Tax tips for selling the shop, part 4

How the new Employee Ownership Trust will work

In this series of articles, I’ve been looking at some tax-planning strategies and options when selling your business. Last time I focused on the first of two important federal budget proposals that will affect sales of businesses starting in 2024. In this article, I’ll put the spotlight on the new Employee Ownership Trust coming into force January 1, 2024

A brand new concept was also introduced in budget 2023. It is the Employee Ownership Trust (EOT). This is a specific, special-purpose trust vehicle that is designed to provide a succession-planning option to owners of privately-held corporations. It aims to facilitate increased employee ownership of privately-held businesses without requiring employees to directly pay for such shares.

What are the conditions?

The following qualifying conditions must be met:

1. The trust must be a Canadian resident and exist solely (i) to hold shares of a qualifying business for the benefit of the employee beneficiaries; and (ii) to make formula-based distributions to such employee beneficiaries;

2. The trustees (including any corporate trustees) must (i) be Canadian residents and (ii) be elected every five years by the beneficiaries;

3. EOT must hold a controlling (51%+) interest in one or more qualifying businesses;

4. All or substantially all (90% or more) of the assets of the EOT must be shares of one or more of such qualifying businesses;

5. A qualifying business (i) cannot be carried out as a partner to a partnership; and (ii) all or substantially all (90% or more) of the FMV of its assets must be used to carry out an active business in Canada (the “Asset Test”);

6. The EOT cannot directly allocate shares of a qualifying business to specific beneficiaries of the EOT; and

7. Once the owner-operator sells the business to an EOT, they (or anyone related who also has a significant interest – 10% or more – in the business) cannot form more than 40% of the trustees, the board of directors of the businesses, or the board of directors of a corporate trustee.

Who are the beneficiaries of the EOT?

They are the employees of the qualifying business. Generally, this captures all employees employed directly by the qualifying business (as well as employees of other businesses that the qualifying business controls).

However, the following employees are excluded: Employees who were significant shareholders pre-sale; and employees who have not been employed for at least 12 months pre-sale. It should be noted that if there are non-resident employees who are beneficiaries, a withholding tax will be required to be made by the Trust for any distributions. Moreover, if an employee passes away or becomes disabled, their surviving family members cannot benefit from the EOT.

How does it work?

At a high level, the mechanics are as follows:

1. An owner-operator enters into a purchase-and-sale agreement with the EOT (or a corporation wholly owned by the EOT);

2. Shares are sold for an amount not in excess of FMV, and as a result of the sale, the EOT must either directly or indirectly hold a controlling interest in the qualifying business.

The funds required for the purchase are either advanced from the corporation itself (as a shareholder’s loan), or through a third-party bank or private financing.

The new rules extend the normal repayment period of the shareholder loan to 15 years (instead of having to be repaid within one taxation year after the year in which the loan was made). Although a bona fide repayment arrangement must be made, there is no requirement that the loan actually be repaid. However, there will be certain deemed-interest inclusions to the EOT.

What to watch for

The Asset Test must be met at all times. This means that an accumulation of excess cash will need to be justified as it relates to maintaining active business pursuits and building cash reserves that may cause a business to become offside.

Legislative provisions that apply to trusts generally apply to EOT. Importantly, this means that income that is retained and not distributed will be taxed at the top personal marginal rate applicable to the province of residence of the EOT. Any income allocations to a beneficiary would be taxed in the hands of the beneficiary.

Note, however, that an EOT is not subject to the 21-year deemed disposition rule as long as it maintains its status as an EOT.

From the vendor’s perspective, if the purchase price that the EOT pays is paid over time, the new proposals allow for an expanded capital-gain reserve so that they can take the capital gain over 10 years as opposed to 5 years.

While the EOT sounds like an interesting proposition, it remains to be seen if this will actually become a practical option for a seller.

Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3^rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. A version of this article first appeared in The TaxLetter, © 2023 by MPL Communications Ltd. Used with permission.

Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.