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Minister of Finance Bill Morneau speaks during an announcement in Erinsville, Ont., Thursday Oct., 19, 2017.

Lars Hagberg/THE CANADIAN PRESS

The Liberal government is dropping one of the three key elements of its controversial small-business tax proposals in response to farmers' concerns that it would harm the ability to pass on the family farm to the next generation.

Finance Minister Bill Morneau and Agriculture Minister Lawrence MacAulay made the announcement at a farm in the small eastern Ontario town of Erinsville.

Draft tax legislation that would restrict the conversion of dividend income into lower-taxed capital gains was one of three proposals Mr. Morneau released for consultation in July. The package also included a draft bill to restrict the use of income "sprinkling" among family members as a way of paying less overall tax. A third, less-developed proposal aimed to curb the use of incorporated small businesses as a vehicle for making passive investments – such as company stocks – that are unrelated to the business.

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The package of measures generated major controversy from small business owners and the government has been making a series of policy announcements this week to respond to those concerns.

The July proposals included a consultation paper that noted there are long-standing concerns that shareholders of corporations are currently ineligible for the lifetime capital-gains exemption – which is $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. The exemption is available, however, should they sell to a third party.

The government sought advice for how to address these concerns. However, during the course of the consultations, business groups said the package of reforms – particularly the two draft bills – would make this situation worse.

On Monday, Mr. Morneau announced that the income-sprinkling provisions would not affect the lifetime capital-gains exemption. On Thursday, he said the government will not be moving ahead with the draft bill on converting income into capital gains.

"We heard from business owners, including many farmers and fishers, that the draft legislation on converting income to capital gains – which was part of our consultation – was too broad and that it could create some problems for intergenerational transfers of businesses and farms. We heard some concern that it might be more difficult for farmers to pass their farm to the next generation. So what I'm announcing this morning is that we're going to take a step back and reconsider that aspect of our tax reform proposal," he said. "We're going to work with farmers … to protect family businesses, including farms and fisheries in particular, and their ability to hand that business, that farm, down to the next generation."

In a news release, the government said it would spend the coming year working with farmers, fishers and other business owners "to develop proposals to better accommodate intergenerational transfers of businesses while protecting the fairness of the tax system."

Earlier this week, the minister announced that the small-business tax rate will be reduced from 10.5 per cent to 9 per cent by 2019 and that the proposed restrictions on passive investment in an incorporated small business will be changed to allow for up to $50,000 a year in passive investment income, which is equivalent to a 5-per-cent return on assets of $1-million.

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The government's announcement Thursday, combined with the other announcements earlier in the week, received a positive response from the main lobby group representing Canadian farmers.

"It's very positive," said Ron Bennett, President of the Canadian Federation of Agriculture. "There's still some work to be done… but it really appears that they heard the message loud and clear that there was going to be collateral damage and made some changes to bring some confidence back into some of the tax planning for farmers."

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