It is no secret that there is a generational shift coming, both in wealth and the family businesses that often make up that wealth.  I could cite many articles to support this statement.  Leaving this fact aside, it is also no secret that no one has yet discovered the fountain of youth and cryogenics is not yet far enough along to provide a certainty of outcome.  The upshot is that everyone ages – even successful business owners.  Despite these realities it is still the case that “only 34% of Canadian family businesses have a robust, documented and communicated succession plan in place”.  See Family Business Survey 2021: PwC.  Perhaps the Federal Government’s recent Budget 2022 announcement about implementing the ‘employee ownership trust’ may change that statistic by offering up another and potentially more aligned option for business owners.

Stepping back for a moment, in general there are three options available to business owners when considering a business transition.  Those options are: transition to family members, a third party sale or a sale or transfer to employees and/or management.  To date, engaging in the latter option has been little used given the challenges posed, in large part, by our current income tax rules.  Yet many business owners would give serious consideration to transitioning part or all of their business to employees, if the income tax rules were more favourable.  For the Canadian economy, which is so dependent on private enterprise and entrepreneurship, facilitating the ongoing success of businesses by facilitating another option in the succession dialogue, is a good thing.

After much lobbying by groups like Social Capital Partners, we see a welcome proposal put forward in the Federal Government’s Budget 2022.  See Unlocking the potential of employee ownership in Canada (newswire.ca).  Specifically, the proposed introduction of the “employee ownership trust” (“EOT”).  For those of our readers who may have missed this part of Budget 2022, the announcement reads as follows:

“Employee ownership trusts encourage employee ownership of a business, and facilitate the transition of privately owned businesses to employees. Budget 2021 announced that the government would engage with stakeholders to examine what barriers exist to the creation of these trusts in Canada.

These consultations revealed that the main barrier to the creation of employee ownership trusts in Canada was the lack of a dedicated trust vehicle under current tax legislation tailored to the requirements of these structures.

Budget 2022 proposes to create the Employee Ownership Trust – a new, dedicated type of trust under the Income Tax Act to support employee ownership.

The government will continue to engage with stakeholders to finalize the development of rules for the Employee Ownership Trust and to assess remaining barriers to the creation of these trusts.  See Chapter 2: A Strong, Growing, and Resilient Economy | Budget 2022.

While the details of what the proposed rules for an EOT will ultimately say are yet to be seen, we can glean a sense of what the benefits and elements of such a trust might be by looking at jurisdictions like the United States and the United Kingdom, where EOTs have been around for a number of years.[1]

An EOT is designed to foster employee ownership by giving business owners the opportunity to sell their shares to an employee owned trust, free from capital gains tax.  EOTs do not involve giving employees a direct share ownership interest in the company.  Instead, a controlling interest in the company is transferred by the owner to a trust, which is then held for the benefit of employees.  Typically the trust would have to be for the benefit for all employees, with perhaps an exclusion for those who have been with the company for less than a certain minimum amount of time.  The terms of the trust would then provide that the employees could benefit from the assets of the trust based on criteria like years of service, hours worked, and remuneration level, with all employees eligible to benefit.  See https://www.pwc.co.uk/services/tax/employee-ownership-trusts.html.

From an owner’s perspective, the benefits of an EOT is that it is expected to provide the owner with another transition option when the options of family transition or third party sale are not readily available.  In addition, establishing an EOT is generally thought to encourage employee engagement.  Having employee interests aligned with an owners’, is expected to enhance the success of the business. Owners can also retain, and typically do, an ownership interest.  Importantly, there is a means for an owner to extract their capital in a tax-effective manner.

From the perspective of employees, having an ownership interest is a form of employment retention and a means to align their interest with that of their employer.  As employers being to grapple with the implications of COVID on their workforce, these are employee benefits that should not be ignored.  In addition, the EOT can be expected to make annual distributions to employees that have some tax advantage.

While the devil will be in the detail of what the ultimate rules for an EOT will provide, assuming they are available to privately held companies, they will be a welcome addition to the succession dialogue.

[1]      Note, EOTs should not be confused with “employee stock option plans”.  While ESOPs give employees an economic benefit derived from their employment, they do not give an ownership interest in or a right to participate in the management of the business.   EOTs are generally intended to indirectly provide employees with some measure of both.