By Julius Melnitzer | March 29, 2023
Tuesday’s federal budget finally provided Canadian businesses with the promise of a vehicle — the employee ownership trust (EOT) — that incentivizes business owners to sell their businesses to their employees.
The budget contemplates that rules governing the EOTs will come into effect on January 1, 2024.
“EOTs first came up in the 2021 federal budget, and subsequently Parliament committed to finalize the rules governing them,” said Michael Decicco, a Toronto-based partner in Stikeman Elliott LLP’s mergers and acquisitions and capital markets group.
Recently, the Canadian Employee Ownerships coalition, a non-partisan group of leaders in Canada’s academic, banking, business and non-profit sectors, has urged the government to create an EOT tax-advantageous framework in the 2023 budget.
“There have been heavy lobbying efforts pressing the government to go ahead with what it promised two budgets ago,” said David Rotfleisch, founding partner of Toronto-based Rotfleisch & Samulovitch, P.C., a tax boutique specializing in advising SMEs and entrepreneurs.
The U.S. and the U.K. have implemented EOT frameworks, both of which, according to Decicco, offer advantages to employers and employees.
“The U.S. allows business owners who utilize the employee stock ownership plan [ESOP] process to defer capital gains depending on what they do with the proceeds,” Decicco said. “U.K. founding owners who sell through EOTs are exempt from capital gains tax, while the seller and their heirs are also exempt from inheritance tax on the transfers.”
EOTs should appeal to long-standing SME owners with loyal staffs.
“Many are loath to sell to private equity firms as they often assume they have short-term investment horizons, so an EOT would both incentivize these people financially and allow them to do good,” Decicco said. “And in the current economic environment, with private equity on the sidelines and IPOs non-existent, EOTs can be a very feasible exit option.”
Employees also get tax breaks. But, perhaps more importantly, studies have shown that employee-owners have 92 per cent more wealth and 33 per cent higher median wage income than their colleagues at non-employee-owned enterprises.
In the U.S., ESOPs have enabled about 14 million employees at 6,000 businesses to accumulate US$1.6 trillion in wealth. According to Decicco, estimates suggest that in the first eight years of a Canadian EOT regime, 500 to 700 SMEs might be sold using the structure, creating up to $9 billion in wealth for 114,000 Canadian workers.
“But, as usual, the devil is the details,” Rotfleisch said. “It depends on how the government implements the concept.”
As Decicco and Rotfleisch see it, providing capital gains relief would go a long way to making Canadian EOTs inviting.
“There is no other mechanism in Canada to promote broad-based employee ownership,” Rotfleisch said. “While there are cases where employees have got together to buy a company, it’s rare, it’s awkward, and there’s no easy way to do it.”
However that may be, EOTs are definitely not for everyone, partly because Canada has not developed financing markets for these structures.
“The U.K. scheme depends almost entirely on vendor take-back financing, but in the U.S. third-party financing is common,” Decicco said. “And if our rules turn out to be similar to U.S. rules [i.e. with capital gains deferral incentives], I can absolutely see a domestic EOT financing market emerging.”
Leveraged EOTs, Decicco adds, can provide lenders with strong returns and attractive debt coverage. They also help improve environmental, social and corporate governance metrics by creating wealth for employees.
Indeed, if EOTs appear in Canada, a financial market to support them may not be that far off, as some Canadian-based institutions are already familiar with the market.
“BMO does this type of lending in the U.S., and the Health Care Pension Plan of Ontario invested in U.S.-based Taylor Guitars’ move to 100 per cent employee ownership in 2021,” Decicco said.
But until and if such a market develops, vendor take backs may not work for all owners.
“If the vendor is not well-heeled, and their retirement depends on proceeds from the sale of the business, there may be a limit on how much take back they can manage,” Rotfleisch said. “Still, the government does have the ability to incentivize financial institutions to lend into this market.”
According to Decicco, there are typically four aspects to EOTs’ structure:
- The owner initiates a trust where the employees are the beneficiaries;
- Financing to support the purchase of the business shares by the trust is put into place;
- The trustees negotiate the terms of the purchase; and
- The trust repays the debt from the business’ earnings.
Rotfleisch cautions that the process is not simple.
“In an ideal world, parties should allow a two- to three-year timeframe to set this up.”
Julius Melnitzer is a Toronto-based legal affairs writer, ghostwriter, writing coach and media trainer. Readers can reach him at [email protected] or https://legalwriter.net/contact.
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