Alternative minimum tax looms larger after capital gains tax changes cancelled

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The revised alternative minimum tax (AMT) represents a bigger tax planning risk for high-income earners after the Liberal government cancelled its proposed hike to the capital gains inclusion rate earlier this year.

At the 50 per cent inclusion rate – rather than the higher two-thirds rate proposed in last year’s federal budget – a taxpayer reporting significant gains is more likely to be subject to the revised AMT, as their taxes payable under the AMT could be higher than under the regular tax system.

The AMT is a parallel method of calculating taxes meant to ensure high-income individuals and trusts pay at least a set minimum rate of taxes.

Ottawa revamped the AMT last year to prevent high earners from combining tax credits, deductions and other “tax preferences” to pay little taxes. While the AMT can be recovered, it represents at least a pre-payment of taxes for those affected.

“You’re expecting to pay a certain amount of taxes and then, all of a sudden, you have the AMT rearing its ugly head,” says Hemal Balsara, head of tax, retirement and estate planning, individual insurance with Manulife Financial Corp. in Toronto.

Many taxpayers may have triggered the AMT for the first time this tax season if they sold assets last year that had greatly appreciated in value to get ahead of the capital gains tax changes proposed in the 2024 federal budget.

Ameer Abdulla, partner with EY Canada in Toronto, says that under the previous AMT rules, he’d seen only about six instances of clients having to pay the AMT over his 16-year career.

He’s already seen as many instances of clients being subject to AMT this tax season, he says. The tax filing deadline for 2024 was April 30, but taxpayers reporting 2024 capital gains have until June 2 to file without incurring interest or penalties.

And while it’s too late to plan for 2024, high earners who realize large capital gains, donate publicly traded securities in-kind, sell a small business or exercise stock options will have to factor in the revised AMT in their tax planning for 2025 and in future years, Mr. Balsara says.

They’ll also have to develop a strategy to ensure they recover the taxes in a future year, says Alexandra Spinner, partner with Crowe Soberman LLP in Toronto.

“AMT becomes a real cost if you cannot claim it back,” she says.

Here’s how the AMT works:

• A person calculates their taxes payable through the regular method and then calculates their taxes payable under the AMT above an exemption amount.
• Under the AMT, a taxpayer is allowed fewer deductions, credits and other tax preferences than those available under the regular income tax regime. (The provinces and territories also have their own AMT regimes.)
• If the AMT is higher than the taxes payable under the regular calculation, the taxpayer must pay the AMT.
• However, any additional taxes paid in the form of AMT can be recovered over the next seven years to the extent that an individual’s taxes payable under the regular tax system are greater than their AMT in those years.

The federal government announced its intention to revise the AMT in the 2023 federal budget. Most significantly, under the revised rules effective for 2024, the AMT rate increased to 20.5 per cent from 15 per cent.

In addition, the availability of certain deductions, credits and tax preferences in calculating the AMT was further limited. For example, under the revised AMT, 100 per cent of capital gains have to be included in the calculation of AMT, up from 80 per cent under the previous rules.

To focus the taxes on the highest earners, the government also raised the AMT basic exemption amount to $173,205 (2024) from $40,000.

With the increased exemption amount, high earners who earn primarily employment income, business income or eligible dividends are unlikely to face the AMT.

However, someone who earns significant capital gains in a year has a higher risk of attracting AMT.

For example, consider a high earner subject to the top federal tax rate of 33 per cent. As the capital gains inclusion rate is 50 per cent, that taxpayer would face an effective 16.5 per cent (half of 33 per cent) tax rate on capital gains, which is lower than the 20.5 per cent AMT rate. As taxes payable under the regular system might be less than under the AMT, the taxpayer could be subject to the AMT.

Under Ottawa’s proposed capital gains tax changes, individuals would have been subject to a two-thirds inclusion rate for capital gains realized above a $250,000 threshold annually.

At the two-thirds inclusion rate, the highest earner would be subject to an effective 22 per cent (two-thirds of 33 per cent) tax rate on capital gains, which is higher than the AMT rate. Therefore, someone reporting significant capital gains would have been more likely to have a higher tax liability under the regular system than under the AMT.

“In a two-thirds [capital gains inclusion] rate environment, the AMT is less of a concern,” Mr. Balsara says.

However, with proposed capital gains tax changes now cancelled, the revised AMT steps back into the spotlight.

Donations affected

It’s not only those earning significant capital gains who may be subject to the AMT.

An individual donating appreciated publicly traded securities in-kind can claim a donation tax credit and is exempted from paying tax on capital gains on the donated securities, representing an effective way of reducing tax.

However, only 80 per cent of a donation tax credit can be applied against the revised AMT, down from 100 per cent under the previous rules, while 30 per cent of the exempted capital gain is added back to income for the revised AMT, up from 0 per cent under the old AMT.

Therefore, an individual making a large donation of publicly traded securities in kind is more likely to be subject to the revised AMT. And depending on their circumstances, they may not have enough high-taxed income in future years to recover the AMT, Ms. Spinner says.

Tax advisors work with clients to determine the potential applicability of the AMT each year and to determine strategies for recovering it by ensuring the taxpayer will be reporting enough higher-taxed income in at least one of the next seven years.

Depending on the amount of AMT paid, clients grow more eager to recover the tax as the end of the seven-year period approaches, Ms. Spinner says.

“In year eight, you’re never getting the [AMT paid] back,” she says.