Balaji Katlai
Tax Consultant, Kreston GTA, Canada
Raising the Stakes: Employee Equity Schemes in Canada
October 11, 2024
Employee Equity Schemes in Canada, specifically Employee Option Trusts (EOTs) were given a sweetener in June this year with a Capital Gains Tax exemption. In Kreston Global’s 2024 research, US entrepreneurs named employee equity schemes as their top choice for raising capital to expand globally. No longer just a staff loyalty scheme, are employee equity schemes be a viable strategy for SMEs looking to raise capital?
In June 2024, Canada increased capital gains tax, leaving businesses considering their options. EOTs, brought into Canadian legislation in 2023, could be one of those options. Pitched as an effective way to raise funding, increase staff loyalty and, with a capital gains exemption, save costs, can EOTs deliver these benefits for Canadian businesses in practice and achieve the same popularity seen in other North American markets?
Balaji Katlai, a Tax Consultant at Kreston GTA Canada, with extensive experience in advising domestic and cross-border clients in Canada on various tax matters, offers his view on the practicalities of EOTs for mid-market businesses.
Employee Equity Schemes and growth
Much like in the US and UK, employee equity schemes in Canada could now play a key role in fostering economic growth. Employee equity schemes help companies preserve cash, align the interests of their workforce with long-term business goals, and make businesses more attractive to outside investors. In the UK, the introduction of EOTs in 2014 sparked a surge in employee ownership conversions, benefiting both employers and employees. Canada is set to follow this model, aiming to drive similar growth in the employee-ownership sector.
However, Katlai explains that implementing these trusts in Canada is not straightforward.
“An Employee Ownership Trust (EOT) is a form of business succession plan, but in Canada, it can be complex to administer,” says Katlai. “The tax legislation and governance around it make it feel like an academic exercise—something you learn exists but is difficult to apply in practice unless there are specific situations that may meet all the compliance and planning requirements”
Canada’s Employee Equity Scheme framework
Employee equity schemes typically involve offering employees a stake in the company, whether through stock options, direct share purchases, or, in the case of EOTs, a trust that collectively holds employee shares. In Canada’s upcoming framework, employees will hold individual stakes in their own accounts, similar to the US Employee Stock Ownership Plans (ESOPs). This differs from the UK model, where employee ownership trusts hold shares collectively. By offering workers governance rights and a share of business profits, these schemes ensure that employees are not just workers, but co-owners.
However, Katlai points out that managing these schemes can be complex, particularly when it comes to balancing the needs of employee-owners and future business growth. He notes that while tax incentives and governance rights are appealing, “the big challenge is that employees, through the trust, have to own the business. That means a lender has to be willing to fund the trust to buy the business, and reliance on management of the business and ability to pay the lender the debt – that’s not always easy. Canadian lenders may hesitate because the trust is held by the employees, and they need to be sure the business can repay.”
Employee equity schemes also help create a more stable workforce. Research shows that employee-owners are more committed to their company, which reduces turnover and increases institutional knowledge. Katlai agrees that in principle, “an engaged workforce with a financial stake in the business is more likely to contribute to long-term success.”
Capital Gains tax incentives
The recent capital gains tax rise in June 2024 is encouraging business owners to opt for employee ownership transitions. Under the new legislation, the first $10 million of a sale transferred through an EOT will be exempt from capital gains tax. This policy is designed to ease the transition for business owners nearing retirement, especially given Canada’s high numbers of ageing entrepreneurs who lack succession plans. With an estimated three out of every four small and mid-sized businesses in Canada set to change ownership within the next decade, this tax incentive could be the deciding factor for many to transfer ownership to employees rather than to private equity firms or competitors.
While this tax incentive is attractive for business owners, Katlai notes that the administrative complexities can be significant. “There’s a two-year holding period where employees must maintain governance. If they do not, the seller, who gets a $10 million capital gains deduction, could lose that benefit. It is risky for the seller and while there are other alternatives to sell a business, the EOT option may not be as appealing.”
The new capital gains rules also offer little incentive for employees, who typically do not face capital gains tax until they sell their shares or receive dividends, similar to other equity holders.
Learning from the UK and US models
The new Canadian legislation draws heavily from successful employee ownership structures in the UK and the US. In the UK, nine out of ten companies that have transitioned to employee ownership through EOTs report satisfaction with the process and would recommend it to other businesses. Similarly, in the US, ESOPs provide substantial tax advantages for companies where employees hold at least 30% of ownership.
The Employee Equity Investment Act proposed in the US, which allows for low-interest debt financing from the Small Business Administration, has shown that policy frameworks can play a crucial role in scaling employee ownership. However, Katlai is practical about it being a financial carrot for all businesses in Canada. “In certain rural areas with small, tightly-knit businesses—like a dairy plant in Alberta with 15 employees—an EOT might work. But that is a niche scenario. For most Canadian businesses, especially those near major centres, the complexity of the rules and the lender hesitancy make it tough to pull off.”
Private Equity vs Employee Equity
When choosing between selling to private equity or opting for an employee equity scheme, each option has its pros and cons. Private equity typically provides faster access to capital and can lead to rapid business growth. However, it often results in loss of control, as private equity firms may restructure or resell the business. Moreover, private equity sales do not benefit from the capital gains tax exemptions available to EOTs.
On the other hand, employee equity offers longer-term stability and keeps control local. It is a good option for business owners who want to preserve the company’s culture and vision. Katlai notes, “For many owners, the choice comes down to their long-term goals for the business. The major hurdle is that employees, through the trust, have to own the business. That means a lender has to be willing to fund the trust to buy the business. Employee Ownership Trusts can take up to ten years to fully pay back the lender, and that is a long time for both the lender and the seller to wait, so mezzanine funding is perhaps a proceedable option for some businesses.”
Conclusion
Katlai feels that EOTs are a niche solution, and there might be other options to consider. “Regular business owners selling a typical business will likely still prioritise traditional tax benefits, such as the Canadian Entrepreneur Innovation Incentive and lifetime capital gains exemptions. However, for larger businesses, selling for $50 million to $100 million, Employee Ownership Trusts (EOTs) could become an option—provided mezzanine capital or alternative lending is available to fund the sale.”
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