, an EOT will not be deemed to have received a taxable benefit when the loan it receives from the Qualifying Business bears little to no interest.

Another benefit of EOTs is that an owner exiting from a Qualifying Business can enjoy a longer capital gains deferral period. A retiring owner is able to claim a 10 year capital gains reserve, allowing the taxable portion of the capital gain to be taken into income over a period of 10 years, rather than the usual five year maximum capital gains reserve.

Further, EOTs are exempt from the 21-year disposition rule that generally applies to trusts, providing a unique opportunity to defer capital gains tax indefinitely and mitigate the odds of receiving an unexpected, and likely hefty, future tax bill.

Key takeaways

While EOTs are an attractive succession tool, they are complex and have many restrictions and disqualifying events that can significantly impact the business’s freedom to engage in ancillary tax planning. Canadian business owners considering EOTs should seek the advice of a qualified financial and legal professional to ensure compliance with the Tax Act and other applicable laws.

When used properly, EOTs may be an appropriate way for some business owners to design an effective and sustainable path to retirement and succession. With years of experience helping organizations structure and complete complex transactions, the MLT Aikins taxation group is qualified to discuss and advice on how EOTs may be able to help you navigate challenges associated with succession planning.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.

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