Overview

The 2022 federal budget included a commitment to introduce employee ownership trusts (EOTs) in Canada to facilitate the purchase of a business by employees and employee ownership of Canadian businesses.  The 2023 Canadian federal budget included proposed amendments to the Income Tax Act (Canada) (the Tax Act) relating to EOTs, which amendments are proposed to come into force on January 1, 2024.  Although the draft legislation imposes many restrictions on an EOT’s structure and activities, an EOT may provide a tax-effective way to structure a sale of an active business to employees in the right circumstances.

Who will this affect?

The introduction of EOTs will affect business owners, in particular owners of small and medium-sized businesses, and their employees.  EOTs provide business owners with an additional option to consider when succession planning for their businesses and facilitate employees becoming owners of the business in a tax-efficient manner. 

Key features

The primary tax relief offered by EOTs is that:

(i) the capital gains reserve is extended to 10 years (instead of five years) for sales of shares of a qualifying business to an EOT, such that only 10% of the gain on deferred proceeds must be brought into income annually;

(ii) EOTs are not subject to the 21-year deemed disposition rule in the Tax Act that is applicable to most trusts; and

(iii) EOTs can fund a purchase of the qualifying business using funds borrowed from the qualifying business itself, and can repay that loan over 15 years without adverse tax consequences (as opposed to the general two-year repayment requirement for individuals and certain other trusts).

Among other requirements, EOTs must be Canadian resident trusts (i.e., central management and control of the EOT must be in Canada) and the EOT must be limited to two purposes, being (i) holding shares of the qualifying business (directly or indirectly) for employee-beneficiaries of the EOT; and (ii) making distributions from the EOT to qualifying employees based on the employees’ length of service, remuneration and hours worked.

EOT beneficiaries must be qualifying employees (i.e., all employees other than employees who hold or who held a significant economic interest in the business, probationary employees, the seller of the business, and anyone related to the seller). EOTs will not be permitted to allocate shares to individual beneficiaries.

EOTs must also hold a controlling interest in the shares of at least one “qualifying business,” and all or substantially all of the assets held in an EOT must be shares of a qualifying business.  A “qualifying business” is proposed to be defined as a corporation that:

(i) is a Canadian-controlled private corporation all or substantially all of the fair market value of the assets of which are attributable to assets used in an active business carried on in Canada, and which does not carry on its business as a member of a partnership;

(ii) not more than 40% of the directors of which consist of individuals that, immediately before the time the EOT acquired control of the corporation, owned directly or indirectly, together with certain persons related to or affiliated with the director, 50% of more of the shares of the capital stock or indebtedness; and

(iii) deals at arm's length and is not affiliated with any person or partnership that owned 50% or more of the fair market value of the shares of capital stock or indebtedness of the corporation immediately before the time the EOT acquired control of the corporation.

Additional governance restrictions imposed on an EOT include requirements that the trustees must be Canadian resident individuals or a registered trust company and elected by the beneficiaries at least every five years, and that the seller of the business and anyone related to or affiliated with the seller cannot together make up more than 40% of the trustees or the board of any corporation acting as trustee of the EOT. 

How we can help

The introduction of EOTs presents an interesting opportunity for business owners to consider transitioning ownership of Canadian businesses to employees in a tax-efficient manner while encouraging employee retention and creating a tax-efficient manner for employees to become shareholders and grow their own wealth over time.  Compliance with the proposed EOT rules will require careful planning and drafting of the related EOT as well as ensuring compliance with relevant tax, trust and employment requirements.  Norton Rose Fulbright can help you assess whether an EOT may be right for your business and employee group.   

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