Feds clarify requirements for EOT tax exemption on capital gains

For business-owner clients interested in selling their companies to an employee ownership trust (EOT), Budget 2024 provided details about qualifying for a previously proposed capital gains exemption on the sale, including owning shares and being actively engaged in the business. It also clarified that the exemption amount is per business, not per business owner.

Last year’s federal budget introduced rules to facilitate the creation of EOTs, which allow groups of employees to purchase a business over time, representing an attractive succession opportunity for some small business owners — for example, those with no suitable family to sell to, or who fear that a third party may not preserve the business’s legacy.

The longer buyout period also allows business owners a longer capital-gains deferral period (up to 10 years). The measure is for the 2024 to 2026 tax years.

The 2023 fall economic statement proposed to exempt from taxation the first $10 million in capital gains realized on the sale of a business to an EOT. Budget 2024 said that exemption will be available to a taxpayer (other than a trust) on the sale if several conditions are met:

• The taxpayer (or a personal trust of which the taxpayer is a beneficiary, or a partnership in which the taxpayer is a member) disposes of shares that are not shares of a professional corporation.
• The transaction is a qualifying business transfer (as defined in the proposed EOT rules), in which the trust acquiring the shares is not already an EOT or a similar trust with employee beneficiaries.
• Throughout the 24 months immediately prior to the qualifying business transfer:
  • the transferred shares were exclusively owned by the taxpayer claiming the exemption, a related person or a partnership in which the taxpayer is a member; and
  • over 50% of the fair market value of the corporation’s assets were used principally in an active business.
• At any time prior to the qualifying business transfer, the taxpayer (or their spouse or common-law partner) was actively engaged in the qualifying business on a “regular and continuous” basis for at least 24 months.
• Immediately after the qualifying business transfer, at least 90% of the beneficiaries of the EOT reside in Canada.

Also, if multiple owners disposed of shares to an EOT and met the above conditions, they may each claim the exemption, but the total exemption in respect of the qualifying business transfer can’t exceed $10 million, the budget said: “The individuals would be required to agree on how to allocate the exemption.”

“The $10 million exemption applies per business, not per shareholder, unlike the lifetime capital gains exemption, which is on a per-shareholder basis,” said Jamie Golombek, managing director, tax and estate planning with CIBC Private Wealth in Toronto. This detail was unclear previously, he said.

Overall, the measure is a “great solution” for business owners looking to exit a business but don’t have a ready buyer, he said.

Disqualifying events

Business owners should also be aware of “disqualifying events,” outlined in the budget, that would disqualify them from the exemption if such events occur within three years of the business transfer.

A disqualifying event would occur if an EOT loses its EOT status, the budget said, or if less than 50% of the fair market value of the qualifying business’s shares is attributable to assets used principally in an active business at the beginning of two consecutive taxation years of the corporation.

If one of the above events occurred within three years of the transfer and the taxpayer already claimed the exemption, “it would be retroactively denied,” the budget said.

If the disqualifying event occurs more than 36 months after the transfer, the EOT would be deemed to realize a capital gain equal to the total amount of exempt capital gains, it said.

Additional details

To claim the exemption, the EOT (and any corporation it owns that acquired the transferred shares) and the taxpayer must elect to be liable for any tax payable by the taxpayer as a result of the exemption being denied due to a disqualifying event within the first three years after transfer.

After three years, the trust would be solely liable for tax realized on the deemed capital gain arising on the disqualifying event, as mentioned above. The budget said the normal reassessment period of a taxpayer for a taxation year regarding this exemption is proposed to be extended by three years.

For purposes of the alternative minimum tax, the capital gains exempted would be subject to an inclusion rate of 30%, similar to the treatment of gains eligible for the lifetime capital gains exemption, the budget said.

It also proposed to expand qualifying business transfers to include the sale of shares to a worker cooperative corporation as defined under the Canada Cooperatives Act. In such cases, the transfer would be eligible for the 10-year capital gains reserve and the 15-year exception to the shareholder loan and interest benefit rules announced in last year’s budget.

Additional details on this aspect of the exemption will be released in coming months, the budget said.

Enabling legislation for EOTs was included in Bill C-59, which is currently before Parliament. Once enacted, EOTs will be effective as of Jan. 1, 2024, for qualifying dispositions of shares that occur between that date and Dec. 31, 2026.