This paper was originally presented at the 2004 Annual Institute of the Ontario Bar Association on January 30, 2004
and is reprinted with permission.

Employees - The Forgotten Buyers

By Robin J. MacKnight, B.A., LL.B., LL.M., TEP

Wilson Vukelich LLP

Without labor nothing prospers. - Sophocles

Every path to a new understanding begins in confusion - Mason Cooley

All wealth is the product of labor - John Locke

1. INTRODUCTION

What is an Employee Buy-out?

Like the concepts of pornography or joint venture, there are different views on what constitutes an employee buy-out, or the even lower threshold concept of employee share ownership. There are companies that hold themselves out as "employee owned" where a small number of managers hold a very small ownership interest while a family or another corporation holds overwhelming control and ownership. In these cases, the "nuisance" value of minority shareholdings may be more valuable than the actual shares. At the other extreme are companies (some public) controlled by blocks of employee shares, representing the shareholdings of a large and diverse workforce. In the middle are companies owned by smaller groups of employees (usually including the senior management team), often arising as part of a business restructuring or succession plan (usually referred to by corporate finance people as a "management buy-out"). This paper focuses on the latter two situations. This paper also focuses on the commercial and business issues in identifying and structuring employee buy-outs, rather than the technical corporate and tax issues - many of those issues are generic to share purchase or estate freeze transactions, and others are entirely dependent on the particular facts.

The Concept of Employee Ownership[1]¹

Employee ownership is a concept that encompasses a wide array of issues and possibilities. At its most basic, employee ownership may be described as "any type of arrangement in which a broad cross-section of employees (both managers and non-managers) have the opportunity to acquire shares in their employer."[2]² Employee ownership can result in significant (majority or complete) ownership of a firm, with all employees participating, or in minimal (or token) ownership, spread among only a small number of participating employees.

The concept of employee ownership does not depend on whether the employees vote their stock individually, nor does it depend on the employees' ability to sell that stock (which would make employees only worker capitalists, not worker owners). Employee ownership seems to fall into one of four categories: social ownership, employee share plan ownership, direct share ownership, and worker co-ops.

Social Ownership

Social ownership may be considered an arrangement in which people in a community, including employees of a particular corporation, have an ownership interest in the corporation. The best example may be the community ownership of Spruce Falls Power and Paper in Kapuskasing, Ontario, where shares of the company formed to acquire the operating company were offered to both employees and community investors.[3]³ Credit unions and cooperative corporations may also be considered examples of social ownership.

The community bond legislation in Saskatchewan and the recently introduced community development bond legislation in Ontario might also lead to social ownership of local businesses.

Employee Share Plan Ownership

This is a vague concept with no consistent definition. Under employee share plan ownership, employees are not necessarily the only shareholders, and, as described below, may not even be significant shareholders. Under this form of ownership, employees hold their shares indirectly through another vehicle (trusts provide the most flexibility). Under some provincial incentive legislation, employees may own shares through an intermediate holding company.

This significant difference between employee share plan ownership and direct ownership (described below under "Control and Decision Making") is that the intermediary used in employee share plan ownership transactions allows the employees, as a group, to exercise the collective power of their holdings.

Direct Share Ownership

Under this approach to employee ownership, the employees hold shares directly. The advantage to this form of ownership is that the employees have a direct ownership stake in their employer. The disadvantage is that, because employees hold shares individually, it is difficult for them to act collectively and vote their shares as a block. Functionally, direct ownership relegates employees to minority shareholder status.

Worker Co-Ops

In worker co-ops, workers are generally the exclusive, and usually equal, owners of the enterprise. Worker cooperatives differ from the corporate form of worker ownership in a number of ways, including one vote per person (rather than one vote per share), equality of membership (instead of varying shareholdings), and the requirement that all workers must purchase an interest in the employer on commencing employment, but give it up on termination. While the corporate form of business is preferred in North America, worker co-ops are common in Europe. The most frequently cited example of a successful worker co-op is the Mondragon Cooperative in Spain, which employs over 18,000 workers and has become the largest manufacturer of household appliances in Spain (the co-op also manufactures many other products).[4]⁴

This paper does not discuss other forms of employee ownership, such as stock option arrangements, participative profit-sharing arrangements, or thrift plans. The first type of arrangement is not broadly based worker ownership. The second is another form of compensation for services rendered. The third is a voluntary savings plan.

The Canadian Experience of Employee Ownership

The overall number of firms with some degree of employee ownership in Canada seems to parallel the number in the United States. However, in Canada most employee ownership takes the form of direct share ownership, whereas in the United States ownership is more likely to arise in an employee stock ownership plan (ESOP) arrangement. In a 1992 study, Professor Long noted that 7.5 percent of companies surveyed had some degree of employee ownership.[5]⁵ The vast majority of these companies had employee share purchase plans. In some cases, shares were sold for less than the market price through some form of discount or employer matching. Several firms paid the brokerage cost or provided low-interest loans. A small minority of firms (approximately 13 percent) had share bonus plans, in which shares were provided to employees without payment (although the value of those shares would constitute a taxable benefit).

In most cases, the degree of employee ownership within the firm was very small. Long noted that while employee ownership ranged from 1 percent or less to 100 percent, the median level of employee ownership was 6 percent. Employee ownership seemed to be higher in private corporations, where the median level of ownership by employees was 11 percent, while in public corporations the median ownership was only 5 percent. A more telling statistic may be the average level of employee ownership-5.7 percent in public companies (so the median and the average were roughly equal) and 31 percent in private corporations (against the 11 percent median). One seems driven to the conclusion that in private companies, employee ownership is more a token than a philosophy.

Employee ownership also seems to be narrowly spread among the work force. While most firms permitted all full-time employees to participate in the ownership plan, non-managerial employees' participation was generally low. In Professor Long's study, the median participation rate by managers was 75 percent, compared with 30 percent for non-managers.

The statistics quoted above reflect the difference in policy between Canadian and US legislators concerning employee ownership. In Canada, the policy of the government has been to provide assistance to purchasers of shares. Government policies have generally been designed to reduce the effective cost for shares by delaying the recognition of a taxable benefit (subsection 7(1.1) of the Income Tax Act), [6]⁶ by reducing the amount of taxable benefit (paragraphs 110(1)(d) and (d.1)), or by providing incentives or tax credits based upon the purchase price for shares. [7]⁷ By contrast, the philosophy in the United States has been to create broadly based employee ownership without regard to the individual employee's ability to raise cash to purchase shares directly. In effect, the US rules allow employees to participate in the ultimate leveraged buyout - buying stock with corporate funds.

The American ESOP: The Capitalist Manifesto

The US rules on ESOPs stem from the ideas espoused by a San Francisco investment banker named Louis Kelso, who felt that everyone should own productive capital and ultimately build a personal capital estate. Kelso's "capitalist manifesto" posited that concentrated economic ownership was unjust and destructive of a free and democratic society, and that the concept of economic justice should be built upon the proposition that everyone should become an owner of capital as a fundamental human right.[8]⁸

One of the more vocal supporters of the ESOP rules, Senator Russell Long, summarized their operation as follows:

Employee stock ownership plans make it possible for workers in the private sector of our economy to share in the ownership of corporate capital without redistributing the property or profits from existing assets belonging to existing owners. Since [their] first application as a financing tool in 1957 [ESOPs] have been implemented by a growing number of successful US corporations. Through the vehicle of a specially designed tax-exempt trust, this method of finance offers corporations certain tax incentives and cost-reductions not available under conventional methods of finance. The [ESOP] also allows workers to accumulate significant holdings of capital in a tax-free manner during their working careers, while being taxed only on second incomes received in the form of dividend checks or on their assets when removed from their trust accounts.[9]⁹

A common form of ESOP requires a corporation to set up an employee stock ownership trust, to which the corporation contributes a predetermined amount of its stock. Using this stock as collateral, the trust then borrows funds from a bank to pay the corporation for the stock. Over time, and in accordance with the terms of the ESOP, the corporation will make payments to the trust, which the trust uses to repay its bank loan. As this loan is paid off and the trust effectively pays for the stock, the stock is gradually vested in the employee beneficiaries of the trust.

This type of ESOP is often used when the issuing corporation foresees the need for new capital to cover expansion. Instead of borrowing money directly to finance the expansion, which would be repaid with after-tax dollars, the corporation sets up an ESOP, which acquires a sufficient number of shares to raise the funds for expansion. All funds paid by the employer corporation to the trust - which are used by the trust to pay both principal and interest on the borrowed money - are tax-deductible. In other words, not only the interest on borrowed money but also the principal amount borrowed becomes tax-deductible, making the cost of capital raised through an ESOP very attractive. This is the "non-conventional" aspect of ESOP financing described by Senator Long.[10]¹⁰

Another common form of ESOP allows a corporation to deduct the value of stock contributed to the trust. Under this type of ESOP, the corporation sets up the employee stock ownership trust and issues treasury stock to it, which is immediately allocated to employees. The corporation is entitled to a deduction equal to the value of the stock contributed to the trust, even though it has not laid out any cash and will not lay out cash until the shares are redeemed by the employees (usually on retirement or termination of employment, at which time the employees are taxable on the ESOP benefit). Neither of these results would obtain under the rules in the Canadian tax system. [11]¹¹

The US ESOP rules provide incentives to vendors of shares to ESOPs. Where an ESOP is used to accommodate a transfer of ownership, the former owner of shares can defer payment of capital gains tax so long as at least 30 percent of original shares are sold to the ESOP and the cash proceeds are used to purchase shares in other companies. This provision has been used as part of leveraged buyouts and more recently as a defence against hostile takeovers.

The US ESOP rules also provide incentives to lenders to ESOP trusts. Such lenders are allowed to recognize as income only one-half of the interest actually received on ESOP loans; the other half effectively becomes a tax-free windfall. Presumably the purpose of this tax preference is to reduce the financing costs to ESOP trusts (which in turn reduces the deduction to the employer corporation, and the loss to the treasury).

Identifying the Target Business for an Employee Buy-out

Employee buy-outs most often arise in one of three scenarios:

·  A multi-business corporation determines that one (or more) or its operating divisions is under-performing, or is no longer a core business, and it seeks to divest itself of that division;

·  A business owner wants to set in motion a succession plan, recognizing that family members are not going to take over the business; or

·  A business must be restructured to survive economically (this may be a subset of the first scenario).

The common element in these three situations is that the current owner and the employee group may have widely differing views as to the value and viability of the business, and the changes necessary to ensure continuing value and viability. An ideal target for an employee buy-out is a business where the "problem" identified by the current owner is that the business is not generating a threshold rate of return (often determined in a vacuum by the corporate finance department in a distant head office), or is taking up too much management time (usually also determined by that same distant head office in the case of non-core businesses). In these cases, the current owner and the local employees may have dramatically different views on the value of the business which can translate into some creative financing opportunities (discussed in more detail below).

In the case of the succession plan, the current owner may have an inflated view of value, but the employees might be prepared to pay that value over time (also discussed below). Such plans could also include a transition period, where the key employees buy part of their interest at the outset, and either "earn in" a greater interest, or commit to buying out the original owner's residual interest at a future date. The open question is whether the terms of that ultimate buy-out would be negotiated at the outset, or left to the future.

In the case of a business restructuring, concessions may be required from the various stakeholders in the business, including employees. Recently we have seen situations where employees trade wage and workplace concessions for ownership, while other creditors trade debt for some form of equity. In these cases, there is really no "transfer" of ownership from the current owners to the new owners - rather, there is a dilution of the current owners' interest, and a system of "earning in" for the stakeholders who have granted concessions. The high interest environment of the late 80's and early 90's led to a number of such employee buy-outs. The current high exchange rate world might lead to a resurgence in employee buy-outs as multi-national corporations revisit the continued viability of their Canadian subsidiaries.

Employee Buy-out Structures

Conceptually there should be no difference between an employee buy-out structure and any other third party purchase structure. The constant issues of price, payment terms and security remain. However, where employee buy-out structures may differ from traditional third party purchases is in the relationships and documentation affecting rights between the shareholders. While a shareholders agreement may work well in a traditional structure with a small group of purchasers, different "control" mechanisms may be necessary where the employee groups have different views. This is discussed below.

In addition, financing the purchase may be different. Where there is a small group of purchasers (as in a typical management buy-out), traditional lenders may be prepared to fund the purchasers, either collectively or individually. Personal assets may be pledged as security for such loans. RRSP's may be one source of funds (although there are serious restrictions on the ability of 10% shareholders to use RRSP funds). In a widely spread employee buy-out, traditional lending and security practices break down under the sheer weight of numbers (both the large number of participants and the relatively small value of financial resources they each have). Novel approaches to asset based and cash flow financing may be required. There may be more reliance on vendor take back financing than in third party purchases (discussed below).

In the case of succession planning employee buyouts, the current owner may provide financing through a preliminary estate freeze. The current owner might freeze the value of the business using traditional redeemable preferred shares. This would minimize the cash purchase price employees must raise. However, the trade-off might be to require a sinking fund to redeem the freeze shares on an aggressive basis. There would other protections for the freezor to ensure due retirement of the purchase price represented by the freeze shares, and possibly some incentives (equity kickers) to compensate for the deferral and risk.

2. WHY SELL TO EMPLOYEES?

There are many reasons why business owners should consider selling to their employees. Many of the following reasons (not listed by degree of significance or importance) come into play at the same time.

The New Form of Succession Planning?

A recent study published in the Canadian Tax Journal has confirmed the suspicions of many business advisors that businesses are no longer automatically passed from generation to generation. An increasing number of family business owners have concluded that their family members are not the appropriate successors to the business - either as managers or owners. There may be issues of fairness (where some family members are involved in the business while others are not) or competence (where no family member is interested in or capable of continuing the business). The best solution may be to sell the business and leave cash for the estate.

Buyer of Last Resort

Many family businesses find difficulties in attracting buyers. While the business may have generated profits and a comfortable life style to its current owner, there may be no "strangers" willing to carry it on. The employees may be the only people interested in (or capable of) continuing the business.

If the reason for the sale is that the business is not meeting threshold rates of return, then it is not inconceivable that a stranger would encounter the same difficulty - especially if the stranger has to use debt financing which would probably lower the overall return and make it even more difficult to achieve the threshold return. However, employees generally represent "patient capital". It is likely they are more concerned with day to day income considerations, such as preservation of jobs and the cash flow and job security benefits that accrue to that, rather than long term rates of return.

Maximizing Value for Under-performing Assets

Different owners may expect or require different rates of return on investment. Local employees of a business may be willing to pay a higher price and consequently accept a lower rate of return on their investment because it preserves their jobs, or pensions, or protects the community. Their economic motives for buying may be more basic than maximizing returns on investment.

Buyer With the Highest Price

The vendor may have an inflated view of the value of the business. Employees of the business might be more inclined to share those views, and pay that higher price, over time, than third party purchasers. While differences in value can be addressed through earn-out clauses, those can be manipulated and may be difficult to enforce. Consequently, the vendor may be more comfortable dealing with employees than third parties. The trade-off for a higher price may be a longer term over which the purchase price is ultimately paid. However, such a longer term may not be a disincentive. Consider that the employees may have other than purely commercial interests in maintaining their jobs and the business in the community. They are probably a better long term commercial risk than an unpaid purchase price owing by a stranger with no loyalty to the business.

Buyer With the Best Security for the Unpaid Price

If the employees are more interested in preserving their jobs, pensions and community, they will likely be less interested in "flipping" the business to realize a profit. This probably also means they are less likely to manipulate the business to the detriment of the vendor. The "patient capital" with a long term view may be the tortoise against the hare of buyers seeking only to maximize economic returns.

Long Term Supply Contracts

Even though a business division may be under-performing, it may be a regular purchaser of product or raw material from another division, or a regular supplier of materials used by another division. That reliability of purchase or supply may support vendor take back financing and represent value or security to non-conventional (cash flow based) lenders.

Competitive Reasons

When a company sells a business division, it has to open its books and records to potential buyers. Notwithstanding the best confidentiality provisions, such disclosure of confidential information to competitors (especially if they decide not to complete the purchase) could have adverse effects. The employees likely have a better view of the opportunities and risks inherent in the business and the disclosure, even of information relating to affiliated businesses, might not be as potentially adverse.

Retaining Key Employees

Sometimes the only way to keep key employees is to give them a "piece of the action". The idea is that employees with an economic interest will be more dedicated to the business. Or maybe they just want to maximize their economic potential.

Political Factors

Don't underestimate the political fallout of selling off, or potentially shutting down, a local business. Large corporations disposing of non-core assets may find no competitor to purchase a plant. However, if the reason for the sale is that the local business is not meeting threshold rates of return, or is not a core business, or is taking more management time than the overall returns would justify on an internal rate of return basis, there may be reasons to sell the business to a local group of employees. Removing inter-company administrative and other charges, and reducing related operating expenses and fixed overheads might revitalize the business and make it viable in the hands of new purchasers - ie. the employees. This can become particularly relevant if the local plant consumes or produces products that are critical to retained businesses (see above - Long Term Supply Contracts). Don't forget that local politicians might have influence in such matters as property tax concessions, zoning variances or other local issues that could affect the ongoing operating costs of the business. If the vendor has any thought of potentially continuing to do business with the local market, a sale to employees may be more advantageous than a sale to a stranger.

3. WHY SHOULD EMPLOYEES BUY?

Some of the reasons employee groups should band together to acquire their employer's business are set out below. Again, many of these reasons are cumulative, and are not listed by degree of importance.

Employee Motivation and Performance

In theory, employees who have a positive association with their employer through share ownership should increase their identification with corporate objectives, which in turn should lead to enhanced overall corporate performance.

This theory has been confirmed in several studies. One study conducted by the Toronto Stock Exchange (using public corporations listed on the exchange) concluded: "Canadian employers are highly positive on the impact of their employee share ownership plans on employee job attitudes and satisfaction, on employees' interest in the financial success of their companies and on employees' sense of ownership and participation within the company." [12]¹² Richard Long's study of companies with employee ownership plans reached a similar conclusion: "[L]arge majorities believed there to be a positive impact on the company overall and key job attitudes, and virtually none perceived any negative impacts." [13]¹³

The experience in the United States also suggests that worker motivation and performance were somewhat or strongly improved because of ESOPs. One of the leading commentators on ESOPs observed:

[E]mployee ownership could be considered revolutionary in terms of the commitment it can create among various work groups within an organization. It can elicit the American version of Japanese loyalty. It can go beyond wages and incentives to forge a joint sense of partnership by establishing a longer-term identification between the worker and the company. [14]¹⁴

At least one court in the United States agreed with these comments, noting that "the evidence is uncontradicted that ESOPs promote productivity."[15]¹⁵

Yet there is doubt that employee ownership alone can bring about the types of changes in the workplace that are required for true productivity gains. Blasi remains skeptical that employee ownership is the panacea some claim it to be:

Employee ownership has not lived up to its potential as a revolutionary advance in labor-management relations and entrepreneurial revival. As the evidence here has shown, employee ownership leads to greater worker identification and commitment to the company, yet increased motivation and productivity only result from practical labor-management problem solving and work organized in an interesting way. A complete transformation of American business would require simultaneous attention to properly structured employee ownership, joint labour-management involvement and co-operation in strategic decisions, redesign of work tasks to enhance job enrichment, and short term profit sharing or gain sharing to reward clearly measurable improvements in productivity. Together, these elements can revitalize a company. But sadly, we have witnessed only partial applications, and as such only limited success.[16]¹⁶

Blasi's conclusion is that "[l]abour-management cooperation is not an inevitable by-product of employee ownership. It requires effort, which is generally not forthcoming because of lack of support and follow-up by management, unions, and unorganized workers. Employee ownership does cause the worker-owner to identify more with the company and can engender greater commitment. But it is participation in management, usually at the shop floor and departmental levels that increases an employee's motivation and provides opportunities for real change."[17]¹⁷

Creating the "conducive culture" in the workplace may require drastic action. Common complaints as to why businesses are closing in Ontario and moving offshore include lack of job training, lack of capital for expansion and technological upgrading, and the adversarial attitudes of labour and management. A shock to the system is required to address these complaints. One such shock could be a change of ownership.

The argument from the labour movement (or at least from that faction of the labour movement that supports employee ownership) is that employee owners have different perspectives from "capitalist" owners, who seek only to maximize return on investment. Employee owners, it is said, are more concerned about jobs, local issues, the environment, and cooperative work practices. If true, employee owners could become more innovative and solve Blasi's concerns.

Social Equity

One goal of employee ownership is to alleviate the inequality in the distribution of financial assets and wealth in society. The creator of the ESOP, Louis Kelso, stated that these plans were created for "no less" than the purpose of redistributing wealth.[18]¹⁸ This is the classic notion of "worker capitalism," which has been advanced as a counter to unionization, and in fact is the main basis for union resistance to the concept of worker ownership - the employees, as owners of the enterprise, will develop stronger ties to the employer than to the union!

In the United States, one of the primary purposes of ESOP incentives was to broaden capital ownership.[19]¹⁹The intent of the legislators was quite clearly more than just to permit another way of funding employee retirement benefits, as the following excerpt from the Tax Reform Act of 1986 shows:

INTENT OF CONGRESS CONCERNING EMPLOYEE STOCK OWNERSHIP PLANS. The Congress, in a series of laws . . . and this Act has made clear its interest in encouraging employee stock ownership plans as a bold and innovative method of strengthening the free private enterprise system which will solve the dual problems or securing capital funds for necessary capital growth and of bringing about stock ownership by all corporate employees. The Congress is deeply concerned that the objectives sought by this series of laws will be made unattainable by regulations and rulings which treat employee stock ownership plans as conventional retirement plans, which reduce the freedom of the employee trusts and employers to take the necessary steps to implement the plans, and which otherwise block the establishment and success of these plans. [20]²⁰

Blasi notes that in the United States the goal of redistributing capital has not been achieved under the ESOP rules. While US government studies conclude that ESOPs "appear to provide a broader distribution of stock than generally prevails," Blasi disputes the methodology used in reaching this conclusion. He points out that the US rules allow lower-paid employees (those most in need of the wealth redistribution) to be excluded from ESOPs. US rules, which allocate stock on the basis of salary, skew stock ownership even in ESOPs that include all employees. He concludes: "The key point remains that employee-ownership law has reproduced the system of economic stratification in American society rather than attempting to reverse it."[21]²¹

Regional Development Objectives

A long held belief is that employee-owned and -operated businesses add stability to the local economy because the profits are more likely to stay in the community. Incentives to invest locally should lead to the creation of new jobs-assuming that the investment is commercially viable.[22]²² The Canadian experience suggests that regional development requires partnerships involving various levels of governments, business, labour, and community interests. Residents of remote areas are logical investors in regional development activities. They will assume some of the risks in exchange for some of the equity. However, most of them lack capital to invest. One means of providing capital is through worker ownership arrangements, where the workers earn their ownership interest.

Preservation of Jobs in Industrial and Financial Restructuring

This is perhaps the most pressing objective behind worker ownership. The report of the Premier's Council[23]²³ concluded that initiatives in Quebec and at the federal level point to worker ownership as a complementary component of industrial restructuring (while recognizing that such initiatives are not intended to be last-resort financing for failing firms). Such initiatives "provide labour with the opportunity to invest in healthy companies that need capital for growth, to put in place new management in restructuring potentially healthy firms, or to buy out discrete businesses from existing companies when those firms no longer have a strong interest in them. They are also intended to maintain good jobs in the country and expand the value-added capability of firms."[24]²⁴

The US experience with job preservation, and even job creation, is very positive. Studies by William Whyte of Cornell University suggest that ESOP-financed worker buyouts saved more than 50,000 jobs between 1980 and 1986.[25]²⁵ One of the best known ESOP success stories in the United States is the employee buyout of Weirton Steel. In 1984 the 7,000 employees bought the company to prevent its being closed. Not only were the 7,000 jobs saved, but new jobs were created (Weirton now employs over 8,500 people) in an industry that is suffering from overcapacity, Third World competition, and environmental regulation. Senator Sasser noted in 1986: "ESOPs are a most encouraging trend in American business - one that is saving thousands of jobs and giving millions of American workers the opportunity to gain direct ownership of the companies that employ them."[26]²⁶ Employee ownership can be used to save jobs in employers who wish to cease operations because of an inadequate return on investment (industrial restructuring) or for a more basic financial reason - unprofitability.

In the industrial restructuring case, an employer may wish to cease operations for any one of a number of reasons, such as unacceptable rates of return on investment, low margins, high costs (including exchange rates), inability to raise capital to acquire new technology, or inability to innovate and respond to changing markets. If existing labour-management relations are confrontational and adversarial, there may be no common ground for reducing costs and finding innovative work rules to increase productivity. The answer may be to change owners, on the premise that once the employees own the business, they will be more willing to accept lower rates of return on investment as a quid pro quo for continued employment. They will also be more amenable to changing work rules to improve productivity and innovate and (re)train the work force.

In the financial restructuring context, employee ownership may be one way to reduce crippling debt burdens, which are the overriding cause of the financial difficulty. Leveraged buyouts traditionally are highly leveraged. The resulting increase in corporate debt has an adverse effect on labour markets. Reliance on debt, especially short-term debt, means that LBO companies are running the risk of illiquidity. Debt service is an inflexible demand on corporate cash flows and on management, since it is a pre-emptive claim on cash flow. Highly leveraged companies are particularly susceptible to reduced sales and revenues, compelling the management to take short-term action to solve the immediate problem of cash flow and debt service. Since labour costs are often the easiest to reduce, employment conditions seem to bear a disproportionate share of the brunt of accommodating the debt service imperative.

The response may be to let workers compete with the LBO buyers for purchase opportunities. The workers will have a long-term view of the business and will make more rational decisions affecting its financing and control over its costs and revenues. Worker capital is patient capital - as long as the jobs continue, the capital is preserved and need not attract the same rates of return that other owners might demand.

In the end, a cost-benefit analysis may support the inefficient allocation of resources implicit in the tax credit for employee investment. The cost of the credit may be small when compared with the cost of the alternative - unemployment, loss of jobs in related industries, and the shutdown of one-industry towns.

Promoting Social Investment

The argument goes that employees who live and work in one locale will make investments that preserve that locale, and will not make investments that might increase the return on their investment but at a greater social cost. In other words, employee owners will develop production practices that minimize damage to their environment at the expense of short-term profits.

This argument is not farfetched. In 1989 the Ontario Federation of Labour approved the establishment of a "social investment fund" designed to invest in "socially useful" projects such as low-cost and co-op housing, environmental technologies, and businesses operated by low-income individuals. In an age when government can no longer afford to provide such public goods, public policy should encourage the private sector to make such social investments. Once again, the return on such social investments may be less than the return on investments in the optimally efficient market - but where is that market? Perhaps the time has come to introduce into the equation for maximum return on investment a social component to reflect the real world, and to acknowledge that purely economic returns do not necessarily lead to optimal social welfare.

International Competitiveness

An Ontario government budget document concluded that "[a] prosperous society must provide high levels of employment in well-paying, high-quality jobs."[27]²⁷ Further, increases in productivity - the capacity to produce more with the same level of inputs (including capital and labour) - provide the basis for high-value-added jobs and stable incomes for workers and employers. In order to improve the quality of the labour inputs, the skills and adaptability of the work force must be enhanced. If there are adversarial relations between labour and management, one may reasonably doubt that this can be achieved. However, so the argument goes, the labour force should be more inclined to adapt and be innovative when it owns the business. As Blasi observes: "Employee ownership may promote a special relationship between employee and company that increases their commitment to resolving problems, and profit sharing may provide the short-term rewards of such problem solving, but in the end people are motivated by contributing to creative solutions that bear results and make exciting use of their skills." [28]²⁸

A study conducted by the National Center for Employee Ownership in the United States contrasted the growth rate of companies for the 5 years before and after the implementation of an ESOP with the growth rate for comparable companies without an ESOP. A total of 73 percent of the ESOP companies significantly improved their performance after setting up the ESOP. The study results indicated that the ESOP companies had an annual growth rate in employment that was 1.2 percent higher than the comparison companies before the ESOP, but 5.1 percent higher after the ESOP. Sales before the ESOP were 1.9 percent higher; after the ESOP, sales averaged 5.4 percent higher. If these performance differences continued for the following 5 years (no studies have been undertaken as yet), ESOP companies would have generated 41 percent higher sales and 46 percent higher employment than their non-ESOP competitors after 10 years.[29]²⁹ While employee ownership frequently leads to improved corporate performance, this is not always the case.[30]³⁰ The key to enhanced productivity and profitability seems to be a system that combines employee ownership with opportunities for increased employee participation in decision making. Employee ownership seems to work best in an environment where there is a relationship of trust, mutual respect, and cooperation between management and employees.[31]³¹

4. POLITICAL ISSUES - CREATING AND MANAGING THE EMPLOYEE GROUPS

Who is Your Client?

One of the biggest problems in dealing with groups of employees is determining how they will make decisions and how any decision will bind all employees. Whose instructions must you follow?

If your client happens to be a unionized workforce, then as advisor you can rely upon the procedures and protocols of the union constitution in making decisions. Your client may be the leaders of the trade union local, although you may find that decisions are either made by or largely influenced by more experienced members of a national organization or affiliate.

However, if you are representing management, you may find that there is a small group of employees (presumably all managers) who operate more or less by consensus, or who follow a more hierarchical decision making structure. Frequently in such circumstances you will find a natural leader, usually the president or likely president. As an aside, it is always interesting to see whether the person who perceives him or herself to be the leader in the negotiations can actually build required consensus among his or her colleagues and negotiate a successful acquisition. In many cases the person who thinks he or she will be the leader does not prove to be the person capable of assuming the position of president of the organization at the end of the day. This creates a different set of issues that has to be addressed separately.

And then there is always the residual group - those members of the workforce who are not protected by a collective agreement, or who are not managers. A non-unionized administrative staff or sales force is the hardest group to deal with because there are no pre-existing decision making processes in place. At least with a unionized work force, one can always fall back on various labour relation statutes to determine how unions make decisions. However, with a non-unionized workforce that is not necessarily ad idem, it is more difficult to find a group of leaders around which it can coalesce. They may just be dragged along with, or may seek to join, another group of employees.

Managing Expectations - Owners Versus Workers

Some employees (usually not those in the management ranks) may think that their status changes because they have an ownership interest in the business. They may think they have more rights as owners than as employees. In particular, they may think they can't be fired or terminated because they are now owners. Wrong!

In virtually all cases, their rights and obligations as workers exceed their rights as shareholders. All they really get as shareholders is the right to receive information (which may or may not be meaningful) and the right to vote (which may also not be meaningful, depending on the structure for holding and voting shares). On the other hand, their rights to compensation for termination, and pension rights, are determined by their employment relationship. That relationship may also affect their rights as shareholders (for instance, requiring a disposition of shares on termination of employment).

Transition Issues - Dealing With New Hires and Retirees

If the structure requires all employees, management, salaried and unionized, to become members of a share ownership plan or arrangement, you may find that new employees do not wish to participate. The question arises whether either existing or new employees can "opt out" of the share ownership structure. The answer should be a resounding "no". If the culture of the organization is to be one of employee share ownership, then one cannot tolerate the disruptive influences of non-owner employees. One of the terms and conditions of employment must be participation in a share ownership plan. That should not become a negotiating point.

5. CONTROL AND DECISION MAKING

A fundamental issue in employee buy-outs is how control of business decisions will be exercised. The sad reality of modern corporate life is that individual shareholders are powerless to make meaningful decisions or influence the affairs of the business. Widely held corporations are functionally controlled by a small group of inside shareholders, including management and institutional investors with whom management has close connections.

Economic and Political Rights

From the standpoint of management, having the shareholdings fragmented and spread among a large number of employees will entrench their continued control of the business. From a standpoint of the employees, this may not be the most advantageous structure. Instead, the employees may wish to "pool" their shareholdings so that they hold a control block which can be used as a device to counter the conduct or control position of the inside management group (for instance, voting on a compensation structure for senior management). Alternatively, the employee groups might agree that different decisions require different forms of shareholder approval. Decisions might be distinguished as "housekeeping" (appointment of auditors, for instance) or "economic" (payment of dividends) requiring one type of approval, or as "fundamental" or "political" (sale of the business, capital expansion, election of directors) requiring a different form of approval. In unionized environments, certain types of decision (such as elections) are based on the concept of "one person, one vote". Decisions affecting the continued viability of the business (such as sale or capital expansion) affect the entire workforce equally, without regard to any employee's particular shareholdings, and may justify a different decision making process.

Different classes of shares carrying "economic" or "political" rights held by trusts address these issues.

For instance, all shares owned by employees might be held by a trust, of which the employees are beneficiaries. So long as an employee continues to be employed by the company, he or she remains a beneficiary of the trust, with a determinable interest in the underlying trust assets. When a decision must be made, the trust could call a meeting of its beneficiaries and conduct a poll, and then vote its block of shares in a manner consistent with the poll. Different questions could require different processes. For instance, if the question was the appointment of auditors, which is generally a shareholder prerogative, the decision making could be based upon each individual employee's proportionate interest in the economic rights shares held by the trust. This would effectively give each employee a vote representing his or her proportionate shareholding. However, a "fundamental" decision would require a direction on how to vote the political rights shares. In this case, each employee would be an equal beneficiary of the trust, and the consequent vote would reflect the co-operative "one person, one vote" concept, rather than proportionate shareholdings. This gives equal weight to all income levels and all seniority levels (since those factors generally apply in allocating the "economic" shares among the employees).

Another great advantage of the trust structure is that it allows employees to "earn in" their interest in the underlying trust shares. For instance, in many employee buy-out situations, employees trade a piece of the ownership for work concessions, including often job security, labour rate reductions or work changes. Given that those are long term concessions, it seems unrealistic to grant the benefit (i.e. share ownership) to those people who are the immediate grantors of the concessions, especially in circumstances where changes to the workforce (layoffs, temporary work force reductions, or rehirings) may suggest that there are more potential beneficiaries than the immediate workforce.

This "earn-in" concept is equally applicable to the salaried ranks and the management ranks. In many cases in an employee buy-out situation, key management positions remained unfilled, and a trust allows a "stakeholder" position or a marker, to allow the future employee to participate in the share ownership.

6. EMPLOYEE OWNERSHIP AND THE INCOME TAX ACT

There is no specific code or set of rules in the Act dealing with employee ownership. As a result, employee ownership transactions in Canada have to fit within rules of general application. While these rules of general application pose no great difficulties for employees and vendors of shares, they do present serious difficulties for employers and lenders.

Section 7 sets out the rules for taxing benefits to employees under stock option and stock purchase plans. These can be broken down into three essential provisions:

1) a rule defining the amount of the benefit realized by the employee;

2) a rule defining when that benefit must be recognized for tax purposes by that employee; and

3) a rule providing that the specific provisions of the section will override any other provision of the statute of otherwise general application.

The section also contains a significant limitation: it becomes operative only "where a corporation has agreed to sell or issue shares of the capital stock of the corporation or of a corporation with which it does not deal at arm's length to an employee of the corporation or of a corporation with which it does not deal at arm's length" (emphasis added).

The effect of this limitation is that section 7 operates only when the corporation is the source of the stock. If the corporation provides funds to employees to allow them to acquire shares from a source other than the corporation (for instance, the public market), no benefit arises under section 7 (although tax consequences may arise under another provision). This distinction provides some planning opportunities and pitfalls, as emphasized in the Placer Dome decision, discussed below.[32]³²

Tax Issues Affecting Employees

Quantifying the Employee Benefit

Under paragraph 7(1)(a) , an employee must include in income, for the year in which shares are acquired, the difference between the amount paid or to be paid by the employee for those shares and the value of those shares. The Canada Revenue Agency takes the view that the "value" of the shares for the purposes of this calculation is their fair market value.[33]³³

Partial relief from this benefit may be available under paragraph 110(1)(d). If certain conditions are met, the employee may claim a deduction in computing taxable income equal to one-half of the amount included in income under paragraph 7(1)(a). The effect is that the employee pays tax on the benefit at capital gains rates (although the capital gains exemption cannot be invoked).

This partial relief is available if all the following conditions are met:

1) the employer corporation has agreed to issue or sell to the employee shares of its capital stock, or shares of a non-arm's-length corporation;

2) the shares must be "prescribed shares" - essentially, no-frills common shares;

3) the amount payable by the employee to acquire the shares must not be less than their fair market value at the time the agreement to sell or issue the shares is made minus the amount paid by the employee for the right to acquire those shares; and

4) immediately after the agreement to sell or issue the shares is made, the employer corporation and the employee must deal with each other at arm's length.

In the context of employee buy-out transactions, at least one of these conditions will often not be met: the shares acquired by the employees will not be "prescribed shares".

Regulation 6204 defines a "prescribed share" for the purposes of paragraph 110(1)(d). In particular, the share conditions must not allow the holder of the share to "cause the share to be redeemed, acquired or cancelled by the corporation." [34]³⁴ Frequently, the exit strategy for employee owners is to require some form of corporate funded buy-back. As a practical matter, this problem can be solved by structuring the transaction so that employees (either directly or through a trust) acquire their shares at (nominal) fair market value, so that no benefit arises under section 7. In such circumstances, the loss of the one-half deduction under paragraph 110(1)(d) will be insignificant.

Recognizing the Employee Benefit

The rules relating to when an employee must recognize the employment benefit and include it in income depend on whether the corporate employer is a Canadian-controlled private corporation (CCPC) (discussed below) or something else. Where the corporate employer is a CCPC at the time the agreement to sell or issue shares is made, the employment benefit is recognized and included in income when the employee disposes of the share. In all other circumstances, the employment benefit is recognized and included in income in the year in which the benefit arises.

Special rules for CCPCs

In addition to deferring the time when the benefit is recognized, employees who acquire shares in an employer CCPC may have the amount of the benefit reduced if the conditions imposed by paragraph 110(1)(d.1) are met.

Employees who acquire shares in CCPC employers are entitled to a reduction in the amount of the taxable benefit corresponding to the deduction available to employees of non-CCPC employers under paragraph 110(1)(d). However, this deduction is available only if the employee holds the CCPC share for at least two years after the acquisition date. If this two-year holding period is not satisfied, an employee of a CCPC employer enjoys the advantage of the deferral in recognizing the benefit, but gets no reduction in the amount of that benefit.

It is interesting to note that the reduction in the employment benefit allowed by paragraph 110(1)(d.1) is not dependent on whether the acquired share is a prescribed share. Consequently, an employee who acquires a redeemable share in a CCPC, and who holds that share for two years, will be entitled to the deduction under paragraph 110(1)(d.1).

Maintaining CCPC status

From the standpoint of employee investors, CCPC status may be significant for two reasons: CCPCs enjoy the preferential (low) tax rate on the first $250,000 of taxable income (for 2004); and employees are not taxed on any benefit arising on their acquisition of shares until they dispose of those shares, and they may be entitled to the 50 percent reduction in the amount of the benefit under paragraph 110(1)(d.1).

A CCPC is defined in the Act as a corporation established under federal or provincial law as a "private corporation" which is not controlled, directly or indirectly, by one or more non-resident persons, by one or more public corporations (other than prescribed venture capital corporations), or by some combination of non-residents and public corporations.

The question of the target operating company's status as a CCPC is more important for the employees than for the corporation. If the corporation is not a CCPC, employee benefits will arise under paragraph 7(1)(a) when shares are acquired (and when there may be no cash to pay the tax on any such benefit), rather than when shares are sold. Planning for the worst case - a taxable benefit on the acquisition of the share, rather than on its disposition - suggests that employees should acquire shares at the outset when values are low, rather than in future when values will, it is hoped, be higher.

Using Trusts to Acquire and Hold Employee Shares

It may be inappropriate for employees to absolutely acquire entitlement to employer shares at the outset of an industrial restructuring. For example, the restructuring may require a temporary shutdown of one product line, pending a turnaround in the economy. When production of that product resumes, the employees of that business should participate in the ownership of the overall business. However, it may be difficult to allocate shares to them at the outset. Some vesting period may be required in the interests of employee equity.

Additionally, there may be some incentive to control a block of employee voting shares, to ensure that the goals of the restructuring are not subverted through future actions.

These and other goals can be satisfied if employee shares are issued to a trust and allocated to participating employees over a period of years. Fortunately, the tax rules accommodate this.

Subsection 7(2) provides that an employee will be deemed to have acquired a share at the time the trust commenced to hold it. Consequently, if the trust acquires the share at the outset of the employee buyout when it has nominal value, but the share is allocated to the particular employee at a later date when it has value, the employee will be deemed to have acquired the share at the earlier time. The increase in value will not constitute a taxable benefit to the employee at the time of allocation.

Relating Wage Concessions to Shares

In a restructuring, there seems to be some inevitable link in the minds of the employees and some parties (notably lenders) between any wage concessions employees are required to make and the shares they ultimately receive. This must be avoided.

If there is an exchange of work for shares, the value of the shares must be included in income as remuneration. The employee will recognize income, but will not have cash to pay the tax. From the employer's standpoint, it will have no deduction for this wage and salary expense (discussed below). This is a "lose-lose" interpretation of the relationship between the employer and the employee.

In the course of an employee buyout or an industrial restructuring, there will be many "gives and gets" between the various interested parties. In this context, one cannot isolate two factors and ascribe any equivalence to them.

Tax Issues Affecting the Corporate Employer

Denial of Deductions to the Corporate Employer

A Federal Court of Appeal decision relied on paragraph 7(3)(b) to disallow the employer's contribution to an employee stock purchase plan.

The facts in Placer Dome[35]³⁵ are not uncommon. The corporate employer had set up a trusteed employee stock purchase plan. Employees were permitted to contribute up to 6 percent of their salary per annum to this plan; the corporate employer was then required to make a corresponding contribution equal to one-half the employee's contribution. The trustee of the plan used the total contributions to purchase shares of the employer, at fair market value, first from withdrawing or terminating members of the plan, and then, if necessary, from treasury.

In computing its income, the employer deducted the amount it had contributed to the plan. On assessment, this deduction was disallowed. On appeal to the Federal Court - Trial Division, the employer's deduction was allowed on the basis that its contributions to the plan were made as additional remuneration to the participating employees. The Federal Court of Appeal denied the deduction because "it is clear that the employer's contributions are provided merely to allow the acquisition of shares by the employees at a reduced price." While the decision did not rely on this point, the express terms of the plan could be read as reflecting that intent.[36]³⁶

The majority decision[37]³⁷ took great pains in describing the circular flow of funds from the employer corporation to the trustee and back to the employer as subscription proceeds for treasury shares. This circular flow of funds, coupled with the findings that any outlay by the employer had a predetermined destination and that more treasury stock was issued than old stock was sold, led the majority to conclude that the employer "has not made any output of funds under the Plan."[38]³⁸ The proper conclusion was that "the true benefit the employees acquire by their participation in the plan is not the entitlement to an additional remuneration but the entitlement to a credit for shares of Placer at two-thirds of their market value."[39]³⁹

Although the common law (apparently accepted by the CRA)[40]⁴⁰ taxes as income payments made by employers to their employees that are then used by the employees to acquire shares from third parties, subsection 7(3)(b) denies the corporate employer a deduction for both payments used to acquire shares from treasury and bona fide wage and salary expenses that are paid in kind in the form of employer stock. This introduces a horizontal inequity to the Canadian tax system, which is not paralleled in other jurisdictions.[41]⁴¹

To show the horizontal inequity, consider the case of two employers who both wish to have employee ownership, and who owe remuneration to their employees. If one employer has access to capital markets and can issue treasury shares into the market to raise new capital to pay salaries to its employees, it will be allowed a deduction for wage and salary expenses. If its employees subsequently use their (after-tax) cash wages to acquire shares in the market, no benefit will be attributed to them under section 7.[42]⁴²

On the other hand, if the second employer issues stock having a fair market value equal to the remuneration owing to its employees, the employees will be taxable on the benefit under section 7, but the employer will have no deduction for its genuine wage and salary expense paid in kind. Since there is no principle of tax policy that advocates non-deductibility of bona fide business expenses, this inequitable result must be considered a trap for the unwary.

Further, it seems anomalous that in this particular area of deductibility of wage and salary expenses the corporation should get no recognition for tax purposes for issuing its stock. If a corporation issues stock in exchange for assets, it is generally considered to have acquired those assets at the value of the stock issued (absent the operation of some specific tax-deferral provision of the Act). If it pays for inventory by issuing stock, its cost of the inventory will be the value of the stock issued.[43]⁴³ If it pays trade expenses by issuing stock rather than cash, it still has incurred that expense, and (subject to the general rules) is entitled to a deduction. Why should wage and salary expenses be singled out for different treatment?

For a policy and technical discussion of the current accounting disclosure proposals, see three articles in the Policy Forum section of the 2003 Canadian Tax Journal, vol. 51, number 3.

Tax Issues Affecting Vendors

In circumstances where an existing shareholder chooses to sell shares to an employee ownership trust or employee group, the vendor will be entitled to claim a reserve for unpaid sale proceeds and capital gains. The only difficulty facing the vendor is matching the reserve with the actual proceeds recovered from the employee ownership vehicle. If the payout exceeds five years, the vendor may find it difficult to match the liability to pay tax with the cash flow from the sale proceeds.

If the buy-out structure contemplates the redemption of freeze shares, the vendor/freezor will probably inject a holding company to hold the shares and receive tax free inter-corporate dividends on their redemption. Care must be taken to ensure compliance with section 55 of the Act, which could apply to convert tax free inter-corporate dividends into taxable proceeds of disposition (this refers to the concept of "safe income" which is beyond the scope of this paper). If shares are redeemed over time, care must be taken in structuring the redemption schedule, to ensure that the penultimate redemption does not reduce the freeze shares below 10% of the corporation's overall value which could attract (refundable) Part IV tax. Also, these redeemable shares could constitute some form of "taxable preferred share" which could attract tax under either Part IV.1 or Part VI.1. Fortunately, there are "safe havens" for the redemption of such shares, but care must be taken at the outset to ensure their availability and ultimate application.[44]⁴⁴

Tax Issues Affecting Lenders

Unlike the United States, Canada offers no special incentives that would exclude from the lender's taxable income a portion of the interest payment on borrowed money used to acquire shares from an existing shareholder, which would also have the beneficial impact of reducing the borrowing cost to the employees.

Interest expense payable on loans made to acquire shares should be deductible in computing the borrower's income (although one might question whether there was an "expectation of cumulative profit" at the time the shares were acquired, which might become an issue if recent legislative proposals proceed)[45]⁴⁵ . If the loans require "incentive" or "participation" payments in addition to base interest expense, such additional payments may be deductible, but there is still considerable uncertainty on this point.[46]⁴⁶

Tax Issues Affecting Venture Capital Participants

Venture capitalists may either lend money in a traditional financing, or make some form of equity investment to assist in the employee buy-out. Frequently, venture capitalists insist on "kickers" as part of their financing package - either participation payments on loans (same issues as above) or bonus (or penalty) dividends on shares, or "free" shares (i.e. fully participating shares that will grow in value, but for which the venture capitalist paid nominal consideration). Usually the financing package requires that these free shares be redeemed or bought in defined circumstances, often at prices determined by formula.

These shares will attract the taxable preferred share and short-term preferred share rules[47]⁴⁷ , both of which come into play when the lender has shares that may be subject to put and call rights. The existence of put and call rights may create a "liquidation entitlement" under paragraph (b)(ii) of the definition of taxable preferred share. However, a safe haven may be found in paragraph (f) if a formula price used for the put or call "may reasonably be considered" to be used to determine an amount that does not exceed the fair market value of the share at the time of acquisition.

Alternatively, relief may be created under part VI.1 by specifying amounts in respect of the lender's stock (see subsection 191(4)).

Investing Through RRSPs

In addition to using RRSPs to obtain the federal and provincial tax credits, RRSPs may invest directly in employee-owned companies.

An RRSP is able to invest in the shares of the capital stock of a public corporation, whether or not those shares are listed for trading on a prescribed stock exchange.[48]⁴⁸

An RRSP is also able to invest in the shares of the capital stock of a private corporation if that corporation is an "eligible corporation" and if the beneficiary of the RRSP is not a "designated shareholder" of that corporation (which generally requires a minimum 10 percent ownership in that corporation). An "eligible corporation" is defined in regulation 5100(1) to mean a corporation that is a taxable Canadian corporation (not necessarily a public corporation) all or substantially all of the property of which is at that time used in a qualifying active business carried on by the corporation or by a corporation controlled by it. A "qualifying active business" means any active business carried on primarily in Canada (which excludes a business that derives income from property such as interest, dividends, rent, or royalties). A business will be considered to be carried on primarily in Canada if, at that time, at least 50 percent of the full-time employees of the corporation and all related corporations are employed in Canada, and at least 50 percent of the salaries and wages paid to employees of the corporation and related corporations are reasonably attributable to services rendered in Canada. A prescribed venture capital corporation is also an eligible corporation.

There is a strange anomaly in the regulations when it comes to eligibility for RRSP investment. "Designated shareholders" (basically those holding more than 10 percent of any class of shares) can invest through their RRSPs, provided that the cost of that investment is less than $25,000. While this is an improvement from what would otherwise be a prohibition, the investment limit is too low. After all, there is no restriction on RRSP investment by non-designated shareholders. Significant shareholders in an eligible corporation suffer discrimination in their source of investment capital; there is no apparent policy reason for this.

Exit Strategies

There is usually only one criteria for an exit strategy - sell for a profit to realize a capital gain (preferably one eligible for the lifetime capital gains exemption)! While that strategy appears simple, it rules out the easiest method of providing liquidity for employee shareholders - redemption by the corporation. Redemption triggers a deemed dividend equal to the difference between the redemption amount and the paid up capital of the shares redeemed - which often means the entire redemption amount will be taxed as a dividend rather than as a capital gain. Even though dividends are subject to preferential tax rates, that rate is greater than zero - which is the desired tax on a capital gain on the disposition of qualified small business corporation shares.

Generally, there will be two sources of funds to provide liquidity - third parties or the corporation. A public offering represents the ultimate exit strategy - but one that may spell the end of employee ownership. Other third party purchases, including sales to other employees, may preserve employee ownership, but may also have the effect of concentrating ownership in the hands of a small group of employees. In many cases, a purchaser must be created.

The Concept of a Market Maker

In many employee ownership situations, there is a desire to preserve the culture of employee ownership, while at the same time recognizing that events will occur which demand liquidity - such as death, retirement, disability, termination of employment or family emergency. There is also a recognition that the corporation is the only source of funds for such liquidity. The question then becomes how the corporation can provide funds to create capital gains, rather than deemed dividends.

The answer is to create a captive corporation which will act as a "market maker" for employee share transactions. The object is for this corporation to cover all its costs, but not otherwise to make a profit on these transactions. For instance, the market maker may purchase shares from a retiring employee, to allow that employee to access the lifetime capital gains exemption. However, the market maker may have to borrow the funds for that purchase, and it should be entitled to resell the shares at a sufficient mark-up to cover the interest expense. Such a resale should be to another employee. The negotiating point becomes how often the market maker is required to purchase shares, and how often it is required to offer to resell them to other employees.

Several political issues arise with market makers. Who controls the market maker? Can the market maker vote the shares it temporarily holds? If so, who decides how those shares should be voted? How long can the shares stay out of circulation - should there be a requirement that the market maker must resell the shares, even if that means selling at a loss?

7. CONCLUSION

In an age of international trade, global multi-national corporations, and apparently decreasing corporate responsibility and accountability, the concept of locally owned businesses seems to be a throwback to the age of the craftsman. But local businesses generate jobs and wealth. They promote and preserve their communities. They deserve our assistance.

Working with businesses to develop employee ownership structures is intellectually challenging, socially responsible, and profitable. I encourage you to consider the possibilities with your clients and prospects.

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This publication is provided for informational purposes only and is not intended as legal or professional advice to any particular reader. Readers are cautioned to seek the professional advice of an experienced lawyer and/or accountant regarding their own specific circumstances.

Readers can contact Robin directly at 905-940-0516 or by e-mail at rmacknight@wilsonvukelich.com.

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[1]¹ The following section comes from a paper entitled "ESOP's Fable: Gargoyles, Tax Policy and Employee Ownership in Ontario" which I delivered to the 1994 Annual Conference of the Canadian Tax Foundation, published in the 1994 Conference Report 22:1-36. While many of the studies and statistics may appear dated at first blush, unfortunately this is an area where little research is undertaken on a regular basis, and more current information is limited or confidential. Notwithstanding that, what little research has been done subsequently confirms the general conclusions discussed below. For more information, check the web page for the ESOP Association Canada, www.esop-canada.com.

[2]² Richard Long, "Employee Profit Sharing and Share Ownership in Canada: Results of a Survey of Chief Executive Officers" (University of Saskatchewan, College of Commerce, Regina, June 1991), 6. Professor Long is one of the few constant researchers on this issue - for a complete list of his publications, check his webpage at www.commerce.usask.ca/faculty/long/publications.asp

[3]³ This company was ultimately taken over by the (original) public company partner.

[4]⁴ Long (ibid., at 7) observes that 393 new co-ops were established in Canada by the end of 1987. Most of these are set up in Quebec, and about 50 percent are in the service sector. The largest industrial sector to use co-ops is the forestry industry

[5]⁵Richard J. Long, "The Incidence and Nature of Employer Profit Sharing and Share Ownership in Canada" (1992), vol. 47, no. 3 Relation Industrielles.

[6]⁶ RSC 1985, c.1 (5th Supp.), as amended (herein referred to as "the Act"). Unless otherwise stated, statutory references in this paper are to the Act.

[7]⁷ Tax incentives for employee investment are provided in British Columbia, Saskatchewan, Ontario, Quebec, and Nova Scotia

[8]⁸ Kelso's theories are explained in a two-part article by Norman G. Kurland, "Beyond ESOP: Steps Toward Tax Justice-Part 1" (April 1977), 29 The Tax Executive 187-99 and ". . . Part 2" (July 1977), 29 The Tax Executive 386-402.

[9]⁹ S rep. no. 1298, 93d Cong., 158-59 (1974), quoted in Kurland, supra footnote 6, at 195-96

[10]¹⁰As Kurland explains, supra footnote 6, at 197, the original shareholders will not feel disadvantaged, because the stock was issued to the ESOP for full value. "Even better, the company, through the unique privileges Congress has extended to ESOP financing, is permitted to service the debt for its expansion capital with pre-tax, rather than post-tax corporate dollars, a tax advantage that increases the company's cash flow by roughly 50% on every dollar borrowed by the ESOP. This is so because Congress has specially recognized the ESOP, both as a socially improved technique of corporate finance and as a new form of employee benefit."

[11]¹¹ Paragraph 7(3)(b) of the Act effectively denies a deduction to the corporation that issues shares to employees at less than their fair market value. The benefit so conferred on the employees would generally be taxable immediately under subsection 7(1) ¨; recognition of that benefit could be deferred if the issuing corporation was a Canadian-controlled private corporation at the time the shares were issued. In such circumstances, the tax results to a Canadian employee would approximate the tax results to a US employee under this ESOP structure.

[12]¹² The Toronto Stock Exchange, "Employee Share Ownership at Canada's Public Corporations" (Toronto, 1987), 6, cited in Edward T. Jackson and Jon Pierce, Mobilizing Capital for Regional Development, Local Development Paper no. 21 (Ottawa: Economic Council of Canada, 1990).

[13]¹³Long, supra footnote 1, at 24

[14]¹⁴ Joseph Raphael Blasi, Employee Ownership: Revolution or Ripoff? (Cambridge, Mass.: Ballinger, 1988), xi-xii.

[15]¹⁵ Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 257, at 274 (Del. Ch. Ct. 1989), cited in Scott Goodwin, "Tax Incentives for Employee Stock Ownership Plans After OBRA 1989: Is Congress Through Tinkering?" (Spring 1990), 43 The Tax Lawyer 743-71, at 746

[16]¹⁶ Blasi, supra footnote 18, at 251

[17]¹⁷ Ibid., at 209-10.

[18]¹⁸ Goodwin, supra footnote 19, at 746

[19]¹⁹ Hubert Humphrey summed up the need for capital ownership nicely: "Capital, and the question of who owns it and therefore reaps the benefit of its productiveness, is an extremely important issue that is complementary to the issue of full employment.[hellip]I see these as the twin pillars of our economy: Full employment of our labor resources and widespread ownership of our capital resources. Such twin pillars would go a long way in providing a firm underlying support for future economic growth that would be equitably shared." Quoted in Blasi, supra footnote 18, at 5.

[20]²⁰ HR rep. no. 3838, 99th Cong., 2d sess., 1271(a) (1986), cited in Goodwin, supra footnote 19, at 766

[21]²¹ Blasi, supra footnote 18, at 114

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