Alternative Minimum Tax - Should We Be Worried?

Background

The Income Tax Act (“ITA”) provides for multiple deductions and tax credits. It may be perceived that some of these tax relief measures are mostly available to wealthy individuals. To ensure that the tax system remains fair for all, the ITA also provides for a parallel tax regime called Alternative Minimum Tax (“AMT”). All individual taxpayers, including most trusts, are required to compute their taxable income under this alternative regime. Should their AMT so calculated exceed their regular income tax balance, they must pay the higher amount. The purpose of this regime is to ensure that wealthy individuals, who can often benefit from a number of tax relief measures, do not end up paying unreasonably low amounts of taxes… Or at least, this was its purpose until the recent proposed amendments to this regime.

It is also important to note that any tax due under the AMT can be carried forward for seven years and used to offset regular (non-AMT) tax due in those years. AMT not used in the subsequent 7 years expires and becomes a permanent tax. The AMT does not apply in the year of death, and it also does not apply to corporations. 

Historically, tax practitioners were not too worried about AMT because it applied most often under specific circumstances. For instance, it was often applicable when the lifetime capital gains exemption (“CGE”) was claimed by a taxpayer having limited taxable income, resulting in AMT that might not be recovered in subsequent years. 

In the 2023 Federal Budget, major changes to the AMT regime have been purposed. Although final legislation has not been enacted yet, the changes were presented as being effective as of January 1, 2024. As explained in the article below, the proposed changes drastically change the importance of AMT on a going-forward basis.

Overview of the former rules 

It is useful to illustrate how AMT used to work before delving into the proposed changes.

As a first step, AMT requires individuals to compute their taxable income using a particular set of rules, resulting in their adjusted taxable income (“ATI”). Most notably, when computing ATI, 80% of capital gains and business investment losses were considered, and taxable dividends were neither grossed up nor did they give rise to a dividend tax credit. Stock option benefit deductions were also limited to 2/5 of the original amount of the deduction[1]. Some of the other adjustments related to tax shelters.

Non-trust individuals and graduated rate estates had a “basic exemption” of $40,000 which reduced their ATI. The resulting amount was taxable at a rate of 15% at the federal level, plus an additional 15% in Quebec, for a combined rate of 30%. If AMT exceeded regular taxes otherwise calculated, the individual had to pay the AMT amount. Additional tax paid under AMT could generally be carried forward for seven years and be credited against regular income taxes, to the extent that regular income taxes exceeded AMT during those years.

The table below illustrates how AMT usually applied when the CGE was claimed by an individual with no other source of income. For simplicity, personal tax credits were omitted.

The new rules

As mentioned above, substantial changes are expected to be brought to the AMT regime. The draft legislation as currently announced proposes to change the computation of adjusted taxable income as follows[4] :

In addition, the federal AMT tax rate will increase to 20.50%, and the basic exemption will increase to the lower limit for the fourth income tax bracket (approximately $173,000 for 2024). 

On a positive note, graduated rate estates (“GRE’s”) and some other specialized trusts will no longer be subject to AMT under the new rules. 

Quebec announced that it will harmonize its legislation with the ITA, except that its AMT rate will increase to 19% and its basic exemption will increase to $175,000. The new basic exemption will also be indexed each year as of the 2025 taxation year.

Analysis: What do the changes mean in practice?

Although it was suggested in the Federal Budget 2023 that the new rules aim to better target AMT to high-income individuals, a thorough analysis of the changes tells a different story. 

The Impact on Capital Gains

The new rules will make it a lot easier to reach the basic exemption threshold. Indeed, whereas the previous rules generally resulted in AMT only under specific circumstances, the new rules will trigger AMT even when the only “tax relief” from which a taxpayer is benefitting is the 50% inclusion rate on capital gains. The table below illustrates the tax treatment for a capital gain when no CGE is claimed under regular tax compared to the new and former AMT regime:

Under the new AMT rules, the threshold under which AMT will generally surpass regular tax for capital gains, assuming no other sources of income, will be approximately $535K. Indeed, when a $535K capital gain is triggered, the combined AMT under the new regime in Quebec will reach $142,990, whereas regular tax will reach $142,604, thus resulting in AMT payable.  In other words, the new AMT regime does not only target high income individuals who benefit from various tax relief measures but could be seen as a backdoor increase in the capital gains inclusion rate. 

Furthermore, considering that many business owners retire after the sale of their businesses, we can expect a decrease in their taxable income in subsequent years, potentially resulting in permanent tax under the AMT regime as it may be impossible to recoup the AMT over the following 7 years. 

Some good news

Although the upcoming changes to AMT are concerning, there is some good news. Firstly, when a capital gain on the disposal of shares eligible for the CGE does not exceed the CGE deduction available, the new rules will result in less AMT than under the previous rules. For an example, if shares are disposed of in 2024 and a capital gain of $1,016,836 is realized, which would be entirely tax free under regular income taxes due to the maximum CGE available[8], the previous rules would have triggered AMT of $79,516[9], whereas the new rules will trigger AMT of only $52,160[10]. If the CGE is multiplied among family members having low income, this could result in significantly less AMT payable. 

Secondly, there seems to exist a fairly easy way to avoid the major downsides of the new AMT regime. That is by transferring, on a tax-deferred basis by virtue of a subsection 85(1) rollover, the asset on which a significant capital gain is about to be realized to a corporation prior to the disposal. It is well known that integration, in Quebec at least, is not perfect, and a capital gain realized through a corporation rather than by an individual usually results in a tax leakage when the proceeds are fully distributed. However, because the AMT on a non-eligible dividend will generally not exceed regular taxes at top marginal rates (i.e., 39.5% vs 48.70%), the distribution of proceeds by a combination of a capital dividend and a taxable dividend will generally not trigger AMT. Therefore, the net effective tax rate should be approximately 29.35% instead of 26.67%. Although this difference can represent a serious tax cost on a large transaction, it may be preferable than incurring a 39.50% AMT rate which may never be refunded.

That being said, one could argue that the transfer of the asset to a corporation immediately prior to its sale has no other purpose than to benefit from a tax advantage (i.e., avoidance of the AMT). As such, this could be construed as an avoidance transaction. Should the CRA be successful in establishing that such a result is a misuse or abuse of the new AMT regime, the CRA could rely on the general anti-avoidance rule (“GAAR”) to reassess the taxpayer. 

Other Impacts

Donations and Charities

There are significant concerns that the new AMT regime will prejudice charities by significantly reducing the incentives to donate. More particularly, under the new AMT regime, the donation tax credit will be limited to 50% of its normal amount. Additionally, while donations of publicly listed shares resulted in no capital gains under the former AMT rules (as is also the case under regular tax), there will now be a 30% inclusion of the capital gain under the new rules. As such, large donations of publicly listed shares which would otherwise be tax-free and give rise to a donation tax credit to be used against other sources of income will now potentially trigger AMT. Taxpayers left with large donation tax credits and AMT balances carried forward might never fully utilize these tax attributes in the future. This is especially true given the fact that the subsequent use of the donation tax credits may trigger additional AMT.

Timing Considerations

One of the most obscure modifications made to the AMT rules is the 50% inclusion of non-capital and capital losses from previous years when applied in the current year for the purpose of computing the adjusted taxable income for AMT. This will lead to situations in which incurring a capital loss and a capital gain in different taxation years as opposed to triggering them in the same year will result in AMT. It is difficult to understand how this result can be acceptable having regard to tax policy since there is no economic gain for the taxpayer in one situation over the other. 

Implications Related to Trusts

Because they don’t benefit from the AMT basic exemption (i.e., the $173,000 exemption), most of the issues raised so far are aggravated when it comes to trusts (other than GRE’s and other specialized trusts). 

If a trust earns passive income and incurs interest expenses and/or carrying charges, it will have AMT payable notwithstanding the fact that it has distributed all its income for the year to its beneficiary. This is because interest expenses and carrying charges incurred to earn property income will now be limited to 50% under the new AMT regime. In many instances, these trusts will have no ability to recoup the AMT paid. This issue will impact, for example, trusts accessing funds via standard prescribed interest loans. Spousal trusts that are not allowed to distribute their capital gains (as a result of the definition of income per the trust agreement not including capital gains) will also pay additional AMT over and above their regular tax.

The same AMT result could arise when a trust is in a net loss position, because the trust may have earned income on preferential items such as capital gains or dividends. In this scenario, no income can be distributed because the trust is in a net loss position based on regular tax rules. If distributions were allowed to the trust beneficiaries, individual beneficiaries could absorb the impact of the AMT owing to the availability of their individual AMT exemption room. However, such distributions are not allowed and therefore AMT is payable by the trust. 

Conclusion

AMT will become an important threat to many types of individual tax planning, and it can no longer be viewed as a secondary consideration. If the Minister of Finance had some of us wondering how what used to be just a safeguard of the regular tax regime is now expected to become one of the most lucrative tax measures of the Federal Budget[11] , it seems that the cat is out of the bag. 

[1]  As a result, for federal purposes, 80% of the stock option benefit was included in income under the former AMT regime.

[2] The CGE limit in 2023 was 50% of $971,190 (i.e., $485,595).).

[3] Combined federal and Quebec rates.

[4] This list includes the most notable changes but is not exhaustive.

[5] The Quebec deduction is less in most cases, as it is limited to 25% of the employee benefit arising from the stock option plan under regular tax.

[6] For simplicity, the Quebec basic exemption as been considered to be equal to the federal.

[7] Combined federal and Quebec rates.