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May 21, 2024 Canada | Finance releases details on CA$10m capital gains exemption on sale to employee ownership trust
On 2 May 2024, Bill C-69, Budget Implementation Act, 2024, No. 1, received first reading in the House of Commons. Bill C-69 implements the measures contained in the notice of ways and means motion that was tabled on 30 April 2024, including the temporary exemption from taxation of the first CA$10m in capital gains realized on the sale of a business to an employee ownership trust (EOT).1 This measure was first announced in the 2023 fall economic statement and confirmed in the 2024 federal budget. This Tax Alert provides a brief overview of the temporary capital gains exemption and related EOT measures included in Bill C-69. The new exemption will operate as an additional incentive to the original proposals relating to the sale of a business to an EOT, which were included in Bill C-59, Fall Economic Statement Implementation Act, 2023. For a discussion of the original proposals, see EY Global Tax Alert, Canada | Finance releases draft legislation to facilitate use of employee ownership trusts, dated 8 December 2024. Background In general terms, an EOT is a form of employee ownership where a trust holds shares of a corporation for the benefit of the corporation's employees. This type of trust can be used to facilitate the purchase of a business by its employees without employees having to pay directly to acquire the shares. The 2023 federal budget proposed new rules to facilitate the creation and use of EOTs. Subsequently, the 2023 fall economic statement proposed to temporarily exempt the first CA$10m in capital gains realized on the sale of a business to an EOT from taxation, subject to certain conditions. Bill C-59, which received first reading in the House of Commons on 30 November 2023, contains the original legislative proposals relating to the use of EOTs to purchase shares of a business. Broadly speaking, the Bill C-59 legislative proposals (i) define the conditions for a trust to qualify as an EOT; (ii) extend the capital gains reserve from 5 to 10 years for qualifying sales to an EOT; (iii) create an exception to the current shareholder loan and deemed interest benefit rules; and (iv) exempt EOTs from the 21-year deemed disposition rule that applies to certain trusts. These amendments apply as of 1 January 2024. Bill C-59 did not include details with respect to the capital gains exemption. The 2024 federal budget provided further details on the capital gains exemption, which are now included in Bill C-69 (with some modifications, as indicated below). Except where noted otherwise, the Bill C-69 amendments are deemed to have come into force on 1 January 2024 so that they apply as of the same date as the original proposals in Bill C-59. Qualifying conditions An individual (other than a trust) can claim a deduction for up to CA$10m in capital gains on the sale of shares to an EOT where all of the following conditions are satisfied:
The legislative proposals also prohibit an individual who claimed a deduction in respect of a qualifying business transfer to an EOT (and any related individuals) from being beneficiaries of the EOT. Disqualifying event A disqualifying event occurs if (i) the trust that participated in the qualifying business transfer loses its status as an EOT, or (ii) less than 50% of the fair market value of the shares of the qualifying business is attributable to assets used principally in an active business at the beginning of two consecutive tax years of the qualifying business. The Department of Finance Explanatory Notes provide examples of disqualifying events, including an example of a qualifying business leasing premises that were previously used as part of the active business to a third party. The consequences of a disqualifying event depend on whether it occurs within or after 24 months of the qualifying business transfer:
It should be noted that the reference to 24 months represents a change from what was stated in the 2024 federal budget. Specifically, the 2024 federal budget stated that the above consequences would depend on whether the disqualifying event occurs within or after 36 months (rather than 24 months) of the qualifying business transfer. Anti-avoidance A number of complex anti-avoidance rules provide that the capital gains deduction will not be available in respect of a qualifying business transfer in certain circumstances. Broadly speaking, the anti-avoidance rules are designed to ensure that:
Alternative minimum tax (AMT) The legislative proposals exempt EOTs from the application of AMT, effective for tax years that begin after 31 December 2023. In addition, as currently worded, the legislative proposals provide that exempted capital gains on the sale of a business to an EOT will not be subject to AMT. This also represents a modification from what was stated in the 2024 federal budget. Specifically, the 2024 federal budget stated that the exempted capital gains on the sale of a business to an EOT would be subject to an inclusion rate of 30% for AMT purposes, which parallels the AMT treatment with respect to gains eligible for the lifetime capital gains exemption. Reassessment period Where an individual has claimed the capital gains deduction, the individual's normal reassessment period for a tax year in respect of the deduction will be extended by three years. Worker cooperatives (currently only included as a proposal in 2024 federal budget) The 2024 federal budget proposed to expand qualifying business transfers to include the sale of shares to eligible worker cooperative corporations. This measure would allow an individual to claim a capital gains deduction on the sale of a business to a worker cooperative, where the necessary conditions are satisfied. Bill C-69 does not contain details with respect to this proposal. Key takeaways The exemption for up to CA$10m in capital gains on the sale of shares to an EOT provides business owners with a significant incentive to sell to an EOT, rather than to a third-party buyer. A number of business owners have been eagerly awaiting details on this measure, and the legislative proposals provide some important particulars, including certain modifications from what was stated in the 2024 federal budget. In addition, the 2024 federal budget proposal to increase the capital gains inclusion rate from one-half to two-thirds for capital gains realized on or after 25 June 20244 makes this exemption even more valuable and may significantly increase uptake of these arrangements, particularly for smaller-sized transactions. Access to this capital gains exemption is only temporary, so this is a time-limited opportunity for business owners considering the sale of their business. Specifically, the exemption will only be available for qualifying business transfers to an EOT that occur after 2023 and before 2027. It is therefore advisable for business owners to review their succession plans and consider whether a sale to an EOT would be beneficial in their circumstances.
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