Media attention for the federal budget in March largely focused on new subsidies for clean energy and technology intended to keep pace with measures in the U.S. Unfortunately, one promising budget proposal with the potential to help reshape Canada’s economy garnered far less attention: Employee Ownership Trusts (EOTs).
You’d be forgiven for not knowing what they are. While EOTs are popular in the United Kingdom and the U.S. — known there as Employee Stock Ownership Plans (ESOPs) — they are seldom heard of in Canada. That should change.
EOTs provide a mechanism for businessowners to manage succession by transforming employees into owners. With more than 76 per cent of Canada’s small businessowners looking to retire in the coming decade, not getting EOTs right would be a significant missed opportunity for Canadian businessowners, employees and local economies alike.
After teasing the business community with the idea of EOTs in two consecutive budgets, the federal government has revealed proposed rules to establish a new made-in-Canada framework for EOTs by January 2024. It’s an important step forward. But the guidelines so far neglect essential ingredients to ensure EOTs will flourish in Canada.
Lack of tax incentives
Tax incentives are critical to the success of an EOT policy initiative. While Canada’s proposed EOT framework is modelled after those in the U.S. and the UK, the draft rules released by the Department of Finance in March lack many of the essential features that would render employee ownership an attractive vehicle for business owners looking to sell and plan their succession.
In the U.S., ESOPs allow business owners a deferral of the capital gains tax on the sale of the business, while contributions to repay the seller are tax deductible. In the UK, EOTs offer complete capital gains tax relief for selling-owners in order to level the playing field with competing offers.
These are significant — and necessary — incentives to help offset some of the risks associated with EOTs for business owners. When an owner sells their company to employees through an EOT, they are not paid in cash at the time of sale but rather over time from profits of the business. They may also take a discount on the purchase price.
The EOT proposal in budget 2023 increases the deferral of capital gains tax to 10 years — up from the current five-year deferral period. This is unlikely to provide sufficient incentive.
Restrictions on eligibility
The EOT proposal in budget 2023 would also limit eligibility for EOTs to firms where all, or substantially all, assets are in Canada. This is an ongoing obligation that businesses must manage to remain eligible.
Unfortunately, such a requirement would not only limit the pool of eligible candidates for EOTs but would also exclude businesses which may currently be eligible but have plans to grow their companies in the long-term and take on a more global footprint.
Talk about an unintended consequence.
No good policy rationale has been provided for narrowing the pool of potentially eligible businesses and imposing onerous requirements for ongoing monitoring.
Issues with governance structure
Surprisingly, EOT governance detailed in th3 2023 budget proposal greatly differs from the successful U.S. and UK models.
These countries prioritize a smooth and gradual transition of governance from owners to employees. The proposed Canadian model, on the other hand, calls for a sudden and dramatic shift in company governance to employee-elected trustees.
This could also have unintended consequences.
Such an abrupt transition could create politicized business structures and perverse incentives, like motivating a quick sale of the company to the highest bidder in order for current employees to realize windfall profits instead of keeping it employee-owned and rooted in the local community for the long-term.
Selling-owners will be more motivated to ensure the success of the business, certainly until they have been paid out (typically from dividends generated by it). Why would they subject themselves to the risk of a governance framework that may work against them and the success of the business?
Empirical research demonstrates EOTs can preserve the character and values of a business, increase wealth (and motivation) for employees, create more resilient companies and protect jobs in local communities — but only when they are done correctly.
While the government’s commitment to establish EOTs in Canada is welcome news, without significant reform to the budget 2023 proposal, very few owners are likely to pursue the EOT path to succession planning.
Photo courtesy of DepositPhoto
