Employee ownership trusts in Canada: Plan carefully to avoid unintended tax consequences

In the United States and the United Kingdom, an employee ownership trust (“EOT”) is a common option for business owners seeking to transfer their business to employees or to establish an employee remuneration plan. In Canada, several different provisions of the Income Tax Act (the “ITA”) may be applicable to a trust created for the benefit of employees depending on the specific facts and circumstances. As such, thoughtful planning is required in the implementation of such trusts in order to avoid unintended tax consequences.  The decision McNeeley v. The Queen[1] illustrates perfectly the uncertainties employers and tax practitioners have to face when creating trust for the benefit of employees in Canada.

McNeeley v. The Queen Decision

In this case, the mother of the company’s founder settled a trust (the “Trust”)  for the benefit of the employees of the D2L Corporation (the “Employer”). The Trust’s objects were to acquire securities of the Employer to be held for the benefit of  certain employees and to eventually distribute such shares to the employees at the sole discretion of the Trustees. The Trust later distributed the shares it held to certain employees and filed an election per subsection 107(2.001) of the ITA to not have the subsection 107(2) rollover apply to the distribution, thus triggering a deemed disposition at fair market value pursuant to subsection107(2.1) of the ITA. The Trust reported a taxable capital gain on the disposition of the shares, which was allocated to the beneficiaries, who in turn each claimed the capital gains exemption.

However, the Canada Revenue Agency reassessed the employees to delete the capital gains and instead included in the employees’ income an amount equal to the fair market of the shares distributed, on the basis that the Trust was not a trust for the purposes of section 107 ITA but an employee benefit plan (“EBP”)[2].

Issues at hand

The issues the Federal Court of Appeal (“FCA”) had to consider were the following:

1. Is the Trust an EBP or a prescribed trust?
2. If the Trust is both an EBP and a prescribed trust, which rule takes precedence over the other?

Pursuant to Regulation 4800.1(a)of the ITA, a trust may qualify as a prescribed trust when one of its main purposes is to hold interests in shares of the capital stock of the employer or a corporation not dealing at arm’s length with the employer where the trust is maintained primarily for the benefit of employees. When applicable, the result is that distributions of property by a prescribed trust to a beneficiary will be subject to subsection 107(2) of the ITA and may be distributed to the beneficiary on a rollover basis.

As for an EBP, this notion is defined in subsection 248(1) ITA and mainly consists of an arrangement under which contributions are made by an employer or by a person with whom the employer does not deal at arm’s length and under which payments are made to for the benefit of employees. Contrary to a prescribed trust, any payments by an EBP are considered to be income from an office or employment pursuant to paragraph 6(1)(g) ITA, and thus precluding the employees from benefitting of the advantageous capital gain tax treatment on the initial distribution from the Trust (including the capital gains deduction).

The FCA’s Decision

In its decision, the FCA stated that while the definitions of EBP and prescribed trust  can overlap, it is possible to create an EBP that is not a prescribed trust and vice versa[3]. However, in the case at hand, the judges found that the rules applying to EBPs and prescribed trusts could not be reconciled as they applied to the Trust.  To resolve the conflict, the FCA principally relied on the paramountcy doctrine which established that regulations cannot conflict with their parent legislation. In this case, the definition of EBP was in the ITA, giving it paramountcy over the requirements of a prescribed trust, which are found in the Regulations.

By coming to this conclusion, the Trust was found to be an EBP. Therefore, the appellants had to include as income from an office or employment the fair market value of the shares at the time of distribution, and were prevented from claiming a capital gains deduction in respect of the growth in the value of the said shares during the period in which the share were held by the Trust

Insights

The FCA’s decision shows the importance of carefully analyzing the rules pertaining to employee trusts when structuring this type of arrangement, as the tax consequences differ greatly depending on which provisions of the ITA apply. While the Canadian government announced in its 2023 federal budget the introduction a new specific type of employee ownership trust, the proposed legislation, which is supposed to come into force as of January 1, 2024, seems to be very restrictive and aims to apply in the specific situation where control of the employer is to be transferred to the employee ownership trust.

For further information regarding employee ownership trusts and other employee remuneration plans, contact a member of Miller Thomson’s Corporate Tax Team.

[1] 2021 FCA 218, application for leave to appeal dismissed by the Supreme Court of Canada in 2022.

[2] For section 107 ITA to apply, a trust can either meet the definition of “trust” in subsection 108(1) ITA, which excludes specifically an EBP, or be a “prescribed trust” pursuant to section 4800.1 of the regulations.

[3] Supra note 1., para. 25.