Moore Stephens
Taxation

Employee ownership trusts: a way to retain key employees

This is the latest in a series of articles on profit-sharing plans, an interesting alternative for companies wishing to improve employee retention within their ranks. Over the past few months, our team of Canadian tax consultants has assisted a number of companies in developing and implementing some of these incentive plans, and has decided to write articles on the subject in order to inform even more entrepreneurs keen to offer their employees the best possible working environment.

Find our other articles on profit-sharing schemes here.

In previous articles, you’ve learned about the bonusplan, freeze strategies, new share issues,stock options, phantom stock plans and employee trusts. This article, the last but not least in the series, focuses on a brand-new plan: the employee ownership trust.

Overview: How do employee ownership trusts work?

When a shareholder is looking to retain their succession, and some of their employees are open to acquiring their business, several options are available. Starting in 2024, a new option will be available to entrepreneurs and their successors to facilitate a qualifying business transfer through an employee ownership trust (hereinafter “EOT”). Although the legislation governing EOTs has not yet been enacted, and subject to the adoption of the final legislation including the legislative proposals put forward, the establishment of an EOT will make it possible to acquire and hold shares in a company, without requiring key employees to pay directly for the acquisition of shares.

The broad outlines applicable to the operation of this type of plan

There are several differences between an EOT and a discretionary trust or an employee trust. These different plans should not be confused.

To set up an EOT, the following criteria must be met:

  • The trust must be resident in Canada, its beneficiaries must be exclusively employees of the company and the company must qualify as a qualifying business;
  • Immediately prior to the transfer of shares from the business to the trust, the trust’s shares must qualify as eligible small business corporation shares (refer to the DGC text);
  • At the time of transfer, the trust must acquire control of the business, which normally corresponds to more than 50% of the voting shares;
  • At the time of the transfer and at all times after the transfer, the seller must not be at arm’s length with the trust, nor retain any right or influence the exercise of which would enable it to control in any way whatsoever the company involved, the trust or a purchaser;
  • The interest held by the EOT beneficiaries will have to be determined in the same way for all employees, based on the application of one or a combination of reasonable criteria such as, for example, the number of years of service since the employee was hired by the company; the number of hours worked by the employee during the year; the total salaries and wages payable to the employee; and so on.

Other considerations

  • When the purchaser is an EOT, the seller has the option of spreading the capital gain over a maximum period of ten years by means of a capital gains reserve, rather than over a maximum period of five years as is normally the case in other dispositions.
  • For the 2024, 2025 and 2026 taxation years, it will be possible for the owner-seller to exempt from tax the first $10 million of capital gains realized on the sale of his or her shares to a EOT.
  • When the purchaser is an EOT, the repayment term of the loan to the shareholder (the EOT) is extended to 15 years. This considerable advantage enables the EOT to repay the loan obtained to acquire the shares over a much longer period, without having to include this amount in its income for the year in which the loan was obtained.
  • Unlike a discretionary trust, an EOT is exempt from the deemed disposition of its assets on the anniversary date of its 21st birthday.
  • Unlike a discretionary trust, an EOT cannot distribute its assets (the company’s shares) in the form of a tax-free rollover to its beneficiaries (the employees). As a result, an EOT will absolutely have to sell the shares it holds for the benefit of the employees to a third party (either an employee personally or an outside third-party buyer) to terminate the plan.
  • The selling owner must be prepared to transfer control of the company irrevocably, i.e. they cannot reacquire control of the company once the shares have been transferred to the EOT.
  • It is not possible to use an EOT in a transfer involving persons not at arm’s length with the owner-seller, such as members of the owner-seller’s family.
  • Repayment of the loan made to the EOT to acquire the Company’s shares is usually made through the receipt of dividend income payable by the Company to the EOT, which dividend income is taxable by the EOT at the highest marginal tax rate.

Case study and analysis of its integration into a profit-sharing regime

According to the preliminary information available, there are currently two possible scenarios for setting up an EOT and transferring a qualifying business in order to benefit from the new tax measures.

1.

The first scenario involves the eligible company involved in the transaction borrowing the equivalent of the amount required to sell the shares to the EOT from a financial institution. The company then makes a loan to the EOT. The repayment terms of this loan can be spread over a maximum of 15 years at the rate subscribed by the company + 0.1%. Following these transactions, the EOT purchases the shares of the capital stock of the eligible business from the selling owner, who receives payment for the entire sale price of his or her shares at the time of the transaction. Finally, the company pays an annual dividend to the EOT to enable it to pay the principal and interest on the loan taken out, which dividend income will, however, be taxed as income by the trust at the highest marginal tax rate applicable to dividends.

In this scenario, and given that the buyer is an EOT, the repayment term of the shareholder loan is extended to 15 years. This considerable advantage enables the EOT to repay the loan over a much longer period, without having to include this amount in its income for the year in which the loan was obtained.

2.

The second possible scenario involves situations in which the seller-owner finances the sale of the shares to the EOT by means of a balance of sale. In such a scenario, the selling owner sells its shares to the EOT in return for an amount payable according to the repayment terms established between the parties at the time of the sale of the shares. Subsequently, EOT makes the annual payment of the balance of sale to the owner-seller using the cash flow generated by the annual dividend payment received by the company.

In this scenario, and given that the buyer is an EOT, the seller has the option of spreading the capital gain over a maximum period of ten years by means of a capital gains reserve, rather than over a maximum period of five years as in other cases. This gives the owner-seller and the EOT greater latitude to spread the payment of the share sale price over a longer period without penalizing either party.

Summary comparison between an Employee Ownership Trust and an Employee Trust

Employee ownership trust

Employee trust

Fiduciaries

Trust company or individual elected for a maximum period of five years by the trust beneficiaries;

Restriction: An individual or related person who held 50% or more of the company’s shares prior to the transfer may not represent more than 40% of the trustees.

Restriction: Must at all times have at least one independent trustee who is neither settlor nor beneficiary of the trust.
Beneficiaries Employee(s) of one or more eligible companies Employees or former employees of an employer
Allocation of income Reasonably: based on hours worked; salary or other remuneration paid; or employee seniority Reasonably: not dependent on the individual’s position, performance or compensation as an employee
Maximum term of a loan granted to the trust by an affiliated company 15 years Must be repaid before the end of the2nd fiscal year of the company in which the loan was granted
Maximum term of seller’s capital gains reserve 10 years 5 years
Deemed disposition of trust property on 21st anniversary No No

Finally, if you have any questions about this type of plan, about how to implement it in your company, or about the other profit-sharing plans we mentioned earlier, contact a member of our team to discuss it further.

We’ll be happy to compare the different types of plans that could be implemented for your key employees to improve staff retention and motivation.

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