Employee Ownership Trusts Made Permanent—But Not Flexible

As part of the spring economic update the Federal Government is proposing to make the Employee ownership trust tax exemption permanent.

We find that EOT regime is intentionally highly restrictive.

While it offers targeted tax incentives, those benefits are tightly controlled through prescriptive statutory rules that significantly limit flexibility in structure, governance, economics, and post-sale control.

The principal restrictive elements can be summarized as follows:

Narrow trust structure requirements

An EOT must be an irrevocable trust factually resident in Canada. Its assets must be tightly concentrated: generally 90% or more of the trust’s value must be derived from shares or debt of qualifying businesses it controls. This leaves little room for diversification, excess cash, or passive investments and requires continuous asset-mix monitoring adding to additional professional fees.

Highly limited beneficiary pool

Only qualifying employees of controlled qualifying businesses may benefit, with limited inclusion of former employees.

Generally, employees are excluded if they:

• have not completed a probationary period (up to 12 months),

• own 10% or more of any class of shares (outside the EOT),

• own 50% or more when combined with related or affiliated persons, or

• were controlling owners immediately before the sale.

As a result, founders, major shareholders, and some key employees may be excluded even if they remain active in the business.

Rigid benefit-allocation rules

Distributions of income and capital must be determined only by:

• hours worked,

• remuneration (subject to reasonableness and effective caps), and/or

• length of service.

No discretion is permitted.

Benefits cannot be tailored based on role, performance, entrepreneurial contribution, or negotiated arrangements.

Trustees must also act even-handedly and cannot favour one group of employees over another.

Prescriptive trustee and governance rules

Trustee composition is tightly regulated:

• trustees must be individuals or licensed Canadian trustee corporations,

• each trustee must have an equal vote,

• at least one-third must be current employee beneficiaries, and

• in many cases, at least 60% must be arm’s length from prior sellers.

In addition, certain major transactions require approval by a majority of current employee beneficiaries, introducing collective decision-making risk.

Narrow qualifying-business criteria

The target company must be a Canadian-controlled private corporation with limits on former controlling owners’ board representation and strict arm’s-length and non-affiliation rules.

Before the sale, substantially all corporate assets must be used in an active business, which can disqualify companies with significant passive assets, excess cash, or non-core investments unless a purification is performed and of course we have to ensure we are compliant with Section 55(2) of the Act.

Strict seller arm’s-length and loss-of-control rules

Sellers must fully relinquish control at closing and remain arm’s length afterward.

They cannot retain rights or influence that could permit direct or indirect control.

This sharply limits common vendor-protection mechanisms and complicates vendor-financed transactions.

Ongoing compliance and clawback risk

Qualification is not a one-time test.

The EOT must continuously satisfy all conditions.

Disqualifying events after closing can result in denial or clawback of tax benefits, sometimes years later, creating long-term compliance risk.

Limited tax advantages outside the transaction

An EOT is not tax-exempt.

Undistributed income is taxed at top trust rates, and advantages are focused on facilitating the sale transaction rather than ongoing low-tax accumulation, as reflected in administrative guidance from the Canada Revenue Agency.

Bottom line

EOTs are designed to support genuine, broad-based employee ownership—but they do so through a highly prescriptive and inflexible framework. The rules deliberately constrain who can benefit, how value is shared, how governance operates, and how sellers disengage, with continuous compliance required to preserve the intended tax benefits. This piece of legislation does indeed work but simpler more flexible rules would certainly be more helpful.