Two alternative minimum tax surprises coming this year

Executive summary: Beware of alternative minimum tax starting 2024

Alternative minimum tax (AMT) is a parallel tax that is calculated for taxpayers every taxation year. Taxpayers are responsible for paying the higher of AMT and their taxes otherwise calculated under normal rules. These rules received significant revisions recently, including an increase in the AMT tax rate and increase to the exemption threshold deduction. The calculation of “adjusted taxable income” for AMT purposes also changed, including an increase to the capital gains inclusion rate, a reduced inclusion rate for loss carryforwards claimed, and certain expenses now being only 50% deductible.

These changes now result in AMT being applicable in situations where they previously were not. For example, when claiming capital loss carryforwards to offset a large gain or when utilizing “prescribed rate loan trusts”. Taxpayers will need to be more cognizant of AMT moving forward to avoid any surprises come 2025.

The alternative minimum tax (AMT) regime underwent significant revisions in Bill C-69 and received royal assent in Canada on June 20, 2024. These changes are effective starting 2024. AMT, in general, is a parallel tax that is calculated for taxpayers every taxation year. The AMT tax calculated is compared to the amount of tax otherwise payable using graduated tax rates and taxpayers are responsible for paying the higher of the two figures. This tax policy is to ensure that taxpayers do not abuse the tax system by taking advantage of too many “tax-preferred” treatments in Canada, such as certain deductions, tax credits, or personal exemptions.

AMT is a convoluted calculation that uses different rules that apply only for purposes of computing the tax. Taxpayers must first compute “adjusted taxable income” and then multiply it by the AMT tax rate. For purposes of computing adjusted taxable income, various rules apply when compared to calculating ordinary taxable income, such as a different income inclusion rate for capital gains. Historically, the AMT tax rate on “adjusted taxable income” was set at 15%, but the new revisions have increased this tax rate to 20.5%. To compensate for this increased tax rate, the exemption threshold, which exempts a certain amount of “adjustable taxable income” from being subject to AMT, was increased from $40,000 to the second highest marginal tax rate threshold (for 2024, this amount is $173,205). This amount increases with inflation annually and is only available to individuals or qualified disability trusts.

While these revisions are heavily technical in nature, taxpayers should pay particular attention to the following changes in how “adjusted taxable income” is calculated:

• Inclusion rate for ordinary capital gains increased from 80% to 100%;
• Inclusion rate for capital gains on donations of publicly listed securities increased from 0% to 30%;
• Ability to deduct net capital losses reduced from 80% to 50%
• Ability to deduct certain expenses, such as expenses incurred to earn property income and non-capital loss carryforwards, reduced from 100% to 50%;
• Inclusion rate for stock option benefits increased from 80% to 100%; and,

These changes have resulted in taxpayers that historically were not subject to AMT to now needing to be concerned about its potential application. The following two examples exemplify this, one involving a taxpayer wanting to claim a capital loss carried forward from a previous year and another involving a family trust. Note that provinces typically also levy their own AMT, oftentimes based on a percentage of federal AMT, but this will be ignored for purposes of these examples.

Example 1: Utilizing a prior year capital loss to reduce a capital gain

Assume a taxpayer sold $1,500,000 worth of personal-use real estate, triggering a capital gain of $1,000,000. Assume they also had a capital loss of $1,000,000 from a previous year that they were planning to use to offset this capital gain. Under ordinary tax rules, no tax would be owing since the loss offsets the gain entirely. Under AMT, however, the new changes may result in an amount of tax owing. Using 2024 figures, the AMT increases from $0 to $65,815, as below:

Under the new AMT rules, the issue that arises is the reduced inclusion rate for capital losses coupled with the increased inclusion rate for capital gains when computing “adjusted taxable income”. This results in possible AMT issues when the gains and losses get large enough such that the increased exemption threshold does not compensate for the higher amount of “adjusted taxable income”. This could be problematic for many taxpayers, since they often have “lumpy” capital gains rather than recurring, annual gains, and thus may need to consider AMT in those particular years.

Example 2: “Prescribed rate loan trust”

Assume a taxpayer utilized a “prescribed rate loan trust”, whereby they loaned $5,000,000 of funds to a trust at an interest rate of 3% and the trust invested in marketable securities. This was an exceptionally common income-splitting strategy when interest rates were low since the trust could then allocate its net income to its beneficiaries (usually children and/or a spouse) without triggering adverse tax consequences. Assume the trust invested in bonds, which yielded interest income of approximately $400,000. In accordance with the terms of the loan, $150,000 of interest expense was owed. Assume, also, that all income of the trust was allocated out to its beneficiaries. Using 2024 figures, the AMT increases from $0 to $15,375, as below:

The key issue that arises in this example is the fact that the allocation to beneficiaries, which is deductible by the trust, is typically based on ordinary tax rules to get the trust income to $0. Since 50% of the interest expense would be denied under the new AMT rules, this would leave some income remaining in the trust for AMT purposes. Since the exemption threshold does not apply to ordinary family trusts to offset this income, tax planning may be required to mitigate this possible risk, but it runs the risk of undoing the value of the structure in the first place.

You may now need to worry about AMT

The key takeaway from these changes is that taxpayers that historically did not need to worry about AMT may now need to consider AMT scenarios when undertaking a potential transaction. While particular circumstances may leave some taxpayers neutral or better off, especially due to the increase in the exemption threshold, many owner/managers and high net worth individuals are likely left worse off with these changes. In the examples above, AMT can now apply when taxpayers try to utilize loss carryforwards or have “prescribed rate loan trust” structures.

These examples are just the tip of the iceberg as AMT concerns can also arise for taxpayers that want to claim the capital gains exemption, engage in charitable giving, or receive stock options. Taxpayers should be aware of AMT and when it can possibly apply to avoid any surprises when they file their 2024 taxes and onwards.