Canada’s new Employee Ownership Trust (EOT) legislation came in effect on January 1, 2024 and includes a temporary capital gains exemption on the first $10 million in proceeds from the sale of a company to an EOT under a “qualifying business transfer.”
This exemption—which ends on December 31, 2026—can translate to significant tax savings and provide an attractive succession planning solution to small-to medium-sized Canadian private businesses with between $5M to $75M EBITDA and/or 30+ employees.
What is an EOT?
An EOT is a Canadian-resident trust that acquires and holds a controlling share interest (more than 50%) of a qualifying corporation on behalf of its employees. The purchase is usually funded through future profits of the company, with payment made to the sellers in installments over time (often 5-10 years). In most cases, external loans are used to fund 40-50% part of the purchase upfront.
What are the Key Tax Benefits of an EOT?
Unlike a management buyout, the first $10M in capital gains realized on the sale of a qualifying business to an EOT would be tax-exempt for tax years 2024, 2025 and 2026. The seller also has up to 10 years (instead of 5 years) to claim the capital gains reserve and the qualifying business can lend funds to the EOT to purchase shares with a repayment period of up to 15 years.
Other tax benefits:
- An EOT is exempt from deemed interest-benefit rules if it receives a low or non-interest-bearing loan from the Qualifying Business to purchase shares and the loan is repaid within 15 years.
- An EOT is exempt from the 21-year ‘deemed disposition’ rule typical for a trust. This means there is no tax triggered on a deemed disposition of its assets every 21 years.
- Capital gains on the sale of a Qualifying Business are exempt from Alternate Minimum Tax (“AMT”).
- The $10M capital gains exemption is stackable with the Lifetime Capital Gains Exemption (LCGE) of $1.25M.
- The $10M capital gains exemption can be applied to “multiple businesses” owned by the same seller(s).
- There is flexibility to divide the $10M capital gains exemption between co-sellers.
Conditions to be met for a Qualifying Business transfer to an EOT
At the time of transfer:
- The corporation must meet the Small Business Corporation test (90% or more FMV of the assets principally used in an active business);
- the seller(s) must not ‘be related’ to the EOT; and
- the EOT must acquire controlling interest (more than 50%) of the corporation.
After the transfer:
- The seller(s) must continue to deal at ‘arm’s length’ with the corporation and the EOT after the transfer, and
- the seller(s) must not retain or acquire control (directly or indirectly) of the corporation or the EOT.
Conditions to be met for $10M Capital Gains Exemption
- The seller(s) must be an Individual (or a personal trust with an individual beneficiary) above 18 years of age;
- the Qualifying Business Transfer must occur between Jan 1, 2024 and Dec 31, 2026;
- the seller(s) must have been actively engaged on a regular and continuous basis in the business for at least 24 months;
- 75% of trust beneficiaries must be residents of Canada at the time of transfer; and
- a joint election (by the EOT and the seller) must be filed with the CRA prior to the EOT’s tax return filing due date.
Disqualifying event
If the trust ceases to be an EOT, or less than 50% of the FMV of the Qualifying Business is attributable to assets used principally in active business at the beginning of two consecutive taxation years, this will be considered to be a disqualifying event and will lead to a reversal of any EOT tax benefits.
Additional Considerations
All current and future employees must be beneficiaries of the EOT. Former employees are also eligible to be beneficiaries if desired.
The distribution of income and capital to employees must be pursuant to a formula that is based solely on the following (or a combination of the following):
- Total hours of employment service
- Total salary, wages and other remuneration paid
- Total period of employment service provided.
Note: the distributions must place a salary cap of 2x the highest marginal tax bracket (~$450k) of any particular employee.
S+C Partners is here to help
If you are a Canadian private business owner and wish to explore the newly legislated EOT rules as a potential business succession option, our tax team and business valuation specialists are here to support you. Please call us at 905-821-9215 or email us at info@scpllp.com if you have any questions or require any assistance.
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