Employee ownership trusts are structured such that the employees buy the business through a loan against the business, amortized up to 15 years, rather than from their own capital.fizkes/iStockPhoto / Getty Images
After 157 years of distinct cultural growth, there are arguably not many British economic models that make their way to Canada nowadays. Employee ownership trusts, which the U.K. has been utilizing since 2014, are an exception. If utilized widely, they might represent a meaningful change to Canada’s business landscape.
On June 20, Bill C-59 received royal assent, meaning that new tax incentives for EOTs are now active in Canada from 2024 to 2026, with perhaps more years to come if the program is successful.
In a nutshell, the new bill allows qualifying business owners to sell their business to employees, via a trust, with a tax exemption on the first $10-million in capital gains. At top provincial tax rates, this equates to roughly $3.5-million in savings.
Even more savings are available via tax deferral as the capital gains reserves period has been extended to 10 years. On a qualifying sale, only 10 per cent of capital gains need to be reported as income each year, spreading the tax cost over a decade.
This represents significant tax savings – far larger than the $1.25-million lifetime capital gains exemption (LCGE) for individuals that was also introduced in this year’s federal budget along with EOTs. And business owners can potentially use both the EOT exemption and the LCGE on the same transaction, further sweetening the savings.
What does this uncollected revenue do for Canadians at large? Business owners could have another $3.5-million to contribute to the economy. But more importantly, EOTs address a looming Canadian business crisis.
A 2022 study from the Canadian Federation of Independent Business found that 76 per cent of owners of small- and medium-sized businesses (SMEs – those with less than 500 employees) were planning to exit their business before 2032. Considering that SMEs employ over 60 per cent of Canada’s labour force, the ramifications could be dramatic. The same study estimates $2-trillion in assets could be changing hands from these exits – almost as much as Canada’s entire 2023 gross domestic product.
While some businesses can be passed on to family or sold to other Canadians, many others – especially large companies – were left without clear futures. Common concerns include the possibility of monopoly consolidation by competitors or the sale of companies to international corporations, both of which could impact Canada’s economy.
Enter the EOT. Instead of selling the business overseas, why not consider selling it to the employees?
Selling to employees
An EOT is an irrevocable Canadian resident trust that holds shares of a qualified business. It’s set up to promote succession by transferring ownership of a business to its employees. EOTs are structured such that the employees “buy” the business through a loan against the business, amortized up to 15 years, rather than from their own capital.
An EOT transfers governance from the owner(s) of the business to a board of trustees. The board is usually composed of company executives, independent advisors and employee representatives.
The board has a fiduciary responsibility to manage the business on behalf of employees, who become proportionate owners, typically based on title, tenure and salary. As the business earns income, the trust can profit-share by distributing earnings to employees, not dissimilar to how stocks pay dividends.
Proponents say the flatter organizational structure aligns long-term incentives for stakeholders with those of the business, creating more resilient companies. According to the U.K.’s Employee Ownership Knowledge Programme, businesses that use EOT structures are 1.5 times more likely to have an expanding workforce, 1.7 times less likely to have high turnover, 1.25 times more likely to have increasing profits, and 1.5 times more likely to have increasing investment in research and development.
The U.K.’s continuation of this program hints at the government’s belief in it. That’s especially interesting considering that the U.K.’s permutation of the policy, unlike Canada’s, has no ceiling on the capital gains exemption.
Qualifying EOT transactions
Shares of a Canadian controlled private corporation (CCPC) with employees can be sold to an EOT if roughly 90 per cent or more of its share value is attributable to assets that are used principally in an active business carried out by the corporation. Even if a CCPC has passive assets above 10 per cent, the CCPC may be able to purify itself (with resulting potential tax consequences) to meet the 90 per cent rule before 2026.
A qualifying transfer occurs when the CCPC’s shares are sold to an EOT in which the trust beneficiaries are employed by the business. As mentioned, owners relinquish governance rights when they sell.
Post-sale ownership can’t be overly concentrated: No more than 40 per cent of the directors can be individuals who, immediately before the EOT acquired control, owned (directly or indirectly, individually or in partnership) 50 per cent or more of the CCPC’s debt or shares. Individual beneficiaries can’t own – except through the trust – more than 10 per cent of the share value, and can’t own more than 50 per cent of the CCPC share value through the trust.
The trust must be properly managed to maintain its EOT status. That status can be lost if there’s a “disqualifying event,” such as the active business assets falling below 50 per cent of the share value. If that happens within 24 months of sale, the capital gains exemption can be denied retroactively. If it happens after 24 months, the trust itself will be liable for a deemed capital gain.
EOTs could represent significant opportunities if utilized correctly. Incentives for business owners potentially stimulate entrepreneurship, and many working Canadians could obtain a greater stake in their own labour. Monitoring these transactions to the end of 2026 will be telling.
Chris Warner is a wealth advisor and client relationship manager with Nicola Wealth Management Ltd. in Victoria. Simran Arora is a wealth advisor and portfolio manager with Nicola Wealth in Calgary.
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