Employee Ownership Trusts: A tool for the succession-planning crisis


By St.John McCloskey and Jaicee Payette

Update (March 28, 2023): Budget 2023 has indeed included Employee Ownership Trusts as a priority. See the supplementary materials here for more details. In short, they are to be given some special treatment, including a possibility effective deferral on capital gains through an extension of the capital gains reserve. This is not quite as generous as the UK’s full capital gains exemption, but it will facilitate the creation of EOTs. As we discussed below, EOTs will be exempt from the 21 year rule, and will allow for more generous shareholder loans between EOTs and their respective businesses.

Budget 2023 is around the corner, which is a special time for those of us who get excited about tax policy. While we’re sharpening our pencils, meditating on good policy, and putting together our wish lists for this year, there’s one item that we wanted to highlight which we hope to see real progress on in the 2023 Budget.

Budget 2021 announced that the government would “engage with stakeholders to examine what barriers exist to the creation of employee ownership trusts in Canada, and how workers and owners of private businesses in Canada could benefit from the use of employee ownership trusts.” Budget 2022 proposed to “create the Employee Ownership Trust—a new, dedicated type of trust under the Income Tax Act to support employee ownership.” Unfortunately, the government has not done so yet. We expect to see a similar promise in Budget 2023, and we hope that it will be fulfilled.

Succession crisis

It is no secret that Canadian business-owners are facing a succession crisis. The Canadian Federation of Independent Business recently released a report, titled “Succession Tsunami: Preparing for a decade of small business transitions in Canada”, which indicates that 76% of small business owners are planning to exit their businesses in the next ten years. These businesses represent approximately $2 trillion of business assets. According to this survey of 2,479 small business owners, only 9% of business owners have a formal succession plan in place. Even among owners intending to exit within 12 months, only 16% have a formal plan. Approximately one-quarter of departing business owners will sell or transfer to a family member, another quarter will sell to the employees of the business and half of owners intend to exit their business by selling to an unrelated owner. However, more than half of business owners reported that finding a suitable buyer is an obstacle to succession planning. Protecting employees was the top priority of exiting business owners, and more than half reported that they would be more likely to sell the business to their employees if the option was available.

The opportunity

One proposed answer to this succession question is the Employee Ownership Trust (“EOT”).  Such an entity would allow a private business owner to transition their business into the hands of their employees on a tax efficient basis. The general structure of an EOT allows shares of an operating company to be held by a trust for the benefit of the employees of that company. One reason that a structure like this is so important is that EOTs can borrow money as their own separate entity to purchase the shares from the departing owner. Individual employees may have a harder time borrowing money to pay the departing owner for shares. Additionally, shares held in an EOT do not need to be allocated to individual accounts, eliminating the need for employees to sell their shares upon leaving the company, as might be required under certain other employee-ownership models.

Several organizations, old and new such as Social Capital Partners and the Canadian Employee Ownership Coalition advocate for this solution. These organizations outline the benefits of employee ownership, both for workers and retiring owners. Similar structures already receive substantial support by the laws of the United States and the United Kingdom, so we can look to their economies for indications of what we might expect in Canada. The US-based National Center for Employee Ownership provides a wealth of data on employee ownership, including EOTs and other structures such as Employee Stock Ownership Plans (“ESOP”). Employee-owners have nearly double the median household wealth of non-owning employees. Their companies grow faster and are more profitable than companies that are not owned by their employees. The UK has embraced the EOT as a succession tool, with nearly 500 UK EOTs established in 2022.

The organizations which advocate for Canada’s adoption of the EOT as a structure suggest that owners who want to sell to their workers are hamstrung by current legislation, and that the EOT represents a uniquely useful vehicle for business succession. One report from Social Capital Partners projects that if Canada were to introduce EOTs via the policies that the report recommends, after eight years 55,000-115,000 Canadian workers would share in $4.3 to $9.6 billion in wealth.

Why EOTs?

With the incoming (and realistically already upon us) “silver tsunami” of retiring small and medium-sized business owners, it is important for Canada to prioritize business succession options that aid in keeping companies locally owned and operated. EOTs allow employees to take ownership of their employer company without having to dip into their personal savings, while the employer receives fair market value for their business without having to find a third-party buyer. EOTs also help bring employees into the middle class. In a recent paper titled “Building an Employee Ownership Economy” from Social Capital Partners, surveys from the US of low- and moderate-income workers in US ESOPs boast a significant increase in wealth over their counterparts who do not have access to ESOPs. The possibility of a Canadian equivalent in the form of EOTs is a promising one.

Additional surveys from the US showed that during the 2001 and 2008 recessions, employee-owned businesses were less susceptible to economic crises. These businesses were able to maintain higher employment numbers and lower risk of bankruptcy in comparison to their counterparts. Our own recent recession has opened many Canadian eyes to employment and income insecurity. EOTs could provide a stable solution that might help workers to better withstand economic peaks and valleys.

Legal challenges

While the socio-economic advantages to creating EOTs seem to be substantial, the Canadian legal system has not yet paved a way for those advantages to be realized without considerable risk to employers. As with any legal structure, there are any number of ways in which an EOT may be organized. Different values can be pursued. In Canada, the most flexible existing option is an “express trust,” which allows flexibility, but at a serious cost.

Trusts receive unusual treatment under the Income Tax Act. Every 21 years, the Act deems the trust to dispose of and re-acquire any property that it has for fair market value. The effect of this deemed disposition is to tax any capital gains earned on trust property. However this can clearly trigger tax liability for the trust at a time when the trust does not have the cash on hand to pay the tax. While there may be non-tax reasons to choose a trust to organize worker ownership, this added tax burden could stifle the intended benefit. There are certain kinds of trusts which are exempt from the 21-year rule (such as RRSP trusts). We hope to see such an exemption for an EOT.

The risks of attempting to implement an EOT in Canada without the appropriate legal support was recently shown in McNeeley v Canada, 2021 FCA 218. In McNeeley. The employer software company established a trust for its employees with the stated intention of acquiring parent company shares for later distribution as capital to its employees. The employer chose to classify this trust as a certain sort of trust under the Income Tax Act, which received certain income tax treatment. Though the employer’s intentions were clear, the CRA disagreed with the trust’s classification and re-classified the trust as an employee benefit plan. The tax consequences of this re-classification were severe. All payments received by employees from an employee benefit plan must be included in the employee’s income, making it subject to tax upon their yearly tax return. This was in direct conflict with the intention of the employer to have these contributions to their employees classified as capital distributions from a prescribed trust, which would have ultimately attracted only partial inclusion in income. Upon appeal to the Tax Court of Canada, and then further to the Federal Court of Appeal, the reclassification of the trust was upheld. This is to say even where intentions are perfectly clear, there remains a risk that trusts may be re-classified in a way that adversely effects those involved.

Canada also lacks proper tax incentives for employers to sell shares to EOTs. In the UK, departing owners receive a complete exemption from capital gains tax that would otherwise be incurred on the sale of shares to an EOT. In the US, possible available incentives include allowing the vendor employer who chooses to sell company shares to an ESOP to defer capital gains on reinvested proceeds.

Legal solutions

So, what might Canada do? There are a few ways in which the Income Tax Act could be adapted to support EOTs. First, the ITA could be amended to include EOTs as a class of trusts that would fall outside the 21-year rule. The accompanying rules would need to allow for the EOT to hold and distribute value to employees in a way that treats them fairly and similarly to a more traditional private shareholder. For example, EOTs could be treated similarly to mutual fund trust, which are exempt from the 21 year rule and income and gains are allocated to unitholders for tax purposes.

Canada should also ensure that the process for setting up an EOT is relatively straightforward. As was seen in McNeeley, even where one goes through the process of ensuring that a trust is correctly created and intentions are clear, there is ultimately no certainty that the CRA will not re-classify the trust. Employers will need clarity and certainty to facilitate the development of this useful structure.

In our view, Canada might also consider creating a capital gains tax exemption for capital being sold to EOTs. As noted above, UK business owners who sell their business to their employees via an EOT are able to claim a complete exemption from capital gains tax. This major incentive is not merely a gift to retiring owners who wish to pursue this socially-beneficial exit strategy, but more importantly, a practical facilitation of the transfer to workers. It would also supplement the lifetime capital gains exemption for the many small business owners who rely on the sale of their shares for their retirement.

We hope to see the budget advance this conversation further. The last two budgets have been very light on details, and it would be an excellent sign to see promises of a whitepaper, or other indications that the government is moving forward with this, following the US and UK in promoting and facilitating employee ownership and helping to resolve some of the issues faced by departing owners.