Employee ownership trusts (EOTs) may soon become one additional avenue for Canadian business owners looking to sell their enterprises. The goal of EOTs is to enable owners to effectively sell their businesses to their employees. As a Canadian EOT framework may be on the horizon, it is important for business owners and other stakeholders to understand the mechanics, and possible advantages, of these trusts.
The Government of Canada initially expressed interest in exploring EOTs in its 2021 Federal Budget. A year later, Parliament committed to finalize the development of rules for EOTs and assess remaining barriers to their creation. Recently, the Canadian Employee Ownership Coalition, a non-partisan group of leaders in Canada’s academic, banking, business, and non-profit sectors, called on the federal government to create a tax-advantageous framework for EOTs under Canadian law in its 2023 Budget, which is expected to be released on March 28, 2023.
Mechanics of EOTs
The structuring of EOTs in jurisdictions in which they have been implemented (including in the United States and the United Kingdom) typically involves the following four steps: (1) a trust is formed and the employees of the target business are made beneficiaries of the trust; (2) debt financing is arranged in order to finance the purchase of shares of the target business by the trust; (3) the trustees of the trust negotiate the terms and conditions relating to the purchase of the shares of the target business; and (4) the trust repays the debt over time using the earnings that are distributed to it from the business. In essence, EOTs are a leveraged buyout for the benefit of employees and the sellers.
Advantages of EOTs
Benefits for business owners seeking to exit
EOTs in non-Canadian jurisdictions typically allow business owners to benefit from deferred or eliminated capital gains taxes, discussed in further detail below. To seek to ensure that the owner receives a price comparable to that of a sales process, an independent appraiser is typically retained to assist in establishing a fair market valuation of the business being sold. Finally, retiring entrepreneurs who are keen on preserving their firms’ legacy and culture can utilize EOTs to avoid selling to competitors or private investors. This can help ensure the business stays in local communities with continuity of management.
Benefits for lenders
Leveraged EOTs can provide lenders with strong returns on their capital with attractive debt coverage. In addition, EOTs can help improve environmental, social and corporate governance (ESG) metrics via wealth creation for employees. In many cases, businesses owned through an EOT structure have significantly outperformed their counterparts in employee retention. The resilient businesses and high-quality jobs attributed to EOTs can positively affect the “social” criterion in ESG, which measures the relationship of a business with various stakeholders, including its employees.
Benefits for employees
EOTs can lead to increased wealth for employees. Studies have shown that employee-owners have 92% more wealth and 33% higher median wage income than their counterparts at non-employee-owned enterprises. EOTs can also lead to improved job stability during crises and provide insulation from economic cycles, with studies showing employee-owned businesses retaining jobs at a 4 to 1 rate compared to non-employee-owned businesses.
The United States EOT regime
Employee stock ownership plans in the United States (US ESOPs) have, based on data published in 2023, enabled some 14 million participants across more than approximately 6,000 businesses to hold a combined US$1.6 trillion in wealth. In US ESOPs, a company establishes a trust fund, which will then be financed in one of two ways. In non-leveraged US ESOPs, the company will contribute newly issued shares to the trust, or contribute cash to the trust, which will then be used to purchase existing shares of the company at no more than fair market value. In leveraged US ESOPs, the trust will take out a loan to purchase new or existing company shares whilst the company makes annual contributions to the trust, which are used to repay the loan. The trustees are the legal shareholders of US ESOPs and have fiduciary duties, which include retaining an independent appraiser to determine, on an annual basis, the value of the company’s shares and voting the trust’s shares in the company to select a board of directors.
Employees have accounts within US ESOPs to which shares are allocated; employees do not pay for the shares with payroll deductions or otherwise with their own funds. Plan participants generally accumulate account balances and their shares begin vesting after one year of full-time service. Contributions, either in cash or shares, accumulate in the US ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred. Employees do not pay tax on shares allocated to their account and are only taxed on US ESOP distributions received on shares allocated to them. However, mechanisms exist to allow distributions to be taxed at favourable rates.
US ESOPs carry with them various tax advantages. In the case of non-leveraged trusts, a company’s contribution of shares to the trust is tax-deductible to the company. In leveraged transactions, a company can make tax-deductible contributions to enable the trust to repay the loan. Notably, owners of C corporations who sell 30% or more of the company’s shares to US ESOPs may be able to defer any capital gains tax on the transaction. Where a US ESOP holds an interest in an S corporation, both the S corporation and the trust are exempt from all federal income tax (and most state income tax) on the share of the income of the S corporation that is attributable to the trust.
The United Kingdom EOT Regime
Employee ownership trusts in the United Kingdom (UK EOTs) were modernized through the Finance Act, 2014. As of June 2021, approximately 730 companies employing nearly 90,000 workers utilize these statutory trusts. In UK EOTs, employees do not directly own shares of their employer firms but rather are beneficiaries of a trust that holds a controlling interest in their employer. The company can then provide annual distributions to participating employees from profits. A business seeking to transition control to a UK EOT can do so in two ways: (1) through an indirect ownership model where employees do not own shares directly but rather are beneficiaries of a trust that owns a majority of the shares; or (2) through a hybrid model that combines trust ownership and direct ownership of the company’s shares.
Business owners in the United Kingdom can also benefit from significant tax breaks through UK EOTs. Importantly, founding sellers will be exempt from capital gains tax on the sale of qualifying shares to the trust. Sellers and their heirs will also be exempt from inheritance tax on this transfer of shares. Lastly, qualifying companies can pay each employee an annual tax-free distribution of £3,600.
There are several conditions that must be satisfied before owners and companies can unlock these tax exemptions. First, only trading companies or principals of trading groups can utilize UK EOTs. Secondly, the trust must hold a controlling interest – more than 50% of the voting rights attached to the company’s shares. Third, trust property must usually be applied for the benefit of all eligible employees “on the same terms”. Lastly, the number of continuing direct shareholders who are directors or employees (and any persons connected with such directors or employees) must not exceed 40% of the company’s entire workforce.
In Canada, the lack of a dedicated trust vehicle under the current tax regime is often cited as the primary obstacle to creating EOTs. Following the creation of a framework for EOTs in Canada, estimates suggest that in the first eight years, 500 to 700 small to medium sized businesses could be sold using an EOT structure, which in turn could create up to $9 billion in wealth for up to 114,000 Canadian workers. We are hopeful the 2023 Federal Budget will contain detailed proposals in respect of EOTs. Stikeman Elliott LLP is monitoring developments in Canada pertaining to EOTs and will be ready to assist our clients in understanding the latest developments in the space. We invite you to contact us with any questions regarding EOTs.
The authors would like to acknowledge the support and assistance of Parsa Farhangdoost, articling student at law.