Écrit par Wade Ritchie, Marshall Haughey, Ted Shoub and Wesley Novotny
There is a growing international movement to increase employee ownership of businesses. Some jurisdictions such as the United Kingdom and the United States have developed tax rules and incentives to facilitate business ownership by trusts created for the benefit of a business's employees. The Department of Finance (Canada) followed this trend when it introduced draft amendments to the Income Tax Act (Canada) (the Act) to create "employee ownership trusts" (EOTs) in the recent 2023 Canadian Federal Budget, released March 28, 2023 (Budget 2023).
In this article, we provide an overview of the proposed rules on EOTs contained in Budget 2023. We then offer our initial impressions from both a tax and a commercial perspective.
While the introduction of EOTs is a welcome development in Canada, we question whether the rules, as currently drafted, which are highly prescriptive and come with relatively meagre tax incentives, will trigger the widespread use of EOTs.
- In Budget 2023, Finance introduced draft legislation to create EOTs to facilitate business ownership by a corporation's employees.
- An EOT is a Canadian-resident trust created for the benefit of the employees of a "qualifying business" that is controlled by the trust and that meets certain other conditions.
- A "qualifying business" is a Canadian-controlled private corporation (CCPC) 90 percent or more of the fair market value of the assets of which are used principally in an active business carried on primarily in Canada.
- EOTs are generally taxed in the same manner as other personal trusts except that:
- the 21-year deemed disposition rule does not apply to EOTs;
- the qualifying business can loan funds to the EOT in certain circumstances without subsection 15(2) applying provided the loan is repaid within a 15-year period; and
- the capital gains reserve period is extended to up to 10 years for vendors of qualifying businesses to an EOT rather than the typical five year maximum.
Conditions to Qualify as an EOT
An EOT means an irrevocable trust that, at all relevant times, satisfies the following conditions:
- Residency: The trust must be resident in Canada (but not a subsection 94(3) deemed resident trust), meaning that the mind and management of the trust must be in Canada.
- Permitted beneficiaries: The trust must be exclusively for the benefit of individuals, each of whom is an employee of one or more "qualifying businesses" (discussed below) controlled by the trust, other than employees that have not completed an applicable probationary period. Additionally, beneficiaries may not hold more than a specified maximum interest in a qualifying business controlled by the trust, including immediately before the qualifying business is transferred to the trust.
- Interests of beneficiaries in the trust: The interest of each beneficiary must be determined in the same manner, based solely on the beneficiary's hours worked, pay, and/or period of employment. The trust must be prohibited from acting in the interests of one beneficiary (or group of beneficiaries) to the prejudice of another.
- Restrictions on distributions of shares: The trust must be prohibited from distributing shares of a qualifying business to any beneficiary.
- Trustees: Trustees must be elected by the beneficiaries for a period not exceeding five years. Each trustee must be either a licensed Canadian resident trust company or a Canadian resident individual, and each trustee must have an equal vote in the conduct and affairs of the trust. Individuals who, together with related or affiliated persons, held a significant interest in the qualifying business immediately before such business was transferred to the trust, generally cannot represent more than 40 percent of the trustees.
- Trust property: All or substantially all the fair market value of the property of the trust must be attributable to shares of qualifying businesses that the trust controls and by which all beneficiaries of the trust are employed. We will refer to this as the "EOT Asset Test".
- Qualifying business: At a particular time means a CCPC controlled by a trust, all or substantially all the fair market value of the assets of which is attributable to assets (other than an interest in a partnership) used principally in an active business carried on primarily in Canada by the particular corporation or a corporation that the particular corporation controls. We will refer to this as the "QB Asset Test".
- Control/governance restrictions: (1) Not more than 40 percent of the directors of the corporation may consist of individuals that, together with related or affiliated persons, owned 50 percent or more of the fair market value of the shares or indebtedness of the corporation immediately before the trust acquired control of the corporation, and (2) the corporation must deal at arm's length and not be affiliated with any person or partnership that owned 50 percent or more of the fair market value of the shares of the corporation immediately before the trust acquired control of the corporation.
Tax Advantages of EOTs
EOTs are generally subject to the same tax rules as other personal trusts, with the following exceptions:
- Shareholder loans: Shareholder loans received by a non-corporate shareholder are generally included in the shareholder's income unless the loan is repaid within one year after the end of the corporation's tax year in which the loan was made. Budget 2023 proposes rules that allow EOTs to repay certain shareholder loans over a 15-year period, without including the loan in income where the loan was made to purchase the qualifying business. This proposed rule would enable an EOT to borrow money from a qualifying business to pay for the purchase of shares of such corporation from a vendor.
- Capital gains reserve: The capital gains reserve generally allows taxpayers to defer the recognition of a capital gain where all or part of the proceeds from a disposition are receivable after the end of the taxation year. The capital gains reserve can generally be claimed over a maximum five-year period, with at least 20 percent of the applicable gain being recognized each year. Budget 2023 proposes an extended 10-year capital gains reserve for dispositions of a qualifying business to an EOT, with at least 10 percent of the applicable gain recognized each year. This proposed rule would be beneficial for a vendor that receives proceeds from a disposition from an EOT over a period longer than the current five-year capital gains reserve, reducing the vendor's tax burden in those years and lining up the tax with the receipt of cash proceeds.
- 21-year deemed disposition rule for trusts: Unless an exception applies, personal trusts are generally deemed to dispose of all of their capital property every 21 years, which results in the taxation of accrued gains. Budget 2023 proposes to exempt EOTs from the 21-year rule, meaning EOTs can hold shares of the qualifying business corporation for an indefinite period without the Act deeming a taxable event every 21 years.
Comparing EOTs to Employee Holdcos
In our experience, when an agreement has been reached to have the employees of a corporation "buy out" the controlling shareholder, it is not uncommon for the employees to incorporate a holding company (the Employee Holdco) to buy the shares. If we compare an EOT structure to an Employee Holdco structure, it quickly becomes questionable as to whether the tax incentives for EOTs are sufficient considering the conditions one has to comply with to obtain them. For one, the qualifying business can loan funds to an Employee Holdco to finance part of the purchase price for the shares of the qualifying business without any concerns of a shareholder loan income inclusion under subsection 15(2) since that provision does not apply when the borrower is a corporation resident in Canada. Because an Employee Holdco is a corporation and not a trust, the 21 year deemed disposition rule also does not apply to an Employee Holdco. It therefore seems that the only potential tax benefit that an EOT might have over an Employee Holdco is the extended capital gains reserve period of up to 10 years. And for that privilege, one has to comply with a relatively restrictive set of rules and conditions, including that the vendor has to give up control of the qualifying business (which in our experience is rare where the vendor is being paid out over time. Typically, the vendor maintains control or the right to re-acquire control until fully paid out). For this reason, we think that most taxpayers and their advisers will prefer an Employee Holdco to an EOT, as the proposed EOT rules are currently drafted.
Specific Tax Considerations
- Asset tests:
- The QB Asset Test requires "all or substantially all" (i.e., 90 percent or more) of the fair market value of the assets of the qualifying business be attributable to assets used principally in an active business carried on primarily in Canada. In our experience, it is quite common for small and medium sized Canadian businesses to have some foreign operations that would make them ineligible to be acquired by EOTs because of this condition. This will restrict the universe of Canadian businesses that can be acquired by employees through an EOT. And even if a corporation is a "qualifying business" when acquired by the EOT, it is prevented from growing its business internationally if that would cause it to cease to meet the QB Asset Test, which could in turn cause the EOT to cease to meet the EOT Asset Test.
- The proposed rules permit the EOT to borrow funds from the qualifying business for up to 15 years in order to fund the purchase of the qualifying business. However, in order to be a "qualifying business" the QB Asset Test places certain restrictions on the types of assets that the qualifying business can hold. The concern is that too much cash and/or a receivable owed by the EOT to the qualifying business would be a "bad" asset for the QB Asset Test. This may significantly restrict the flexibility of the qualifying business to undertake these transactions, including the ability to make loans to the EOT to facilitate a purchase.
- The QB Asset Test would also require constant monitoring, which is a compliance burden that medium or smaller business may struggle to meet.
- Financing concerns:
- The proposed rules would enable EOTs to obtain shareholder loans from the qualifying business in order to facilitate a qualifying business transfer. Presumably, the repayments would have to occur with the after-tax portion of dividend payments received by the EOT from the qualifying business. This dividend income would be subject to high marginal tax in the EOT which in many cases would exceed the beneficiaries' tax rates.
- The shareholder loan by the qualifying business to the EOT would presumably be subject to a deemed interest benefit under subsection 80.4(2) if interest on the loan was charged at less than the prescribed rate. So either the EOT has a deemed interest benefit or it pays interest on the loan which is taxed in the corporation's hands. This seems to be a relatively tax-inefficient financing structure.
- Limited tax benefits:
- As noted above, the tax incentives for setting up EOT structures may not be generous enough for EOTs to be widely adopted in Canada.
- The EOT incentives should be contrasted with incentives of other jurisdictions. For example, in the United Kingdom, if certain requirements are met, the vendor of a business to an employee ownership trust can be completely exempt from capital gains tax on the sale. Further, in the United Kingdom example, a business owned by an employee ownership trust can pay a specified amount out to its employees each year tax free.
- Sale of the qualifying business by the EOT:
- The proposed rules require that the EOT prohibit the distribution of the shares of the qualifying business to the employee beneficiaries. This would seem to leave two options for the trust vis-à-vis the qualifying business it holds: (1) the EOT must exist and hold the qualifying business perpetually, or (2) the EOT must sell its shares. This is limiting, and there should be circumstances where it would be permitted for the trustees to collapse the EOT and distribute the shares out to the beneficiaries, if desired.
- Technical tax concerns:
- Employee benefit plan: The EOT Asset Test requires that all or substantially all the fair market value of the property of the trust must be attributable to shares of qualifying businesses that the trust controls. What happens if the trust sells those shares and then holds only cash? Does it cease to be an EOT? If the trust is no longer an EOT, would it fall within the provisions of being an "employee benefit plan" for purposes of the Act? It would seem inappropriate for the trust to be considered an employee benefit plan that could result in a distribution of a capital gain from the trust (arising from the sale of the shares of the qualifying business) being treated as an income distribution in the hands of the employee beneficiaries.
- Capital gains exemption: Will the beneficiaries of an EOT be entitled to the capital gains exemption on a sale of shares of a qualifying business, assuming the shares otherwise qualify? Presumably the answer is yes.
- Subsection 84(2): The proposed rules contemplate the EOT using the target qualifying business' cash to buy-out the vendor. This raises the issue of the potential application of subsection 84(2), which could apply to convert a capital gain into a deemed dividend for the vendor.
- Sections 84.1 and 212.1: It is not inconceivable that sections 84.1 or 212.1 could apply in a scenario where a vendor sells shares to a purchaser corporation wholly-owned by an EOT (which can be a "qualifying business transfer" under the proposed rules) and the vendor (or an employee or agent thereof) is a trustee of the EOT and therefore may not deal at arm's length with the purchaser corporation.
Recommendations to Department of Finance
The following is a list of some tax related recommendations that could be considered by the Department of Finance that we believe would resolve some of the issues noted above and would further incentivize taxpayers to use an EOT structure:
- QB Asset Test:
- Reducing the threshold in the QB Asset Test somewhat from "all or substantially all" to "primarily" would ensure that many more small and medium-sized Canadian businesses could qualify for a sale to an EOT.
- Consideration should be given to whether the QB Asset test should only have to be satisfied periodically (e.g., at the beginning of each tax year) rather than continually and whether qualifying business status should only be lost after failing to meet the QB Asset Test in two consecutive periods to give the corporation time to comply. This could reduce the compliance burden for continuing qualification as an EOT.
- Mechanism for purification of qualifying business:
- There is no simple way to extract "bad" assets in the QB Asset Test (e.g., passive investment assets, foreign subsidiaries, etc.) on a tax-deferred basis before selling the shares of an operating company. Consideration should be given to including a mechanism to allow business owners to "purify" their operating companies on a tax-deferred basis before selling the shares to an EOT. For example, some sort of exception to subsection 55(2) might be created to permit business owners to "butterfly" their investment assets into a holding corporation before selling the shares of their operating company to the EOT.
- Restriction on share distribution:
- The purpose of the restriction on the distribution of shares to beneficiaries is not entirely clear. It would be helpful if this restriction was explained and narrowed to leave EOTs with more flexibility if it were to dispose of a qualifying business or to be wound-up.
- Vendor control restriction:
- We believe the restriction on vendor's maintaining control of the qualifying business (or even the ability to regain control of the qualifying business on certain events such as default of payment of purchase price) will be a major stumbling block. Consideration should be given to loosening these rules and allowing more vendor involvement for an extended period allowing the vendor to be paid out, and to properly transition the business. Perhaps by including (even periodically) some sort of employee /beneficiary consent to the structure, but not necessarily employee control, a more practical middle ground could be reached.
- Carve out of specific rules: In terms of specific tax rules, clarity and simplicity is important, especially because these rules are aimed more smaller and medium sized businesses. Some changes to the proposed rules should make clear that:
- subsection 84(2) will not apply to cash loaned from the qualifying business to the EOT that is then paid to the vendor;
- neither section 84.1 nor section 212.1 will apply to consideration received in respect of a qualifying business transfer;
- no subsection 80.4 benefit will apply to the EOT on a loan from the qualifying business;
- an EOT is not an employee benefit plan or an employee trust for purposes of the Act, and its exclusion from those rules should extend for a period of time after it no longer meets the EOT requirements, such as on a disposition of the qualifying business, to allow the EOT the be wound-up without being caught in other rules, such as the employee benefit plan rules. The taxation of trusts that involve employers and employees is a confusing area of the Act, with many overlapping rules, and clarity here would be helpful; and
- beneficiaries can claim the lifetime capital gains exemption for any capital gains distributed to them by an EOT, if the EOT disposes of the qualifying business and the shares would otherwise qualify.
As the vendors will typically be the parties setting up the EOT and structuring the qualifying business transfer, the transaction should prove to be quicker, simpler and less adversarial than selling the company to a third party, such as to a competitor or private equity (or even for a management buyout). The purchase agreement should also present less risk for the vendors as it would likely contain much less liability for aspects of the company's pre-closing operations, via representations and warranties and indemnities, as compared to agreements with arms' length purchasers. Vendors looking towards succession planning may also be motivated to see their employees take over the company. While this benefits the employees, it also helps the vendors, as it eliminates the burden of finding an interested third party buyer, and potentially allows the vendors to work out their last years in the business on their own terms (and not be subject to the demands of a third party buyer). Accordingly, it may be a great solution for vendors who want to carry-out a phased transition out of the business.
Regarding purchase price, while the sale of the EOT would be based on a fair market valuation, a competitive/auction process (seeking third party buyers) might net a higher price than such valuation. Even if the purchase price was comparable, the payout would generally be over a period many years (as discussed below), which effectively lowers the return on the sale. As well, the risk of non-payment of the balance of the purchase price following any closing payment is significantly higher than in a typical sale to a third party, as such payments are dependent on the continued success of the business, which is the sole means of funding those long term payments. In order to lower such risk, vendors would typically want to, or even have to, stay actively involved in the business for an extended period of time (as discussed below), which would not necessarily be the case in arm's length transactions. As well, before such a sale can occur, administratively, the onus will be on the vendors to set up the EOT structure, draft the purchase documentation and arrange the acquisition financing.
If setting up an EOT is the route of choice for a vendor, then consideration should be given to a number of issues when setting up an EOT and carrying-out a qualifying business transfer:
Much of the purchase price will, effectively, have to be financed by the vendors or the company, and third party financing may limit the company's ability to grow. Unlike in a typical sale of a business, the EOT will not be in position to contribute any of its own money for the purchase price, so it will have to borrow 100 of any closing payment, and for the balance, to rely on the vendors agreeing to be paid over a long period of time, using profits from the company. The financing for any closing payment of purchase price would come from either a third party lender, the company itself (perhaps if it has cash reserves, subject to tax imposed asset restrictions discussed above) or the vendors.
It remains to be seen whether third party lenders in Canada will be less inclined to provide financing for this type of sale transaction, however, those that do will typically want to take security in the shares of the company and/or its assets (together with a guarantee of the company). Such participation by the company and its assets in financing a qualifying business transfer will impact the business' ability to get financing for its operations, which may impact the ability of the business to grow. Additional complications may result in a situation where there are minority shareholders of the company who do not participate in the qualifying business transfer (i.e., they remain as shareholders alongside the EOT). As they will not be benefitting from the transaction, they may oppose the company board agreeing to such participation in the financing.
Governance Considerations for the Company and the EOT
Unlike in a typical arm's length sale of a business, as the new owner, the EOT will not be well-positioned to run the business after the sale. Accordingly, subject to the control restrictions noted above, the existing management and board of directors of the company will need to remain in place, including the vendors (if they were so involved). In fact, the vendors will want to stay involved as the payment of the deferred portion of the purchase price is dependent on the success of the company post-sale. Accordingly, the vendors will want to continue to offer their skills and experience to the business and to continue to exert some level of influence over the company. That said, such participation by the vendors should only be for a transition period, either until the purchase price has mostly been paid out or until their management roles can be replaced.
The EOT would be expected to generally take a similar governance role to that of a majority shareholder. That is, while it will elect directors to the board of the company, it would not generally have a say in the day-to-day operation of the business. It will, however, wish to weigh in on major decisions, significant transactions or significant changes in the business. In addition to such major shareholder role, it would be responsible for allocating the profits of the business paid to it, so as to ensure that the acquisition financing and deferred purchase price are being paid, and to determine how any remaining funds are divided amongst the beneficiary employees.
Accordingly, vendors should also consider who should act as the trustees of the EOT. Typically, EOTs in the United Kingdom, as an example, have trustee representation from: (1) the employees; (2) the vendors, and (3) independent persons. As the beneficiaries of the EOT, employees will want to know that their voices are being heard. For the reasons noted above, vendors will want a say at this level, as well. Meanwhile, independent trustees can bring worthwhile industry or governance experience, and can serve as a mediating voice between the interests of the employees and that of the vendors.
Employee Entitlement Considerations
As noted above, the trustees will have the task of determining how the remaining profits of the company will be allocated amongst the employee beneficiaries. The vendors may wish to propose a formula for that. Under the proposed rules, the EOT is permitted to make distinctions as amongst the employees as to their respective interests in any such distributions. As noted above, distinctions can be made based on an employee's hours worked, pay, and/or period of employment. Thought will have to be given to designing a formula that employees feel is equitable, and which effectively motivates the employees to make the business succeed. That said, the ability of the company to offer any kind of distribution to the employees is likely going to be limited in the early years of the EOT, given the EOT's obligations to first have to repay the acquisition financing and deferred purchase price.
The EOT rules proposed in Budget 2023 are a welcome development in the Canadian tax and business succession landscape. We hope that the proposals are amended to increase their flexibility, and to provide additional incentives for their use. Stay tuned to see what if any changes are made to the proposed rules based on comments provided to the Department of Finance in the comment period.