Canada: The "Evils" Of Alternative Minimum Tax

Selling your farm is supposed to be tax free, right? At least the first $800,000. So why is that not always the case, and what can you do about it?

What is alternative minimum tax?

The alternative minimum tax (AMT) is an alternative way to calculate taxes owing in Canada when an individual experiences preferential tax deductions. It was brought into effect to guard against situations in which high-earning individuals might be in a position to pay little or no tax by using certain deductions or "tax preferences" to reduce a large portion of their income. There is a "minimum tax" the Canada Revenue Agency wants individuals to pay when using these tax preferences.

Thus, there is the typical way of calculating taxes, which considers the special tax deductions and credits such as the lifetime capital gains exemption, and there is this alternative method. The typical way will usually result in more tax owing. But when the second calculation results in higher taxes, the higher amount – the AMT – will apply.

When does AMT arise?

For farmers, the AMT often is associated with the lifetime capital gains exemption. The impact can be substantial on retiring farmers selling their businesses and incurring sizable capital gains in a tax year. Farmers subject to AMT should consider treating it as a tax installment or prepayment because they can recover the AMT amount to offset future taxes within seven subsequent years. Thus, individuals with no taxable income in subsequent years will forego the opportunity to recover AMT.

For example, a farmer who uses the $800,000 lifetime capital gains exemption on the sale of qualified farm property would owe $25,000 to $48,000 in taxes, depending on the province of residence. This can be a significant amount and can affect cash flows, particularly if the capital gains exemption was triggered on a rollover.

Minimize and plan for AMT

There are two key strategies to minimize and plan for the cost of AMT:

  • Carrying forward net capital losses – Individuals should obtain their most recent notice of assessment to confirm they are using up all capital loss carry forwards. These capital losses can be carried forward indefinitely and can be applied to reduce taxable income and thus reduce the capital gains exemption, which will lower AMT. However, if an individual locks in the capital gains exemption on qualified farm property and plans to use the full $800,000, this will not reduce AMT. Carrying forward capital losses in essence simply increases the cost base of the property rolled over, as the intention is to use the full exemption.
  • Using a reserve on the sale of qualified farm property – A reserve will allow for a deferral of the capital gain, resulting in less minimum tax each year. A reserve may only be used if a portion of the consideration on the sale remains outstanding. Typically, this occurs when part of the consideration for the sale is a note payable. This strategy will help smooth out the burden of the minimum tax, as any other taxable income in those years will help recover the AMT. The reserve will also help extend the period for which the AMT can be recovered; the seven-year clock starts running when AMT is incurred.

Getting AMT back

In the years after using the capital gains exemption, individuals will want to recover AMT by having adequate taxable income. An individual who has limited taxable income in subsequent years may not recover all of the AMT paid, which will then result in a true cost upon disposition of qualified farm property. This is when the true "evil" of AMT becomes apparent.

Depending on the individual's situation, there are many tax planning strategies that can help to recover the AMT. For example, a farmer who operates through a corporation and usually receives dividends as compensation could convert to a salary structure, which would increase tax at the individual level and provide more opportunity to use up the minimum tax. In addition, realizing capital gains in non-registered accounts or withdrawing RRSPs in years of low income can generate taxable income that can be offset by the AMT balance.

Be prudent and seek help when necessary

The rules governing capital gains and the use of the capital gains deduction are complex. The purpose of this article is simply to remind farmers of the two-tax system. If you are considering business management activities that could trigger a capital gain, it is wise to have a Collins Barrow adviser and a financial planner on your management team.

Most importantly, give yourself time to plan, since time will increase your options when it comes to minimizing the tax consequences. The tax law, as it relates to taxable capital gains and the AMT, does have an upside: increasing the potential returns and advantages of good planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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