Hemal Balsara is the Head of the Tax, Retirement & Estate Planning Services, with the Manulife Insurance team,
providing case level support on tax and estate planning matters to advisors across the country.
The 2023 Federal Budget proposed changes to the Alternative Minimum Tax (AMT) rules that target some of Canada’s wealthiest Canadians. The AMT rules are not new; they were implemented in 1986 and positioned to promote fairness in the tax system by ensuring high-income earners are paying a minimum amount of tax. However, the proposed legislative amendments (Amendments) released on August 4, 2023, may result in greater complexity and a higher tax liability than the Department of Finance (Finance) initially suggested, and may capture more taxpayers than the ones who are seemingly just not paying their fair share.
The proposed changes are intended to target Canadians who earn more than $300,000 per year. Taxpayers will need to pay the higher of the income taxes payable under the normal framework and amounts determined under the AMT tax rules. The amendments will apply for taxation years that begin after 2023.
AMT is calculated using the formula A × (B - C) – D.
AMT = Alternative minimum tax rate x (individual’s adjusted taxable income – basic exemption) – individual’s basic tax credit.
The Amendments to the AMT rules will change the formula itself and amounts determined under personal adjusted taxable incomes. The proposed changes to the AMT tax formula are as follows:
- A, which represents the alternative minimum tax rate, is increased from 15 per cent to 20.5 per cent.
- B represents an individual’s adjusted taxable income for minimum tax purposes.
- C represents the basic exemption from minimum tax. The amount was previously set at $40,000 but the Amendments change this amount to correspond with the fourth federal income tax bracket (expected to be $173,000).
- D represents an individual’s basic tax credit. The proposed changes will decrease the amounts by one half.
The second part of the Amendments change how an individual’s adjusted taxable income is calculated for AMT purposes (item B from the formula above). These measures could significantly and unexpectedly impact the tax liability of taxpayers, including those selling their business, engaging in charitable giving, and implementing leveraging strategies personally – including leveraging with life insurance.
Sale of business
Generally, when a business owner sells their business, they should be aware of the potential application of AMT when the lifetime capital gains exemption (LCGE) is involved. The amendments provide that taxpayers who claim the LCGE and are subject to AMT will be required to include 100 per cent of the capital gain in calculating their adjusted taxable income but will be eligible to claim a deduction equal to 7/5 of the LCGE. In effect, this would result in approximately 30 per cent of the capital gain amount that was subject to the LCGE being added back to the taxpayer’s income. This is not a change from the current AMT regime, however when the higher proposed AMT rate is combined with the provincial AMT, this could result in a higher overall capital gains tax rate when compared to situations where the AMT didn’t apply. The AMT rate varies by province but averages out to 33 per cent to 35 per cent. Also, for the purposes of calculating a taxpayer’s adjusted taxable income, non-capital losses and limited partnership losses carryforward amounts from previous years would be limited to only 50 per cent, and additionally, 100 per cent of capital gains, allowable capital losses and gains from listed personal property will be included in the taxpayer’s adjusted taxable income, where previously these amounts had an 80 per cent inclusion rate. In effect this may disincentivize riskier capital investments as realized capital losses are limited in offsetting future income where AMT is applied.
AMT is not applicable in the year of a taxpayer’s death, so post-mortem planning is unlikely to be affected by the Amendments. However, should a business owner choose to sell their business during their lifetime, the increased tax rate for those subject to AMT could significantly affect the overall tax liability for business owners. This is even more punitive where a business owner is looking to retire and has minimal income in the following years (the AMT framework allows for an offset for the 7 years following a tax year in which AMT applies). This may essentially amount to a prepayment of tax which can only be recovered by taxpayers with high enough incomes in the years following a payment of AMT to utilize the offset.
Charitable giving
Previously, capital gains on gifts of publicly listed securities to qualified donees (i.e., charities, private foundations) were excluded from the calculation of a taxpayer’s adjusted taxable income. The proposed changes will now include 30 per cent of the capital gain in calculating the taxpayer’s adjusted taxable income, an amount that was previously nil.
Additionally, the availability of an individual's basic tax credit (variable D in the formula above) has now been limited to one-half for the purposes of minimum tax. This includes the calculation of donation credits, so in addition to an income inclusion (for gifts of capital property) where one previously did not exist, eligible tax credits have also been halved for taxpayers subject to AMT.
This brings about a concern that inter vivos charitable giving, particularly by high net-worth individuals, will be tempered by these measures. These changes can lead to the curtailment of charitable giving incentives and are particularly punitive to taxpayers with dividend and capital gain income (for example from the sale of a business), where charitable donation tax credits would have previously provided some tax relief (in addition to supporting a social good).
Whether the new AMT measures will have a significant effect on the philanthropic activity of Canada’s highest income earners is yet to be seen. However, the Amendments indicate that the incentivization of charitable giving through tax policy is being diminished.
The silver lining is that this isn’t all bad news for life insurance strategies using charitable giving. For example, AMT is not applicable in the year of death and tax credits for charitable donations of private company shares by a business owner’s estate (which could be carried back to the terminal return) are still available, and when redeemed using the proceeds of a life insurance policy, can yield meaningful results for the estate as well as the qualified donee (see Charitable giving and life insurance). Where clients are charitably inclined, life insurance can be positioned to support charitable giving objectives as well as estate preservation.
Leveraged life insurance – personal borrowing
The Amendments include a limitation on claiming interest and financing expenses for the purposes of earning income to 50 per cent for the purposes of calculating a taxpayer’s adjusted taxable income. This is relevant to the availability of an interest deduction when borrowing personally using a life insurance policy as collateral, such that where AMT applies the limitation on interest deductibility could impact the internal rate of return of personally leveraged life insurance strategies. This also adds an additional disincentive for taxpayers looking to claim interest deductibility on shareholder borrowing using a life insurance policy that is corporately owned, in addition to the existing pitfalls of guarantee fees, shareholder benefits, and so on. Clients and their advisors should be particularly cautious when assessing leveraging options where the individual is the borrower if there is a possibility that AMT may apply.
Additional considerations
In addition to the considerations above, it’s noteworthy that family trusts are not subject to the minimum income amount for AMT to apply. Trustees must now consider the application of AMT on income earned by a trust, and the potential mismatch where income is allocated out to beneficiaries, but deductions are limited to 50 per cent as discussed above. The challenge when working with AMT and trusts is that many trusts aren’t eligible for the basic exemption of $173,000. As a result, this means that these trusts could be subject to AMT for every dollar retained in the trust.
Life interest trusts (Alter-ego, Joint-partner or Spousal trusts) are also not eligible for the basic exemption. This can be problematic in scenarios where a spousal trust was established for the spouse of a second marriage. Often these trusts are set up so that income gets allocated to the spouse and any capital gains or capital are retained for the children as residual beneficiaries after the spouse passes away. In situations where capital gains are retained within such a spousal trust and all other income is allocated out of the trust, since the $173,000 (in 2024) deduction is unavailable, the trust will be subject to AMT each year on its capital gains and have no other sources of income to create part I tax to offset the AMT deduction.
There are some exceptions to the general AMT rules on trusts. Graduated rate estates (GREs) are now exempt from AMT under the Amendments. The original AMT proposed in Budget 2023 had GREs only being eligible for the basic exemption of $173,000. As a refresher, GREs are created when a person dies, and can only exist for 36 months. If the administration of an estate exceeds 36 months, the GRE becomes a regular testamentary trust — and subject to the AMT. Qualified disability trusts will be eligible for the increased basic AMT exemption. The application of AMT may present an opportunity to consider the benefits of tax deferred treatment of life insurance when considering utilization or investment of trust assets (see Trusts and life insurance - the basics).
Conclusion
The AMT was implemented to capture a relatively small number of high-income earners who appeared to be paying less than their fair share under the normal framework. However, under this iteration of the rules, the Amendments may cast a much wider net than narrowly targeting avoidant taxpayers – especially those with “lumpy” income – as the AMT framework limits the preferential tax treatment of certain activities and could now amount to punitive results for the unwary.
A silver lining is that exempt life insurance policies continue to be a great place to overfund and achieve tax-deferred growth without attracting AMT.
