Jul 16, 2024
What is an Employer Ownership Trust?
An Employee Ownership Trust (EOT) is a Canadian-resident trust designed to hold shares in qualifying businesses on behalf of employees, supporting succession planning and promoting employee ownership in small and medium-sized enterprises. The EOT framework allows employees to borrow from the business to fund a buyout, offering an extended repayment period and longer capital gains deferral for retiring owners, provided specific conditions are met. This structure aims to ease the financial burden on employees, who would otherwise need to fund the acquisition from their personal savings.
What are the requirements of an EOT?
EOT Residency:
For tax purposes, an Employee Ownership Trust must be a Canadian-resident trust, meaning its central management and control must be located in Canada. Refer to “EOT Trustees” below for additional information on the trustee requirements.
EOT Beneficiaries:
The EOT must benefit all active employees of the business and, optionally, former employees, with the following exceptions:
- Employees who, outside of their interest in the EOT, own directly or indirectly at least 10% of the fair market value of any class of shares in the qualifying business (i.e., significant shareholders outside of the EOT).
- Employees who, along with related or affiliated persons or partnerships, own directly or indirectly at least 50% of the fair market value of any class of shares in the business (i.e., employees affiliated with major owners).
- Employees who, prior to the EOT’s acquisition of the qualifying business, individually or with related parties, owned at least 50% of the fair market value of the business’s shares or debt (i.e., members of or related to the vendor ownership group).
- Employees who have not completed a reasonable probationary period, which may be up to 12 months, can also be excluded.
Limits on EOT Distributions:
When distributing assets, the EOT must treat all employee beneficiaries equally, using a formula based on a combination of the employee’s length of service, remuneration (capped at twice the highest marginal income tax bracket), and hours worked. While different formulas may be applied in varying situations (e.g., distinguishing between active and former employees, or between income and capital distributions), the trustees must not show favoritism among beneficiaries.
EOT Trustees:
Each trustee must be either a Canadian-licensed trust company or an individual, and must be elected at least every five years by the active employee beneficiaries. At least one-third of the trustees must be active employee beneficiaries. If not elected by active beneficiaries, at least 60% of the trustees must be independent from any vendor ownership group. Note that election is not a requirement. Trustees are granted equal voting rights.
Special Approvals by Employee Beneficiaries:
A majority (over 50%) of active employee beneficiaries must approve:
- Any transaction or event that would cause 25% or more of the active employee beneficiaries to lose their jobs, unless it is a termination for cause.
- Any winding up, amalgamation, or merger of a qualifying business (except with affiliates).
EOT Property:
The EOT must invest the majority (90% or more) of the fair market value of its assets in shares of qualifying businesses controlled by the EOT. These qualifying businesses must be Canadian-controlled private corporations (CCPCs) that meet certain broad? representation and control criteria, ensuring the EOT operates independently of the previous controlling shareholders or their affiliates.
Control Over the Business:
The EOT must hold a controlling interest in one or more qualifying businesses. Additionally, at least 60% of the business’s directors must not have previously controlled the business (directly or through related parties) and must act independently of the previous controlling shareholders or affiliates.
What are the tax advantages of an EOT?
EOTs are generally subject to the same tax rules as other personal trusts (such as attribution rules, trust income distribution rules and the annual T3 reporting requirement), with the following key exceptions:
Shareholder Loans:
Typically, loans received by a non-corporate shareholder are included in the shareholder’s income unless repaid within one year after the end of the corporation’s tax year in which the loan was made. However, Budget 2023 introduces a provision allowing EOTs to repay certain shareholder loans over a 15-year period without including the loan in income. This applies when the loan is used to purchase a qualifying business. This proposed rule facilitates EOTs borrowing from the business to finance the purchase of shares from a vendor.
Capital Gains Reserve:
Normally, taxpayers can defer recognizing capital gains if the proceeds from a sale are received after the end of the tax year, claiming a capital gains reserve over a five-year period with at least 20% of the gain recognized each year. Budget 2023 proposes extending this period to 10 years for sales of qualifying businesses to an EOT, with a minimum of 10% of the gain recognized annually. This extended reserve benefits vendors who receive payments from an EOT over a period exceeding five years, reducing their tax liability and aligning it with the receipt of proceeds. A temporary tax exemption on up to $10 million in capital gains from a sale to an EOT for the 2024 to 2026 tax years, subject to certain conditions, was enacted on June 20, 2024. When multiple owners are selling their shares to an EOT as part of a qualifying business transfer, the $10 million exemption must be allocated amongst them in an agreed-upon manner.
21-Year Deemed Disposition Rule:
Personal trusts are usually deemed to dispose of their capital property every 21 years, triggering taxation on accrued gains. Budget 2023 proposes exempting EOTs from this 21-year rule, allowing them to hold shares in qualifying businesses indefinitely without a deemed taxable event every 21 years.
Pro tax tips – The setup of an EOT requires thoughtful planning
The introduction of EOTs offers a compelling opportunity for business owners to transition ownership of Canadian businesses to employees in a tax-efficient way, fostering employee retention and providing employees with a tax-advantaged path to becoming shareholders and building wealth over time. Implementing an EOT will require careful corporation tax planning, thoughtful drafting of the trust, and adherence to applicable tax, trust, and employment regulations to ensure compliance with the proposed rules. Therefore, it is highly recommended for business owners to consult with an experienced Toronto tax lawyer to plan ahead.
FAQ:
What is an EOT?
An EOT in Canada is a legal structure that allows a company’s shares to be held in trust for the benefit of its employees. It facilitates employee ownership without requiring employees to buy shares directly and is often used for ≈ and ensuring long-term employee participation. Introduced in the 2023 federal budget, EOTs offer potential tax advantages and allow employees to benefit from the company’s success collectively.
What are the tax benefits of an EOT?
Budget 2023 introduces new rules allowing Employee Ownership Trusts (EOTs) to repay shareholder loans over 15 years without including the loan in income. This helps EOTs finance the purchase of shares from a seller, facilitating smoother ownership transitions to employees.
Capital gains reserve period is extended from five to ten years for sales of qualifying businesses to an Employee Ownership Trust (EOT), requiring at least 10% of the gain to be recognized annually. Additionally, a temporary tax exemption allows for up to $10 million in capital gains from such sales to an EOT for the 2024 to 2026 tax years, which must be allocated amongst multiple sellers as agreed upon.
EOTs are exempt from the 21-year rule that typically deems personal trusts to dispose of all capital property, leading to taxation of accrued gains. This allows EOTs to hold shares in qualifying business corporations indefinitely without triggering a taxable event every 21 years.
Disclaimer: This article only provides broad information and is up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
