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Federal tax proposals penalize businesses that want to transition to next generation

Michael Cadesky is a partner at Cadesky Tax in Toronto. He is chairman of the CPA Canada tax committee for small and medium-sized business and a past chairman of STEP Canada and STEP Worldwide.

Peter Weissman is a partner at Cadesky Tax in Toronto. He is a past governor of the Canadian Tax Foundation and National Chair of the Education Committee for STEP Canada.

Much has been written about the fundamental flaws in the government's July 18, 2017, tax proposals. To date, the government has not acknowledged these weaknesses and has continued to promote its proposals with conviction instead of noble humility. So, let's provide an fictitious example of why the proposals will kill a vital part of Canadian business: transition to the next generation.

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Thirty years ago, for $100, George started Restaurant Linen Supplies Ltd. to service the restaurant and hotel industry. The business is simple. It picks up, washes, presses and delivers tablecloths and napkins for restaurants and hotels. It has approximately 100 major customers.

While George is not likely to win the Order of Canada, he has nevertheless touched many people's lives, including those of his employees. Some of them have worked with him since he started the business.

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When his wife died 20 years ago, George raised his two children as a single parent and made sure they completed their university education. His children, Henry and Iris, are now actively involved in the business.

At the age of 65, George is now looking to transition the business to his children by selling them the shares of the business for their fair market value of $3-million. Since his children will have to fund the purchase out of their salaries, George will let them pay him over five years. Even with the payment terms, Henry and Iris would have to reduce their annual spending so they can fund the purchase from their father. George will consult to his children to help them transition and take over the business, just as he would do if he sold to an outsider.

George understands that on the sale of his business, he will realize a capital gain of $2,999,900 (the current value minus the $100 spent to create the business) and that he will be entitled to claim the capital-gains exemption of approximately $830,000 to reduce the gain for tax purposes to $2,169,900.

With capital-gains tax rates of about 25 per cent, George realizes that he will pay about $550,000 in tax. That will leave him about $2.45-million to fund his retirement. All is in line with how George has been planning for retirement.

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Sorry, George. If you go ahead with this sale to your children, the government's proposed tax changes will leave you with only $1.65-million for your retirement. That's an $800,000 increase in tax – $800,000 less to fund your retirement.

Why? Because you are selling to your children (non-arm's-length people). With these proposals you won't be allowed your capital-gains exemption and, even worse, your full capital gain of $2,999,900 will be taxed as a dividend at 45 per cent. That's $1.35-million of tax instead of $542,000. George's retirement plans just got derailed by this train wreck of tax proposals.

But there is a solution. You can sell your business to an outsider in order to be taxed under the normal capital-gains rules, and have the money you need for retirement.

Who will that outsider likely be? A public or foreign company, as they are not affected by the tax proposals. They, in fact, are being handed a competitive advantage over private Canadian businesses.

The latter will be less inclined or able to afford buying George's company because of other problems buried in these tax proposals.

We aren't making this up. Finance Minister Bill Morneau's proposals will reward George for cutting his children off and selling his business to an outsider, likely a large foreign or public company.

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The icing on the cake? When this company consolidates George's operations with its own, Henry, Iris and many other employees will be looking for jobs.

Yet, Mr. Morneau and Prime Minister Justin Trudeau are still telling Canadians that these proposals are just "tweaks" that will only affect the rich.

It is unconscionable for our government not to support the transition of Canadian private businesses to the next generation of family members. Worse, how can our government justify giving public and foreign companies a competitive advantage over the heart of our economy and financial culture, private businesses?

This is but one example of a significant flaw in Ottawa's tax proposals. And it's not even an extreme example. There are so many more problems that have been outlined in dozens of articles since Mr. Morneau dropped his bombshell on July 18 that are not being acknowledged by the government.

We are sure that those who constructed the new rules to treat George's gain as a dividend did not fully understand the implications to families. It is difficult to understand why they would intentionally create a large disadvantage compared with selling to unrelated parties.

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