Anonymised, illustrative composite. An employee ownership trust and a worker cooperative reach the same place by different statutes. Three things the founder wanted to keep were fatal to one of the two, and it was not the one he expected.
At a glance
A Quebec specialty food manufacturer with 118 employees was being sold by its 64-year-old founder. The two external approaches he had taken seriously both wanted to consolidate production out of the province. The workforce had been organised for two decades, and the plant committee proposed buying the business itself.
The firm's first proposal was an employee ownership trust under section 110.61 — the structure described in employee ownership trusts and the Canadian rules. The employees turned it down. They wanted membership, one member one vote and a defined share of surplus, not beneficial interests in a trust. That is a worker cooperative, and a different section governs it.
Section 110.62 is not a variant of section 110.61. It is a parallel section with its own conditions, its own definitions in subsection 248(1), its own disqualifying-event rules and its own reserve. Three of the founder's requests failed on three separate conditions, and none of them is about price.
First, the board seat. The definition of a worker cooperative in subsection 248(1) requires that “at least one-third of the directors of the corporation are qualifying cooperative workers of the corporation”, and that “not more than 40% of the directors of the corporation consist of individuals” who, immediately before the conversion, owned 50% or more of the fair market value of the corporation's shares or indebtedness. The founder may sit on the board; he counts against the 40% ceiling and cannot count towards the one-third floor.
Second, the pledge. The definition of a qualifying cooperative conversion requires that, at all times after the disposition, “the taxpayer does not retain any right or influence that, if exercised, would allow the taxpayer” to control the purchaser or subject corporation. The founder wanted his vendor note secured by a pledge of the co-operative's shares with a right to vote them on default. That definition has no security-interest carve-out, and the Act writes one expressly elsewhere — paragraph 13(21.2)(c) excepts a right “other than a right, as security only, derived from a mortgage, hypothec, agreement for sale or similar obligation”. The absence of comparable words here is at minimum a live risk.
Third, a timing point that reads like a contradiction and is not. Paragraph 110.62(1)(c) requires that, immediately before the disposition time, “the purchaser corporation is not established for the purposes of providing employment to its members”, while the s.248(1) definition requires that “the corporation is established for the purpose of providing employment to its members”. The clock reconciles them: the co-operative must be a new vehicle not yet employing its members when it buys the business.
Price $13,200,000 for 100% of the shares; adjusted cost base $90,000; capital gain $13,110,000. Subparagraph 110.62(1)(e)(ii)(A) requires the parties to state an elected amount in the joint election, “not exceeding $10,000,000”. With one selling shareholder there is no percentage to allocate.
The deduction under paragraph 110.62(2)(a) is A × B × C less D. At the one-half inclusion rate in paragraph 38(a) the deduction is $5,000,000, against a $6,555,000 taxable capital gain. Net: $1,555,000 outside the deduction.
That residue is why the reserve matters. Subsection 40(1.4), marginal note Reserve — dispositions to worker cooperatives, provides that subparagraph 40(1)(a)(iii) “is to be read as if the references in that subparagraph to ‘1/5’ and ‘4’ were references to ‘1/10’ and ‘9’ respectively, if the shares were disposed of by the taxpayer under a qualifying cooperative conversion”. Ten years instead of five.
Funding: $4,600,000 of senior debt, $1,900,000 of member share capital and co-operative development finance, and a $6,700,000 vendor note amortised over ten years.
The governance conditions are the price of the deduction. Beyond the board rules above, the definition requires that at least 75% of employees of the co-operative and the businesses it controls, excluding anyone inside a probationary period of no more than twelve months, hold a membership share; that each initial membership share be issued for a nominal amount determined the same way for every member; and that the by-laws provide that “not less than 50% of those earnings must be paid on the basis of the remuneration earned by the qualifying cooperative workers” or their labour.
The disqualifying-event rules then run for a decade. Subsection 110.62(3) fixes the event at the earlier of the co-operative ceasing to be a worker cooperative and a year beginning with the active-business test below 50%. Subsection 110.62(4) then splits the consequences by date: inside 24 months, subsection (2) is deemed never to have applied and the vendor loses the deduction; between then and eight years later, the co-operative is deemed to have a gain equal to the elected amount. Same event, different month, different taxpayer.
The co-operative was incorporated under the province's co-operatives legislation with a board of seven: five elected by the members, four of them qualifying cooperative workers, plus two appointed directors, one the founder. Four of seven clears the one-third floor; one of seven prior majority owners is inside the 40% ceiling.
The share pledge was dropped. The vendor note took a second-ranking general security agreement over the operating company's assets instead, with no right to vote or acquire shares in any circumstance — because a right to acquire is still a right. The founder's management contract became a fixed-term consultancy with no authority over the board or the by-laws. The joint election was filed “on or before the earlier of the individual’s and the worker cooperative’s filing-due date for the taxation year that includes the disposition time”.
Without section 110.62 the founder would have had a $6,555,000 taxable capital gain sheltered only by whatever remained of his lifetime capital gains exemption, and a five-year reserve on a vendor note the buyer could only service over ten. The financing would not have closed.
With the pledge left in, the exposure is worse than losing the deduction. A disqualifying event inside the first 24 months brings subsection 160(1.7) into play, making the subject corporation, the purchaser corporation and the vendor jointly and severally liable for the vendor's additional tax — so the business the employees have just bought carries the founder's reassessment. See the clawback the trustees were liable for too.
The tell was in the term sheet's security section. A vendor selling to employees almost always wants a route back to control if the note is not paid, and that instinct is the commonest way these transactions fail their own definition.
The second tell was procedural: the transaction had been drafted from the section 110.61 precedent with the nouns changed. The two sections share a shape and almost no conditions, so the board composition, the membership share terms and the surplus by-law all come out wrong.
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