Employee Ownership Trusts - $10M Capital Gains Exemption and Other Benefits

Employee Ownership Trusts - $10M Capital Gains Exemption and Other Benefits

Introduction

The employee ownership trust (EOT) was first introduced in the 2021 Federal Budget as a potential vehicle to encourage employee ownership of a business and facilitate the transition of privately owned businesses to employees. After a period of consultation, the government announced the intention to facilitate the creation of a dedicated trust vehicle to advance the concept to implementation. This initiative led to detailed draft legislation in Bill C-59. More recently, the federal government introduced a $10M capital gains exemption in respect of dispositions of shares to an employee ownership trust. This is a significant development for business succession planning especially in the context of rising capital gains inclusion rates.

Employee Ownership Trust Benefits

The employee ownership trust rules contemplate a sale of shares of a target corporation to the trust. In this context, there are three potential benefits:

• Shareholder loan exclusion,
• 10-year capital gain reserve, and
• $10M capital gains exemption.

Shareholder Loan Exclusion

An employee ownership trust will not be subject to shareholder loan consequences under certain conditions. If a shareholder borrows money from a corporation, the shareholder would generally be required to include the loan in his or her income unless the loan is repaid within one year. Under certain conditions, these consequences will not apply to a loan made in respect of a sale of the shares to an employee ownership trust. This would allow the purchasing trust to receive a loan from the target corporation and thereby access the liquidity in the target to finance the purchase price of the shares without shareholder loan consequences.

 10 Year Capital Gains Reserve

A shareholder who sells shares to an employee ownership trust will be able to defer the income taxes payable from the disposition over a 10-year period under certain conditions. Generally, a capital gains reserve is available to defer tax on capital gains over 5 years where the proceeds of the disposition are payable over 5 or more years. For sales of shares to an employee ownership trust, this 5-year reserve will extend to 10 years under certain conditions and thereby, extend the payment of income taxes from the gain over a longer period of time.

$10M Capital Gains Exemption

The third significant potential policy benefit is the $10M capital gains exemption. Individuals who sell shares of a target corporation to an employee ownership trust will be eligible for a $10M capital gains exemption in respect of their gains from the disposition under certain conditions.

Core Concepts

The proposed employee ownership trust rules employ three key terms: a “qualifying business”, a “qualifying business transfer” and “employee ownership trust”. Their definitions contemplate a sale of shares of the corporation to a trust that acquires control.

Qualifying Business

A qualifying business (QB) is a Canadian-controlled private corporation (CCPC) controlled by a trust that meets certain conditions. The conditions are aimed at restricting the control and influence of shareholders who had a predominant economic interest in the corporation immediately before the trust acquires control.

One condition relates to the corporation’s relationship with such shareholders. It requires that the corporation deal at arm's length and not be affiliated with any person or partnership that owned, directly or indirectly, 50% or more of the FMV of the shares or indebtedness of the corporation immediately before the trust’s acquisition of control.

Another condition relates to the composition of directors. No more than 40% of the directors can consist of individuals who, immediately before the trust’s acquisition of control, owned (directly or indirectly) together with any person or partnership related to or affiliated with the director, 50% or more of the fair market value (FMV) of shares or indebtedness of the corporation.

Qualifying Business Transfer

A qualifying business transfer (QBT) is defined as a disposition by a taxpayer of shares of a corporation (subject corporation) to a trust or a CCPC controlled and wholly-owned by a trust (purchaser corporation), which meets a number of conditions.

There is an active business condition. Immediately before the disposition, all or substantially all the FMV of the assets of the subject corporation must be attributable to assets (other than an interest in a partnership) that are used principally in an active business (Business) carried on by the subject corporation or a corporation that is controlled and wholly-owned by the subject corporation.

There are conditions that must be met at the time of the disposition:

• The taxpayer deals at arm's length with the trust and any purchaser corporation.
• The trust acquires control of the subject corporation.
• The trust is an employee ownership trust, the beneficiaries of which are employed in the Business.

There are post-disposition conditions:

• the taxpayer deals at arm's length with the subject corporation, the trust and any purchaser corporation; and
• the taxpayer does not retain any right or influence that, if exercised, would allow the taxpayer (whether alone or together with any person or partnership that is related to or affiliated with the taxpayer) to control, directly or indirectly in any manner whatever, the subject corporation, the trust, or any purchaser corporation.

These conditions must be met “at all times after the disposition”. A violation of either condition appears to taint the disposition from being a qualifying business transfer and essentially nullify the EOT benefits.

Employee ownership trust

An employee ownership trust (EOT) is an irrevocable trust resident in Canada that meets a number of conditions.

The trust must be a special purpose vehicle for holding shares of qualifying businesses. Accordingly, all or substantially all (90%) the fair market value of the property of the trust must be attributable to shares of one or more qualifying businesses that the trust controls.

There are restrictions on beneficiaries. The trust must be established exclusively for the benefit of all individuals, each of whom is an employee of one or more qualifying businesses (QBs) controlled by the trust (Current Employee Beneficiaries), or if the trust permits, an individual (or the estate of an individual) who is a former employee of one or more QBs controlled by the trust and who was an employee of the QB while the trust controlled the QB. The following employees are excluded:

• An employee or former employee who has not completed an applicable probationary period not exceeding 12 months (probationary employees).
• An employee who owns, directly or indirectly (other than through an interest in the trust), shares of a class of a QB controlled by the trust, the value of which is equal to or greater than 10% of the FMV of the class.
• An employee who owns, directly or indirectly, together with any person or partnership related to or affiliated with the individual, shares of a class of a QB controlled by the trust, the value of which is equal to or greater than 50% of the FMV of the class.
• An employee who owned, immediately before the qualifying business transfer to the trust, together with any person or partnership related or affiliated with the individual, shares or indebtedness of the QB, the value of which is equal to or greater than 50% of the FMV of the shares and indebtedness of the QB.

The composition of trustees is also subject to conditions. Each trustee must be either a natural person or a corporation resident in Canada licensed to provide trustee services. At least 1/3 of the trustees must be Current Employee Beneficiaries.

If any trustee is appointed, at least 60% of the trustees must deal at arm's length with each person who has, directly or indirectly, sold shares of a QB to the trust (or to any person or partnership affiliated with the trust) prior to or in connection with the trust acquiring control of the QB. An exception applies where the trustee is elected within the last five years by Current Employee Beneficiaries.

There are also conditions relating to trust governance. Each trustee has one equal vote in the conduct of the affairs of the trust. However, the approval of more than 50% of the Current Employee Beneficiaries is required for the following transactions prior to their occurrence:

• Any transaction or event or series of transactions or events causing at least 25% of the beneficiaries to lose their status as Current Employee Beneficiaries (unless the change in status is in respect of a termination of employment for cause).
• A winding-up, amalgamation or merger of a QB (other than in the course of a transaction or event or a series of transactions or events that involves only persons or partnerships that are affiliated with the QB).

Trustees are prohibited from exercising their discretion to act in the interest of one beneficiary (or group of beneficiaries) to the prejudice of others. Capital and income interests of each beneficiary must be determined in the same manner as other beneficiaries based on hours worked, compensation and period of employment.

Reflection

The shareholder loan exclusion and the 10-year capital gains reserve is available if an employee ownership trust structure meets the conditions of a “qualifying business”, a “qualifying business transfer” and “employee ownership trust”. However, individuals who want to claim the $10M capital gains exemption must satisfy additional conditions.

Conditions - $10M Capital Gains Exemption

To qualify for the $10M capital gains exemption, an individual must meet the following additional conditions:

1. Limited Period of Availability: The person must claim the exemption in respect of a gain from the disposition of shares (subject shares) of the capital stock of a corporation (subject corporation) to a trust (or a purchaser corporation wholly owned by the trust) that occurred after 2023 and before 2027 under a qualifying business transfer.
2. Active Business Condition: Throughout the 24 months immediately preceding the disposition time, more than 50% of the FMV of the subject shares was derived from assets which were used principally in an active business.
3. One-time Exemption: No individual has prior to the disposition time sought the exemption in respect of a disposition of shares that, at the time of that disposition, derived their value from an active business that is also relevant to the determination of whether the disposition of the subject shares satisfies certain QBT conditions.

According to the Explanatory Notes, this condition is intended to improve neutrality by ensuring that an established EOT does not hold a tax advantage (i.e., the exemption) over its non-EOT competitors when acquiring a new business. It mitigates the advantage held by an established EOT (due to greater access to financing) bidding against a newly formed trust for the benefit of workers of a target business who wish to form their own EOT. The exemption is intended to reduce the disincentive of selling a business to a newly created EOT that may not have the financial resources of a third-party buyer.

1. Canadian Resident Beneficiary Condition: At the disposition time, at least 75% of the beneficiaries of the trust are resident in Canada.
2. Joint Election: The trust, any purchaser corporation owned by the trust, the vendor and any other individual entitled to the exemption in respect of the QBT must make a joint election. If more than one individual is eligible to claim the exemption, the election form must set out the percentage of the exemption allocated to each individual.

Disqualifying Events and Tainting the Exemption

The occurrence of a disqualifying event will taint the exemption. If a disqualifying event occurs within 24 months after a QBT, the exemption would be deemed to have never applied. If a disqualifying event occurs after 24 months, the trust would be deemed to have a gain equal to the exemption amount claimed.

There are two disqualifying events:

• A disqualifying event will occur when the trust that participated in the QBT ceases to be an EOT.
• A disqualifying event will occur if less than 50% of the FMV of the shares of the QB is attributable to assets used principally in an active business carried on by one or more QBs controlled by the trust at both that time and at the beginning of the preceding taxation year of the QB. The time of this disqualifying event will be the beginning of the taxation year of the QB in which this event occurs.

An example highlights the intricacies of this and other EOT provisions. As mentioned, a violation of post-disposition conditions at any time appears to preclude a disposition from being a “qualifying business transfer”. The definition of an “employee ownership trust” contemplates the occurrence of a qualifying business transfer. What happens if a disposition ceases to meet the definition of a qualifying business transfer? Would the violation trigger a disqualifying event?

There are other provisions relating to anti-avoidance, compliance and restrictions on implementation. These provisions also raise the complexity of the rules and could taint the exemption.

Closing Comments

The conditions for the $10M capital gains exemption as well as other benefits offered by the EOT proposals are complicated. Structuring an arrangement to meet the conditions for the benefits will be challenging especially given that such arrangements inherently involve multiple stakeholders (i.e., individual owners, employees, trustees). Rules that potentially taint the exemption also raises the complexity level. It is also questionable whether some of the conditions, especially those relating to trustee composition and governance, could hinder the optimal structure for business purposes.