Federal Budget 2023 - Part II: Employee Ownership Trusts

Canada’s federal budget was released on March 28, 2023. The McLennan Ross tax team is publishing a three-part series to highlight conditions of the budget most likely to impact our clients. These consist of:

1. A summary of measures of interest to private corporations, which can be found here;
2. Employee Ownership Trusts; and
3. Further changes to section 84.1 (following up on Bill C-208 which deals with transfers of shares and wealth to the next generation).

In Part II, we will take a deeper dive into the new Employee Ownership Trusts proposed by the federal government.

Employee Ownership Trusts

One challenge under Canada’s current tax regime is the transition of ownership of private companies to employees in a tax efficient manner. Without going into details, there are risks of numerous negative tax consequences for employees associated with giving them shares.

In Budget 2023, the federal government proposes rules governing “Employee Ownership Trusts” or “EOTs” in an effort to combat this issue in limited circumstances. When these rules come into effect, an EOT will be able to acquire, and hold shares of certain Canadian-Controlled Private Corporations (“CCPCs”) while providing tax benefits to the seller of the business and the employee beneficiaries.

The Budget sets out a comprehensive scheme for the qualifying conditions and taxation of EOTs. These new rules and amendments are to apply as of January 1, 2024.

Qualifying Conditions 

All the below requirements must be met for a trust to be considered an EOT:

Residency and Purpose

The trust must factually be a Canadian resident trust (i.e., deemed resident trusts are excluded). The factual residence of a trust is determined based on where its real business is carried on, that is where the central management and control of the trust occurs.[1]

The EOT may only have two purposes: holding shares of qualifying businesses for the net benefit of the employee beneficiaries, and making distributions to such employee beneficiaries.

Qualifying Business

The EOT must hold a controlling interest in the shares of one or more “qualifying businesses”, and such shares must make up all or substantially all of the assets of the EOT.

To be a qualifying business, the business must be a CCPC, and all or substantially all of the fair market value of its assets must consist of assets used in an active business carried on in Canada. Such assets are not to include an interest in a partnership.

Additional tests apply where an existing business is acquired by an EOT. In particular, no more than 40% of the directors of the corporation can be individuals who owned (together with any related or affiliated persons) 50% or more of the shares or indebtedness of the corporation prior to the acquisition by the EOT. Also, once acquired by the EOT, the corporation must deal at arm’s length, and not be affiliated with any person who owned 50% or more of the fair market value of the shares or indebtedness of the corporation prior to the EOT’s acquisition.

Governance

As for governance, the trustees (including corporations serving as trustees) must factually be Canadian residents, and are to be elected by the adult beneficiaries at least once every five years. The trustees must each have an equal vote in the conduct of the affairs of the EOT.

Where an existing business is sold to an EOT, there are additional restrictions. In particular, no more than 40% of the trustees of the EOT can be any combination of:

• individuals who, together with any related or affiliated persons, owned 50% or more of the shares or indebtedness of a qualifying business prior to sale to the EOT; and
• corporations of which more than 40% of the directors fall into the above category.

Beneficiaries

The beneficiaries of the trust must consist exclusively of “qualifying employees”. Qualifying employees include all individuals employed by a qualifying business controlled by the EOT, other than employees who:

• individually own 10% or more of the fair market value of any class of shares of a qualifying business controlled by the EOT (other than through the EOT);
• collectively with related or affiliated persons own 50% or more of the fair market value of any class of shares of a qualifying business controlled by the EOT;
• immediately prior to the transfer to the trust owned, collectively with all related or affiliated persons, 50% or more of the fair market value of the shares and indebtedness of a qualifying business; and
• have not completed a reasonable probationary period of up to 12 months.

The interest of each beneficiary of the trust must be determined in the same manner, based solely on the application of one or more of the following criteria: the employees’ length of service, total remuneration and/or hours worked.

The EOT will not be permitted to allocate or distribute shares of qualifying businesses to individual beneficiaries. Instead, the shares are held on behalf of the collective employee beneficiaries. The EOT is also prohibited from acting in the interest of one or more beneficiaries to the prejudice of others.

Taxation

The EOT will receive various tax benefits compared to a typical personal trust. Certain of these benefits will apply to the trust as a whole, the employee beneficiaries, and to the transferor of the business to the EOT.

The EOT will be a taxable trust, and its undistributed income will be subject to tax at the top personal marginal tax rate. Where income is distributed to the beneficiaries, the income will instead be subject to tax at the beneficiary level. Further, dividends received from qualifying businesses and distributed to beneficiaries will retain their character when received by the beneficiaries, making them eligible for the dividend tax credit.

Also, “qualifying business transfers” to an EOT will obtain some beneficial tax treatment for the transferors, i.e., the previous business owners. A “qualifying business transfer” occurs when a taxpayer disposes of shares of a qualifying business for no more than fair market value to an EOT or a CCPC wholly owned by the EOT. Immediately following the transfer, the EOT must own a controlling interest in the qualifying business.

The transferor will then be eligible to claim a ten-year capital gains reserve. To illustrate, typically when taxpayers are permitted to receive proceeds of a sale of capital property on a deferred basis, a minimum of 20% of the gain must be recognized in income each year, creating a maximum five-year deferral period. For qualifying business transfers to EOTs, instead a minimum of 10% of the gain must be recognized each year, creating a 10-year deferral period. This will allow for significant tax deferral for the transferor, creating an incentive for the use of the EOT.

The EOT is also anticipated to be exempted from two important trust tax rules: the shareholder loan rules and the 21-year rule. The standard shareholder loan rules mean that a loan to a shareholder will be included in that shareholder’s income in the year received unless it is repaid within a year. If this rule applied, an EOT which borrowed money from a qualifying business to finance the purchase of shares would be required to repay such amounts within a year or pay taxes on the loan amount.

Instead, Budget 2023 proposes to introduce a new exception which will extend the repayment period to 15 years. This exception will apply only where an EOT borrows from a qualifying business to purchase shares in a “qualifying business transfer” (as defined above). In such case, so long as bona fide arrangements are made for repayment within 15 years at the time the loan is made, the loan amount will not be included in the EOT’s income.

Lastly, the EOT is anticipated to be exempt from the 21-year rule, a rule deeming certain trusts to dispose of all their capital property at 21-year intervals. The EOT would be exempt from this rule while it continued to meet the qualifying conditions discussed above. If it no longer met those conditions, the 21-year rule would be reinstated.

Conclusion

We anticipate the qualifying conditions will significantly limit the use of EOTs. Because the trust must have a controlling interest in a qualifying business, and those individuals who held a significant interest prior to sale effectively cannot control the EOT, the EOT will likely not be a useful mechanism for a gradual passage of ownership interest to employees.

Also, the EOT will not be helpful in the transition of family business to the next generation (due to the restrictions surrounding individuals who held a significant economic interest and their related persons) or to a select few employees (due to the requirement that all qualifying employees be beneficiaries of the trust).

Instead, the EOT’s use will likely be limited to situations where owners wish to transfer control of the business to arm’s length trustees for the benefit of, effectively, all the employees of the business.

This is not something that has traditionally been done very often in Canada. However, previously tax law made such a plan quite difficult. It will be interesting to see how popular EOTs will become once they become available, especially given the large number of business owners who may be retiring over the next decade.

As previously mentioned, the rules surrounding EOTs are anticipated to come into effect on January 1, 2024. Please contact the McLennan Ross tax team if you think an EOT may be right for your situation. Stay tuned for Part III of this series addressing the amendments to section 84.1.