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tax changes

Finance Minister Bill Morneau in Toronto on Oct. 4, 2017.Fred Lum/The Globe and Mail

Finance Department officials admit they are "struggling" to find a way to address concerns about the intergenerational transfer of family businesses and are hoping to get inspiration from suggestions that emerged in public consultations.

Officials have also warned that one broad policy option the department has analyzed would reduce federal tax revenues by about $1-billion a year.

Consultations on the government's proposed changes to small-business tax rules closed on Monday, and Prime Minister Justin Trudeau promised a formal response to feedback in the coming weeks. Finance Minister Bill Morneau said this week that the plans will be revised according to specific principles, and ensure the changes do not affect the transfer of a family business to the next generation.

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However, as Mr. Morneau was outlining his goals for reworking the tax proposals within weeks, one of his senior officials was telling Senators the department does not have a plan to address the concerns related to intergenerational transfers.

"We're still struggling to find another approach to this," Brian Ernewein, general director of legislation in the department's tax policy branch, told the Senate national finance committee on Tuesday. "With the consultation period closing [on Monday], we're hopeful there's something in there that will give us inspiration."

Liberal MPs are hoping that Mr. Morneau's promised changes to the plan will help the governing party manage the loud negative feedback from constituents since the proposals were announced in July.

"We're getting it on the chin big-time right now," Liberal MP Sean Casey said. "If an election was tomorrow, it would hurt us."

The government's original proposals included draft legislation aimed at discouraging the conversion of dividends into lower-taxed capital gains and measures that would restrict income "sprinkling" to family members through an incorporated small business, unless the payments meet a new reasonableness test. A third, less developed proposal, would restrict the use of incorporated small businesses as a vehicle for making passive investments.

The first two changes could affect the transfer of a business to a family member.

Among the challenges for tax policy specialists is that the sale of a family business to the next generation is not always a simple one-year transaction. When an incorporated small business is sold to an adult child's incorporated small business, the child's business sometimes pays the parent over time through dividends. The parent may or may not still be involved in the business. Finance officials say the goal of the changes is to ensure that others are prevented from using such arrangements simply as a way to avoid taxes.

The July consultation paper released with the policy said concerns have been raised that shareholders of corporations are currently ineligible for the lifetime capital gains exemption – which is currently $835,716 for shares of a qualified small business or up to $1-million for qualified farms and fishing property – when they sell their shares to a corporation owned by their adult children. Yet the exemption is available should they sell to a third party.

The paper asked for submissions on how it would be possible to "better accommodate genuine intergenerational business transfers in the Income Tax Act while still protecting the fairness of the tax system."

The department said this week that it received more than 21,000 written submissions in the consultations.

Daniel Lauzon, a spokesperson for Mr. Morneau, said on Wednesday that this part of the paper addresses a "broader issue" than what is in the draft legislation and will require "more thought and study."

Even before the July proposals were released, the Canadian Federation of Agriculture and the Canadian Federation of Independent Business were among those saying the existing tax system includes incentives for selling a family business to a third party.

Tax experts have said those problems were worsened by the proposals on income sprinkling.

Small business lobby groups supported an NDP private members bill, C-274, that would have allowed the use of the lifetime capital gains exemption for the sale of a small business to family members under certain conditions. The Liberal majority defeated the bill in February.

The Liberals said then that the bill would reduce federal revenues by at least $800-million a year, citing Finance Department estimates.

Mr. Ernewein said last week at a Canadian Tax Foundation conference in Ottawa that the private member's bill provides an example of a potential policy response.

"We still struggle with whether it's possible to do something in this space without creating pretty significant revenue losses," he said. "And when I say 'pretty significant,' I'm talking in the hundreds of millions or potentially a billion dollars. There was a private members bill … that pertained to this. Our own revenue estimate of the potential cost of it – and it sought to do something at a general level along the lines of what I'm talking about – our own revenue estimate was half a billion to a billion-plus cost."

Allan Lanthier, a retired accountant and former chair of the Canadian Tax Foundation, said the department should address the intergenerational concerns even if it costs Ottawa more.

"Everything else [in the package] is a tax grab except for that one proposal," he said. "Is the billion-dollar cost a reasonable cost? Of course it is. Do you really want a tax regime that almost forces one generation to sell to third parties, including venture capital firms, rather than sell the shares to your own children?"