DFK Tax Newsletter

 

Issue 3 - 2023 Edition - November 9, 2023 - Ashna Pahwa, Fruitman Kates LLP

Budget 2023 and changes to the Alternate Minimum Tax

What is Alternate Minimum Tax (“AMT”)?

The AMT is a separate tax system which is designed to ensure that wealthy individuals (including certain trusts) with high gross income that is taxed at preferential tax rates (such as dividends, and capital gains) who might otherwise use various deductions and credits to significantly reduce their tax liability still pay a minimum amount of tax.

AMT operates parallel with the regular tax system and taxpayers subject to AMT are required to compute their annual tax liability under the regular method and the AMT method and must then pay the higher of the two calculated tax amounts.

For instance, AMT could apply where a taxpayer claims the Lifetime Capital Gains Exemption (“LCGE”) on the sale of their Qualified Small Business Corporation (“QSBC”) shares or claims significant deductions from investments such as flow through shares.

AMT paid in a given year in excess of regular tax may be carried forward seven years and can be deducted from the ordinary tax liability that is in excess of AMT liability if certain conditions are met. If these credits are not utilized within the seven years, then the AMT becomes a permanent tax liability instead of a prepayment of tax.

How is AMT calculated?

The AMT calculation consists of four main elements:

  • AMT Base – this is the starting point and is determined by adding back certain deductions which were allowed under the regular income calculation in order to calculate income for AMT purposes.
  • AMT Exemption – the exemption is an amount subtracted from the AMT Base which serves as a threshold, allowing income as adjusted for AMT purposes below it to be exempt from the AMT calculation. 
  • AMT Rate – this is a fixed percentage applied to the AMT Base after deducting the AMT exemption in order to calculate the tax owed under the AMT system before deducting AMT Tax Credits.
  • AMT Tax Credits – after calculating the AMT amount, certain non-refundable tax credits are applied to lower the taxpayer’s AMT liability. 

Thus, the AMT calculation begins by calculating the AMT Base, deducting the AMT Exemption, and then applying the AMT Rate. The resulting tax is reduced by certain non-refundable tax credits to determine the individual’s AMT for the year.

Proposed changes to the AMT calculation beginning in 2024

Budget 2023 proposes the first major changes to the AMT since its introduction in 1986 with the stated goal of “ensuring the wealthiest Canadians pay their fair share.”

As part of the proposed changes, the rate of AMT is set to increase from the current 15% to 20.5% federally (from the first tax bracket rate to the second tax bracket rate). This aims to ensure that taxpayers subject to AMT pay a higher amount in taxes.  Provinces also have AMT, which is generally a percentage of the federal AMT. This article is about the changes to federal AMT and does not deal with the provincial AMT. 

Simultaneously, to reduce the impact on middle-income taxpayers, the basic exemption amount available to individuals and certain trusts is proposed to increase from the current $40,000 to $173,000 (indexed to inflation annually), thus targeting high income earners more specifically.

In addition to the above, other proposed changes to the AMT are:

  • increasing the AMT capital gain inclusion rate from 80% to 100%;
  • increasing the AMT capital gain inclusion rate for donated publicly listed securities from 0% to 30%;
  • using the regular 50% inclusion rate for capital loss carryovers and business investment losses in the calculation of the AMT Base (in other words, the AMT capital gains inclusion rate would increase from 80% to 100%, and the AMT inclusion rate for capital losses and business investment losses would be reduced from 80% to 50%);
  • maintaining the inclusion of 30% of capital gains that are offset by the LCGE (under the current AMT, the LCGE is not adjusted to reflect the 80% inclusion rate for capital gains);
  • denying the entire employee stock option deduction so that stock option benefits are included at 100%;
  • increasing from 0% to 30% the stock option benefit associated with donated publicly listed securities;
  • disallowing 50% of the deductions for: interest and carrying charges, limited partnership losses of other years, non-capital loss carryovers, employment expenses (other than those incurred to earn commission income), CPP, QPP, and provincial parental insurance plan contributions, moving expenses, child-care expenses, disability supports, workers’ compensation and social assistance payments, and guaranteed income supplement payments,  northern residents, Canadian armed forces personnel and police;
  • reducing most non-refundable personal tax credits by 50%.

Illustrations

Example 1 – The Sale of property not eligible for LCGE

Suppose Jim sells capital property with a fair market value of $1,000,000 and an adjusted cost base of $200,000, realizing a capital gain of $800,000 (a $400,000 taxable capital gain). This is his only income for the year. The table shows the tax calculations:

In this scenario, no AMT is payable under current rules, because AMT is less than regular income tax. Under the new rules, the AMT is higher, because the entire capital gain is included in calculating taxable income, the AMT tax rate is higher and only 50% of the basic personal amount tax credit is allowed. The result is $127,475 of tax payable including $21,852 of AMT in excess of the regular income tax.

Example 2 – Sale of property eligible for LCGE

Suppose Jim sells the shares of his private corporation resulting in a capital gain of $800,000 ($400,000 taxable). The shares are determined to be QSBC shares and Jim has never claimed LCGE before.  The table below shows the tax calculations:

1.  The start of the fourth bracket at $173,000 in 2024 implies an estimated indexation factor of 4.58% for 2024. For consistency, this factor is used to index all the brackets including basic personal amount for 2024 in the calculations.

2.  As per footnote above, the following are the federal tax brackets for 2024:

3. The graduated tax and AMT payable calculations are approximate and only include the basic personal amount tax credit.

Under current AMT rules, 30% of capital gains eligible for the lifetime capital gains exemption are included in the AMT Base. The government proposes to maintain this treatment resulting in Jim paying lower AMT, because of the increased AMT exemption.

Example 3 – Donations

In continuation of example 1, let’s assume Jim makes a charitable donation worth $400,000. The table below shows the tax calculations:

Under the proposed rules, Jim would be subject to AMT, however, he would pay no AMT under the current rules.  This result is due to the higher capital gain inclusion in the AMT Base, the increase in the AMT Rate, and the 50% reduction in the AMT Tax Credits.

Example 4 – Donation of publicly listed securities 

Suppose Jim has $500,000 of employment income and publicly listed securities worth Fair Market Value of $1,200,000 and with Adjusted Cost Base of $400,000 resulting in an accrued capital gain of $800,000. He then donates these securities to a charity. The table below shows the tax calculations:

The inclusion of 30% of the capital gain on donated publicly listed securities and the reduction of the AMT Tax Credits by 50% results in higher AMT under the proposed measures. 

Conclusion

The federal AMT payable under the proposed rules may be significantly higher than under the current rules, even though the AMT basic exemption will be increased. It is expected that it will affect very few taxpayers as whole, however, we expect this will affect several of our clients. 

Individuals impacted by the AMT often need to plan their future income to ensure that they recover their AMT tax credit in the seven year carry forward period.  The proposed AMT changes will make this planning more important. One potential strategy to mitigate the implications of AMT could be to transfer the assets to a corporation as AMT is not applicable to corporations.  This strategy may require careful planning, because of the income tax rules designed to prevent the deferral of corporate income tax on investment income earned by Canadian Controlled Private Corporations. The proposals, if passed into law, would come into effect beginning in 2024.