Employee Ownership Trusts

Overview

Initial draft legislation to facilitate creating employee ownership trusts (EOTs) was introduced in the 2023 federal budget. After consultation, changes to the EOT rules were made in a legislative package released on August 4, 2023, and in Bill C-59, Fall Economic Statement Implementation Act, 2023. Notable changes in Bill C-59 included allowing for an EOT to distribute shares of a qualifying business to a beneficiary, and changing the definition of qualifying business to remove the requirement that all or substantially all of the fair market value of the corporation’s assets be attributable to assets used in an active business carried on primarily in Canada. Additionally, the 2023 fall economic statement (2023 FES) proposed a temporary exemption for the first $10 million in capital gains realized on the sale of a business to an EOT.

The 2024 federal budget provides additional details on the $10 million exemption from taxation on capital gains realized on the sale of a business to an EOT that were not included in 2023 FES or Bill C-59, and also proposes to expand a qualifying business transfer (as defined for purposes of the EOT rules) to include the sale of shares to a worker cooperative corporation meeting certain definitions in the Canada Cooperatives Act.

Who will this affect?

The $10 million exemption from taxation on capital gains will affect business owners by providing an additional tax incentive to consider when planning for business succession and retirement. The EOT rules also affect employees and worker cooperative corporations by facilitating employee ownership of a business in a tax-efficient manner.

Key features

The $10 million exemption from capital gains on the sale of shares to an EOT would be available where certain conditions are met. The exemption requires that the individual, a personal trust of which the individual is a beneficiary, or a partnership in which the individual is a member, disposes of shares of a corporation (other than a professional corporation) pursuant to a transaction that is a qualifying business transfer (as defined in the proposed EOT rules). Additionally, the trust acquiring the shares cannot already be an EOT or a similar trust with employee beneficiaries, and 90% of the beneficiaries of the EOT must be resident in Canada immediately after the transfer. Like the lifetime capital gains exemption (LCGE) available on the disposition of qualified small business corporation shares, the EOT exemption imposes certain requirements on ownership of shares and involvement with the business prior to the transfer:

• Throughout the 24 months immediately prior to the transfer (i) the transferred shares must have been owned exclusively by the individual claiming the exemption (or a related person or a partnership in which the individual is a member) and (ii) over 50% of the fair market value of the corporation’s assets must have been used principally in an active business.

   

• At any time prior to the transfer, the individual (or his/her spouse or common-law partner) must have been actively engaged in the business on a regular and continuous basis for a minimum period of 24 months.

The exemption for up to $10 million in capital gains can be claimed by multiple individuals on the same transfer, but the total exemption claimed cannot exceed $10 million, and the individuals must agree how the exemption is allocated. The exemption cannot be claimed by a trust. Further, any exempted capital gains would be subject to the alternative minimum tax (AMT) at an inclusion rate of 30%, which matches the AMT inclusion rate for capital gains eligible for the LCGE.

There are certain disqualifying events that would cause the exemption to be unavailable or denied, and could cause tax liability for the EOT following the transfer. A disqualifying event would occur if (i) an EOT loses its status as an EOT or (ii) less than 50% of the fair market value of the shares of the business is attributable to assets used principally in an active business at the beginning of two consecutive taxation years. The EOT would be deemed to realize a capital gain equal to the total amount of exempted capital gains unless the disqualifying event occurs within 36 months of the transfer, in which case the exemption is not available and is retroactively denied for the individual if it has already been claimed.

An election is required in order for an individual to claim the exemption whereby the EOT (and any corporation owned by the EOT that acquired the shares) would be jointly and severally, or solidarily, liable for any tax payable by the individual in circumstances where a disqualifying event has occurred within 36 months of the transfer. The normal reassessment period of an individual claiming the exemption would be extended by three years for the exemption.

Lastly, qualifying business transfers for EOT purposes would be expanded to include the sale of shares to a worker cooperative corporation meeting certain definitions in the Canada Cooperatives Act. Selling a business to a worker cooperative would allow an individual to claim the $10 million exemption, and would also be eligible for the extended 10-year capital gains reserve and the 15-year exception to the shareholder loan rules that are otherwise available on a qualifying business transfer to an EOT.

The $10 million exemption from taxation on capital gains realized on the sale of a business to an EOT would apply to qualifying disposition of shares starting January 1, 2024, and ending on December 31, 2026.

How we can help

The $10 million exemption from taxation on capital gains on a sale to an EOT provides an additional incentive for business owners considering retirement and succession planning for their Canadian businesses. Careful planning will be required to claim the $10 million exemption and avoid subsequent tax liability for the individual or the EOT as a result of a disqualifying event. This complexity would be in addition to the planning needed to comply with the proposed EOT rules, and the related tax, trust and employment requirements needed for an EOT structure. Norton Rose Fulbright can help you assess whether an EOT may be right for your business and employee group.