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The employee ownership trust is set up to secure a loan for employees to buy the company’s shares.kate_sept2004/AFP/Getty Images

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Small business owners will have more succession planning options – and some new restrictions to consider – due to proposed changes in the recent federal budget.

The Liberal government plans to amend rules regarding the intergenerational transfer of a business to restrict its application. The budget also introduced a new employee ownership trust (EOT) structure that enables employee groups to buy a business over time.

“It was a significant budget for Canadian private business owners,” says John Waters, vice president and director of tax planning services at BMO Private Wealth in Toronto.

The changes come as many older business owners consider selling their companies to retire or pursue other interests. A recent KPMG LLP survey shows almost 8 of 10 (78 per cent) business owners surveyed last summer are developing a succession plan or expecting to transition the business to the next generation within three years, with more than quarter (26 per cent) of them saying they plan to sell their companies.

A recent Canadian Federation of Independent Business (CFIB) report also shows that more than three-quarters (76 per cent) of Canada’s business owners plan to exit their business within the next decade and more than half (53 per cent) of them would be more likely to sell to their employees if the option was available.

The pair of proposed budget changes, which take effect Jan. 1, 2024, may also encourage business owners to keep their companies in their communities, says John Lennard, partner in the tax group at Stikeman Elliott LLP in Toronto.

“It’s part of that broader trend of trying to keep things a little closer to home,” he says.

Here’s a closer look at each of the business succession-related measures in more detail:

Two transfer options for an intergenerational sale of business

The budget proposes changes to Bill C-208, a law passed in 2021 that put the tax treatment of a sale of a small business to a company owned by family members on a level playing field with the sale to unrelated third parties. It enabled business owners to claim proceeds from sales of shares to certain family members as capital gains, which are taxed at a lower tax rate, rather than as dividend payments, which are taxed at a higher rate.

Ottawa had been signalling plans to amend the legislation to prevent tax-avoidance loopholes such as surplus stripping when retained earnings are converted to capital gains without a genuine business transfer.

“There was a need for some clarification in the context of what constitutes a genuine [business] transfer,” says Dino Infanti, partner and national leader with KPMG’s private enterprise tax practice in Vancouver.

“Budget 2023 provides some clarification and modifications to those existing rules.”

Amendments in the latest budget include two transfer options for a genuine transfer to be met – immediate, over three years based on arm’s length sales terms, or gradual, over five-to-10 years using traditional estate-freeze planning. There are also some control factors, management considerations, and the required active involvement in the business by the child, Mr. Infanti says.

“It requires a broader involvement of the next generation in actively managing the business … and a transfer to them of the economic interest and control of the company by the parent over time,” Mr. Waters of BMO Private Wealth adds.

And while the changes are more restrictive, he says they were expected and provide certainty for business owners.

Stikeman Elliott’s Mr. Lennard says some gaps in the proposed amendments will likely be addressed before the changes kick in next year. For example, he notes there are restrictions for two siblings who each own 50 per cent of a corporation that would likely need to be resolved.

“Like anything, when you have a complicated tax statute, there will be items that come up later,” he says.

‘Another exit option’ for EOT

The budget also introduces EOTs as an alternative structure for business owners seeking to sell their companies. The EOT is set up to secure a loan for employees to buy the company’s shares. It allows the owners to sell the business at market value and be repaid from the company’s profits over time.

The CFIB, which lobbied for the EOT, notes similar structures are already in place in countries like the U.S. and the U.K.

“It provides another exit option for business owners to sell to an employee group rather than a competitor,” Mr. Waters says. “The idea here is that this is not a short-term play; employees are not going to have enough capital to buy the company immediately but maybe collectively, over time, they can.”

One of the tax changes proposed to facilitate EOTs is an extension of the capital gains reserve to 10 years from five years for taxpayers who transfer their qualifying businesses to an EOT. A minimum of 10 per cent of the gain would be required to be brought into income each year.

EOTs would also be exempt from rules that trusts must undergo a deemed disposition every 21 years. There’s also an exception to shareholder loan rules, which will extend the repayment period from one to 15 years for amounts loaned to the EOT in a qualifying business transfer.

Mr. Infanti of KPMG says the EOT provides a succession planning option and may be a useful tool to structure the sale of a business to an employee group. Still, he encourages business owners and their advisors to ensure they qualify. For instance, he says there are various governance and control matters to consider.

“Be mindful of the employee beneficiaries of the EOT and, in particular, their tax residency or citizenship status,” he says.

Mr. Lennard says there are also some unanswered questions about the EOT that may need to be worked out, including what happens to the accrued value of the business when an employee dies or no longer works at the business after the EOT is set up.

The CFIB stated in a release that it’s “encouraged” by the introduction of EOTs in the budget, and will be reviewing the proposals “carefully and propose any needed changes.”

Start succession planning sooner

Mr. Lennard says the budget changes should encourage business owners to think more about who to sell their company to, when to do so, and the sale structure.

He also recommends advisors start the succession planning conversation with business owners years in advance, considering who they want to take over, such as family members, employees or a third party. Those plans can also evolve, Mr. Lennard warns, depending on the family or business circumstances.

“For instance, if you start to see that your kids aren’t interested in running the business, maybe start identifying some employees who might be able to assume that role,” he says.

“There are several options available now, and advisors should be communicating them to small business owner clients to make the most of their succession plans.”

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