Stephen Bowman and John (Jay) Winters of Bennett Jones present a capital gains case study on the impact to taxpayers of changes to the AMT regime
THE 2023 Budget proposes material changes to the alternative minimum tax (AMT) regime which, as discussed below, could result in significant increases to taxes on capital gains (i.e.,5-6 percentage points). Although practitioners have been half-expecting a capital gains inclusion rate increase since 2016 (which has not come to be), this is the practical effect of the AMT amendments for larger capital gains.
The AMT is a regime aimed at increasing the fairness of the tax system by ensuring that high-income individuals (including most trusts) pay a minimum amount of tax notwithstanding their entitlement to various tax deductions. The taxpayer must pay the higher of (1) AMT calculated on the taxpayer's "adjusted taxable income", and (2) income tax calculated under the ordinary rules. "Adjusted taxable income" is generally determined by taking taxable income calculated the normal way and then adding back certain tax preferences (e.g., part of the tax-free portion of capital gains and stock option benefits).
The current federal AMT tax rate is 15% on "adjusted taxable income", with individuals and graduated rate estates (GREs) generally being entitled to a $40,000 exemption. There are also certain carryforward rules that allow the excess AMT (i.e., over and above regular tax) to be deducted from a person's income tax payable in the subsequent seven taxation years. The provinces have enacted parallel AMTs of their own, which generally follow the federal scheme and are in the range of one-third of the federal AMT.
The following are some of the important proposed changes to the federal AMT regime:
- Increasing the AMT rate from 15% to 20.5%.
- Increasing the "add back" rate for:
- Capital gains (other than capital gains eligible for the lifetime capital gains exemption) from 80% to 100%.
- Employee stock option benefits (i.e., stock options subject to "capital gains-like" treatment) from 80% to 100%.
- Donations of publicly listed securities (i.e., gifts not subject to capital gains) from 0% to 30%.
- Further limiting the following deductions in calculating "adjusted taxable income":
- Non-capital loss carryforwards from 100% to 50%.
- Capital loss carryforwards from 80% to 50%.
- Allowable business investment losses from 80% to 50%.
- Deductions of limited partnership losses of other years from 100% to 50%.
- The AMT exemption for individuals and GREs is increased from $40,000 to the 4th Federal Tax Bracket (expected to be ~$173,000 in 2024).
The changes are proposed to come into effect for taxation years that begin after 2023.
Capital Gains Case Study — Overall Capital Gains Tax to Increase 5-6 Percentage Points
Historically — other than where a taxpayer could use their lifetime capital gains exemption — the AMT calculated on a taxable capital gain was always less than the regular income tax and therefore was rarely a concern. The new AMT rules change all this. The following represents the applicable federal taxes in respect of a capital gain assuming (1) the top federal tax rate of 33%, (2) no basic AMT exemption, and (3) no basic minimum tax credit:1
Accordingly, this represents a 4 percentage point increase in the federal capital gains rate. This increase is essentially equivalent to raising the capital gains inclusion rate (i.e., under the ordinary income tax regime) from 50% to roughly 62%.
In most cases the provincial AMTs simply track the federal rules, and therefore the proposed changes should generally flow through to the provincial calculations so that we would expect the provincial AMTs to remain equal to one-third of the "excess" of federal AMT over "ordinary" federal tax — this shakes out to an additional 1 to 2 percentage points over current rates. In other words, in addition to the 4 point increase in the federal component, we expect the provincial component will increase 1-2 points (depending on the province) for a total aggregate rate increase of 5-6 percentage points over the current level of taxation of large capital gains.
A couple other points to note — the AMT calculations are sensitive to how much ordinary income (i.e., not capital gains) the taxpayer reports, and how much the taxpayer claims in deductions that are targeted by the AMT rules. If ordinary income is high relative to capital gains, then the AMT calculation may not generate an amount that is higher than the taxpayer's tax payable under the normal rules. Also, the substantial increase in the basic exemption to roughly $174,000 will also take a lot of taxpayers out of the AMT system. Further, AMT does not apply in the year of death, but it does apply in the year a taxpayer departs Canada to become a non-resident. It also applies to trusts that are deemed to dispose of their capital property on their 21st anniversary.
While historically the AMT has not been a concern where large capital gains are realized (other than where the lifetime capital gains exemption is used), Budget 2023 marks a departure from this. Although draft legislation has not been released (including any potential provincial level amendments), we expect the new AMT rules to increase the combined federal-provincial tax on large capital gains by 5-6 percentage points, unless ordinary income is comparably high. The impact is expected to be felt most often by those taxpayers who realize very substantial one-time gains from the sales of their businesses, dispose of substantial stock option positions, or make very substantial donations of appreciated capital property.
Given that these rules are proposed to come into effect for 2024, taxpayers have time to plan their affairs with these changes in mind.
1 Although the basic AMT exemption is going up to ~$173,000 in 2024, that amount becomes less material as capital gains increase. In absolute terms it represents an approximate $50,000 reduction in federal AMT. The basic AMT exemption is not material to our discussion.
Originally published in Canadian Accountant
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