Between January 1, 2024 and December 31, 2026, business owners can access significant tax benefits when selling a qualifying business to an employee ownership trust (“EOT“) pursuant to a transaction that constitutes a qualifying business transfer. Among other benefits, eligible vendors are entitled to receive a shared pool of up to $10 million in capital gains deductions (the “EOT Deduction“).

This article covers the following topics:

  1. Qualification Requirements for EOTs;
  2. Distribution Structures for EOTs; and
  3. Qualification Requirements for EOT Transactions.

Generally speaking, an EOT is an irrevocable trust resident in Canada whose only assets comprise qualifying businesses subject to certain conditions concerning beneficiaries, trustees, distributions, and fundamental decisions. Unlike traditional ownership models, where shares are owned by individual shareholders, an employee ownership trust model allows the employees of a business to benefit from the growth and success of the company as beneficiaries of the EOT which is the controlling shareholder.

EOTs are a particularly effective solution for business owners looking to transition ownership in a way that preserves the company legacy and enables the owners to take advantage of significant tax savings, making it an appealing option for both owners and employees.

In a previous article which was titled ‘Unlocking $10 Million in Capital Gains Deductions with Employee Ownership Trusts’ (“Part I“) we provided a sample transaction structure with a $10 Million EOT Deduction and explained the other benefits and considerations of such a transaction structure, including the EOT Deduction eligibility requirements for business owners. Part I is viewable on our website at https://linmac.com/employee-ownership-trusts-transaction-deduction.

Qualification Requirements for EOTs

To qualify as an EOT, at all relevant times an irrevocable trust resident in Canada must satisfy the following requirements:

Beneficiaries

The trust must be exclusively for the benefit of: (A) all non-probationary employees (“Eligible Employees“) of a qualifying business controlled by the trust; and (B) if the trust permits, all former Eligible Employees (“Eligible Former Employees“) of a qualifying business controlled by the trust who were employed while the trust controlled the qualifying business, except that, the following individuals are always prohibited from being beneficiaries:

  1. Any individual that directly or indirectly owns 10% or more of the fair market value (“FMV“) of any class of shares of a qualifying business controlled by the trust;
  2. Any individual that, together with any related or affiliated person or partnership, directly or indirectly owns 50% or more of the FMV of any class of shares of a qualifying business controlled by the trust; and
  3. Any individual that, together with any related or affiliated person or partnership, directly or indirectly owned 50% or more of the FMV of the shares or debt of a qualifying business controlled by the trust immediately before it was transferred to the trust.

Trustees

All of the following requirements respecting trustees must be adhered to:

  1. the trustees may not act in the interest of one or more beneficiaries to the prejudice of any other beneficiary or beneficiaries;
  2. every trustee must be an individual or a corporation that is resident in Canada and authorized to act as a trustee;
  3. every trustee has an equal vote;
  4. one-third or more of the trustees must be Eligible Employees; and
  5. if any trustee is appointed, 60% or more of the trustees must deal at arm’s length with every person who sold shares of a qualifying business to the trust (or any person or partnership affiliated with the trust) prior to or in connection with the trust acquiring control of the qualifying business (there is an exception if the trustees are elected).

Fundamental Decisions

More than 50% of the Eligible Employees that are beneficiaries must approve the following transactions:

  1. any transaction or event that causes 25% or more of the Eligible Employees to lose their status as beneficiaries (unless the change in status is in respect of a termination of employment for cause); and
  2. a winding-up, amalgamation or merger of a qualifying business (unless it involves only persons or partnerships affiliated with the qualifying business).

Trust Property

All or substantially all of the FMV of the trust’s property must be attributable to shares of qualifying businesses controlled by the trust.

A “qualifying business” is defined as a corporation controlled by a trust that meets the following requirements:

  1. It is a Canadian-controlled private corporation (“CCPC“);
  2. Immediately before the trust acquired control of the corporation, not more than 40% of the directors directly or indirectly owned 50% or more of the FMV of the shares or debt of the corporation together with any person or partnership that is related to or affiliated with the director; and
  3. Immediately after the trust acquires control of the corporation, it must deal at arm’s length with and cannot be affiliated with any person or partnership that owned directly or indirectly 50% or more of the FMV of its shares or debt.

Distribution Structures for EOTs

The capital and income interests of all beneficiaries (both Eligible Employees and Eligible Former Employees) must be exclusively based on one (1) or more of the following criteria:

  1. Total hours of employment with the qualifying business during a particular time period;
  2. Total salary, wages and other remuneration paid or payable by the qualifying business during a particular time period (up to a maximum amount set forth in the Act); and/or
  3. Duration of employment with the qualifying business since a particular time.

For trust distributions to Eligible Employees, each of their capital and income interests must be determined in the same manner, but it may be different from the manner used for Eligible Former Employees.

For trust distributions to Eligible Former Employees, each of their capital and income interests must be determined in the same manner, but it may be different from the manner used for Eligible Employees.

Qualification Requirements for EOT Transactions

Building on Part I, which set out the requirements necessary for businesses to be eligible for the EOT Deduction, in order to successfully claim the EOT Deduction, the EOT transaction must also constitute a qualifying business transfer and the EOT transaction itself must meet certain requirements.

Qualifying Business Transfer

A “qualifying business transfer” is the disposition by a taxpayer of shares of a corporation (the “Subject Corporation“) to a trust, or a CCPC that is wholly-owned by a trust (the “Purchaser Corporation“) where the following conditions apply:

  1. Before the disposition, all or substantially all the FMV of the Subject Corporation’s assets must be attributable to assets used principally in an active business (the “Business”) carried on by the subject corporation or a wholly-owned subsidiary.
  2. At the time of the disposition:
    1. The taxpayer deals at arm’s length with the trust and any Purchaser Corporation;
    2. The trust acquires control of the subject corporation; and
    3. The trust must be an EOT, whose beneficiaries are employed in the Business.
  3. After the disposition:
    1. The taxpayer must continue to deal at arm’s length with the subject corporation, the trust, and any Purchaser Corporation.
    2. The taxpayer must not retain any rights or influence (alone or with any related or affiliated person or partnership) that could allow them to directly or indirectly control the Subject Corporation, the trust, or any Purchaser Corporation.

Additional EOT Transaction Requirements and Restrictions

Individuals that sell the shares of a qualifying business to an EOT will be entitled to claim the EOT Deduction if the transaction satisfies all of the following requirements:

  1. The vendor is an individual of at least 18 years of age.
  2. The business is not divided up in order to create multiple transactions in respect of which the EOT Deduction will be claimed for each.
  3. Amounts payable as dividends are not used to create capital gains under circumstances where:
    1. a significant part of the capital gain is attributable to the fact that dividends were not paid on a share; or
    2. dividends paid on such a share in the taxation year or in any preceding taxation year were less than 90% of the average annual rate of return on that share for that year.
  4. Immediately prior to closing, the trust does not control a corporation whose employees are beneficiaries of the trust.
  5. No individual can have previously claimed the EOT Deduction in respect of shares that derived their value from any active business relevant to the determination of whether the disposition is a qualifying business transfer.
  6. At the disposition time, 75% or more of the beneficiaries of the trust are resident in Canada.
  7. The capital gain cannot be from a disposition of property which is part of a series of transactions or events in which any property is acquired by a corporation or partnership for consideration that is significantly less than FMV.
  8. A joint election is timely filed by the trust, any purchaser corporation owned by the trust, and the vendors eligible for the EOT Deduction which sets forth the amount of the capital gain eligible for the deduction and the allocation of the deduction amongst the eligible vendors. The election must be filed on or before the trust’s filing-due date for the taxation year involving the sale.

Disqualifying Events

The following events (a “Disqualifying Event“) can result in unintended tax consequences:

  1. The trust ceases to be an EOT.
  2. At the beginning of the two consecutive taxation years of the qualifying business, less than 50% of the FMV of the shares of the qualifying business is attributable to assets used principally in an active business carried on by one or more qualifying businesses controlled by the trust.

If a Disqualifying Event occurs within 24 months of the qualifying business transfer, the EOT Deduction is deemed to have never applied in respect of the transaction and the individual vendors that claimed any or all of the EOT Deduction will be liable to pay any capital gains tax that is payable as a result. If a Disqualifying Event occurs after 24 months of the qualifying business transfer, the trust is deemed to have a gain equal to the amount of the EOT Deduction previously claimed, which will be included in income for the year in which the Disqualifying Event occurs.

Conclusion

Settling a trust with a structure that enables it to qualify as an EOT which is eligible to participate in a qualifying business transfer is a complex endeavour. Prior to effecting any relevant transactions, it is important to consult a lawyer who is familiar with the legal framework and capable of tailoring an implementation strategy that is specific to your business. If you have a specific question or would like to further discuss how to effectively navigate this process, please do not hesitate to reach out to any member of our team.