As founders of owner-operated businesses consider exit strategies, the choice made can have far-reaching implications, not only for your financial gains but also for the legacy and future of the company. With the Department of Finance (Canada)’s release of the draft amendments to the Income Tax Act (Canada) to create an employee ownership trust (EOT) on March 28, 2023, an attractive avenue for business owners seeking tax advantages and a smooth transition while empowering their employees may have emerged. In this article, we explore the benefits of utilizing an EOT to structure the sale of a business compared to that of a holding company.
Understanding EOTs:
EOTs are a unique legal structure that enables business owners to sell their businesses to a trust established for the benefit of their employees. As seen in the jurisdictions in which EOTs have already been implemented (such as the United States and the United Kingdom), they typically employ the following steps:
- Form a trust and make the employees of the business the beneficiaries;
- Set up financing to facilitate the sale of shares from the business to the trust;
- Determination by the trustees of the terms by which the shares of the business will be purchased; and
- Debt repayment by the trust over time using the earnings distributed to it from the business.
The primary purpose of EOTs is to hold the shares of the business and distribute the benefits among the employees, fostering a sense of ownership, motivation, and long-term stability within the company.
Tax benefits of EOTs:
EOTs offer several tax benefits compared to other personal trusts, being:
- The proposed amendments to the Act set out that EOTs will not be subject to the “21-year rule” that most personal trusts are subject to, whereby a trust is deemed to have disposed of all capital property every 21 years, and therefore taxed on any accrued gains. This means that an EOT can hold the shares of the business for an indefinite period prior to incurring a taxable event.
- The proposed amendments to the Act extend the capital gains reserve period to ten years for EOTs, with only 10% of the capital gains recognized each year. This extension is advantageous for business owners who anticipate receiving the proceeds over a period longer than five years, allowing them to spread out tax payments[;
- EOTs will be allowed to repay shareholder loans over a period of up to 15 years without counting the loan as income, making the purchase of the corporation through an EOT more feasible and less expensive for the purchasers.
Other benefits of EOTs:
In addition to tax considerations, there are a number of other benefits to business owners looking to sell their company through an EOT:
- EOTs help create wealth for employees, fostering employee loyalty and improving environmental, social, and corporate governance (ESG) metrics of the company. The firm’s legacy and culture are preserved, as business owners can transition out of their company without selling to competitors or private investors.
- Selling to an EOT ensures the continuity of the business and the preservation of local jobs. By providing employees with an opportunity to participate in the ownership and management of the company, EOTs contribute to the long-term stability and growth of the business.
- The disposition of a business through an EOT structure is likely to be faster, simpler, and less adversarial, incurring lower professional fees compared to selling the company to a third party. Moreover, the need to find an interested third-party buyer is eliminated.
- A business owner can transition out of the business at their own pace and on their desired terms, without being subject to a third-party buyer’s demands.
- Compared to selling the business to an arms-length purchaser, an EOT is less risky for a business owner, as they are not required to provide the same representations, warranties, and indemnities.
Drawbacks to EOTs:
EOTs are trusts that are created for the benefit of a “qualifying business”, which satisfy a number of conditions at all time. A qualifying business is a Canadian-controlled private corporation controlled by a trust, with all or substantially all the fair market value of the assets of which is attributable to assets (other than an interest in a partnership) being used principally in an active business carried on primarily in Canada by the particular corporation or a corporation that the particular corporation controls. Further, all or substantially all the fair market value of the property of the trust must be attributable to shares of the qualifying businesses that the trust controls and by which all beneficiaries of the trust are employed.
There are also a number of stipulations governing a EOT that must be satisfied at all times; including specific residency requirements, restrictions on who may be considered a permitted beneficiary, and to what extent each beneficiary may have an interest, who can be a trustee, certain governance/control restrictions of the EOT, and restrictions on how shares may be distributed.
The extensive compliance requirements to qualify as an EOT present a significant drawback for someone looking to sell their business, and suggest that and EOT structure may only be attractive to certain kinds of business owners.
EOTs compared to employee holding companies:
An alternative to employing an EOT in the sale of a business is utilizing a holding company for the employees to buy out the shares. While both EOTs and employee holding companies offer tax benefits such as the avoidance of the “21-year rule,” EOTs stand out due to their extended capital gains reserve period of up to ten years. However, considering the extensive compliance requirements of EOTs and the relatively limited unique tax benefits, some sellers may prefer the flexibility and simplicity of an employee holding company.
Conclusion:
Employee Ownership Trusts present Canadian business owners with a potentially compelling alternative to structuring the sale of their businesses through employee holding companies. EOTs offer unique benefits, such as an extended capital gains reserve period and empowerment of employees, promoting long-term stability, and contributing to business continuity and the retention of local jobs. However, business owners should carefully consider the compliance requirements and tax implications before deciding on this structure. As you consider the sale of your business, consulting with a legal and tax professional experienced in Canadian law and tax statutes is crucial to ensure compliance and maximize the benefits of an EOT. By exploring the advantages of EOTs, you can make an informed decision that aligns with your financial goals, the well-being of your employees, and the future success of your business.