New Legislative Proposals Boost the Appeal of Employee Ownership Trusts

Key Highlights

Disqualifying Events

Under the current rules, the C$10 million capital gains deduction available on a sale to an EOT operates as a deferral—at least from the federal government's perspective. If such deduction is claimed, the vendor (for 24 months following the sale) and the EOT (thereafter, on an ongoing basis) remain liable for the deducted amount as a deferred capital gain, with the gain effectively triggered if a "disqualifying event" occurs at any time in the future. A disqualifying event generally arises where a trust ceases to qualify as an EOT (for example on the sale of the qualifying business controlled by the trust) or where it fails to satisfy certain active business asset thresholds.

The Proposals amend the regime in two significant ways: 

• Expiration of contingent liability: If a disqualifying event does not occur within the 10 years following the qualifying business transfer (i.e., the sale to the EOT), the deferred capital gain is eliminated.
• Debt repayment relief: Where business assets are sold to satisfy debts of the EOT or the qualifying business, no disqualifying event occurs. Accordingly, if the qualifying business becomes insolvent the deferred capital gain should not be triggered.

Substituted Property

An individual must satisfy a 24-month holding period test to qualify for the C$10 million EOT capital gains deduction. This test generally requires that throughout the 24 months preceding the disposition time:

(i) the subject shares must not have been owned by anyone other than the individual or a person or partnership related to the individual; and

(ii) more than 50% of the fair market value of the subject shares must have been derived from assets which were used principally in an active business.

Before the Proposals, it was unclear how this 24-month holding period test would apply where shares were issued within the 24-month period in exchange for other shares, for example on an amalgamation or share exchange.

The Proposals clarify that the 24-month holding period test can be met where shares were issued in exchange for other shares during the 24-months preceding a sale, by introducing a "substituted share" concept, similar to the substituted share rules under the lifetime capital gains exemption regime. Under the Proposals, if, at any time in the 24-month period immediately preceding a sale, the subject shares were substituted for other shares (the old shares being the "substituted shares"), the subject shares shall generally be considered to have met the requirements of the 24-month holding period test where the substituted shares met the required tests throughout the period beginning 24 months before the sale and ending at the time of substitution.

This is helpful in permitting taxpayers to engage in certain restructuring steps in advance of a sale to an EOT, and should help more taxpayers qualify for the C$10 million EOT capital gains deduction.

Holding Company Sales

The Proposals include several amendments aimed at clarifying that the sale of a holding company that wholly-owns an operating qualifying business can qualify for the C$10 million EOT capital gains deduction, including by adding "directly or indirectly" language to more clearly look through holding companies to the assets of the qualifying business below.

While the Proposals do not extend access to the C$10 million EOT capital gains deduction to sales of holding companies that hold less than 100 percent of the qualifying business, pre-sale restructuring may help some taxpayers qualify for the deduction in some cases. We remain hopeful that future legislative amendments will further extend access to the C$10 million EOT capital gains deduction to more common holding company structures.

Actively Engaged Requirement

The Proposals include a clarifying amendment to the requirement that a vendor be "actively engaged on a regular and continuous basis" in the business in order to claim the C$10 million EOT capital gains deduction. Under the amended provision, a vendor is deemed to have been "actively engaged on a regular, continuous and substantial basis" if the individual has worked in the business at least an average of 20 hours per week throughout any 24-month period preceding the sale. 

This is a helpful clarifying amendment which provides a brightline test that taxpayers can rely on when selling their business to an EOT.

Takeaways

These Proposals are beneficial for both vendors and EOTs. In particular:

• The C$10 million EOT deduction now functions as a true exemption where no disqualifying event occurs for at least 10 years following the sale to an EOT, rather than as an indefinite deferral.
• Relief from the deferred capital gains where a business ultimately fails.
• Clarity on how share exchanges and other reorganizations affect access to the C$10 million EOT capital gains deduction.
• More clarity in the applicability of the rules where the operating business is held through a holding company.
• A clear threshold to meet to ensure the actively engaged in business test is met.

Overall, the Proposals improve the EOT framework, making it a more practical and attractive succession planning tool for Canadian business owners.

Please contact any of the authors to discuss EOTs and these changes in more detail.