This article will appear in the forthcoming issue of Investment Executive.
Ottawa’s proposed alternative minimum tax (AMT) regime will have negative consequences for certain trusts used in common tax and estate planning strategies.
Under draft legislation tabled in August to implement the new AMT, trusts such as life interest trusts will be subject to a 20.5% tax rate, up from 15%, on adjusted taxable income (ATI). The 20.5% rate also would apply to individual taxpayers. However, unlike individual taxpayers, these trusts remain ineligible for the basic exemption amount, which will rise to an estimated $173,000 in 2024 (indexed annually), up from a fixed $40,000.
When a trust distributes all its income in a year to beneficiaries, AMT may not be a factor.
However, when a trust can’t or doesn’t distribute all its income to beneficiaries, “the impact of not having access to [the basic exemption] is significantly higher” under the proposed 20.5% tax rate for trusts, said Kevin Wark, a tax consultant with the Conference for Advanced Life Underwriting (CALU) in Toronto.
In addition, trusts and individuals can claim only 50% of certain deductions and expenses in determining their ATI for AMT purposes under the new rules. This includes interest expenses, which are 100% deductible under the current AMT, such as those incurred when a trust holds a prescribed-rate loan.
These factors make a trust far more likely to be subject to AMT than under the current rules, wrote Evan Crocker, senior tax associate with Moodys Private Client Law in Vancouver, in an Aug. 22 blog post.
And with little means for trusts to recover AMT carried forward in future years, the AMT will result in “permanent tax” and “a form of double taxation” for affected trusts, Crocker wrote.
The Department of Finance released draft legislation to implement the proposed new AMT regime as well as other federal budget proposals on Aug. 4, and the consultation period ended Sept. 8.
The draft legislation largely followed the AMT framework proposed in the 2023 federal budget, with some key changes. Notably, the list of trusts excluded from the proposed AMT rules was expanded to include graduated rate estates (GREs). Previously, GREs were subject to the AMT but eligible for the basic exemption. In addition, qualified disability trusts will be eligible for the increased basic AMT exemption.
Those two changes were positive, but “not expansive enough,” Wark said, as most taxable inter vivos and testamentary trusts would remain subject to the proposed AMT. That means common trust structures, some of which are used for non-tax reasons, would be negatively affected.
In a Sept. 7 submission, CALU asked Finance to consider the example of a testamentary trust where a settlor’s second spouse is entitled to the income until the spouse’s death, after which the settlor’s children from their first marriage receive the capital. If terms of the trust restrict capital from being distributed to the second spouse, any capital gains will be retained in the trust and subject to AMT each year, with probably no way for the trust to recover it in future years.
Brian Ernewein, senior advisor with KPMG LLP in Ottawa, said Finance probably was reluctant to extend the basic exemption to all trusts to prevent taxpayers from accessing the exemption multiple times by establishing multiple trusts.
CALU’s submission, however, recommended that the settlor or beneficiary of a life interest trust be allowed to share their unused personal AMT exemption with the trust. Life interest trusts include structures commonly used for estate planning, such as alter-ego, joint-partner and spousal trusts.
“It’s not multiplying the exemption,” Wark said. “It’s allowing the sharing of exemption [among] the beneficiaries of the trust.”
But even if Finance integrates CALU’s recommendation, other common trusts will still be disadvantaged under the new rules.
For example, GREs are created when a person dies, and can only exist for 36 months. If an estate’s administration takes longer than 36 months, which isn’t unusual, the GRE would become a regular testamentary trust — and subject to the AMT.
“That seems like an unfair situation, where just because the estate is open for five years and not [wound up in] three years, you might get caught under AMT,” said John Oakey, vice-president of taxation with CPA Canada in Halifax.
Trusts created for non-tax reasons, such as an inter vivos trust for a spendthrift child or a disabled family member, also would be caught under the new AMT rules, which tax practitioners suggest might create an unfair result for these taxpayers.
“Finance has become a little bit more willing to allow a certain level of collateral damage” in pursuit of its policy goals, Oakey said.
Other consequences of the new rules may align with Finance’s broader goal of targeting high-income earners.
For example, trusts that hold prescribed-rate loans may be subject to the AMT, even if the trust has no income. In his blog post, Crocker gave the example of a trust that earns $1,000 in property income and $800 in interest expenses. The $200 of net income is paid to the trust’s beneficiary, leaving the trust with no taxable income.
However, for AMT purposes, half of the $800 interest expense is included in ATI. With no exemption amount to offset the tax, the trust will incur AMT of $82, or 20.5% of $400.
“I’m unsure if Finance is overly concerned” about such effects, Oakey said, since prescribed-rate loans are typically used to split income and reduce tax overall within a wealthy family.
The consultation period for the draft legislation was five weeks and included two statutory holidays, giving stakeholders scant time to review not only the AMT proposals, but a raft of other proposals in the same legislation.
Ernewein said the Sept. 8 deadline probably was chosen to give the government flexibility to table an implementation bill this fall. Parliament resumes sitting Sept. 18.
“It’s a bit through gritted teeth that we have to accept these short [consultation] periods, but I can only believe that it’s a genuine consultation, and they’re just trying to manage the [workload] realities they face,” Ernewein said.
However, Oakey believes Finance is unlikely to make any changes to the draft legislation. In the absence of critical errors, the legislation “is probably going forward as drafted,” Oakey said.
Proposed changes to the AMT
The alternative minimum tax (AMT) is a parallel method of calculating taxes incurred that permits fewer deductions, exemptions and credits than the ordinary tax rules do. The AMT is intended to prevent high-income earners from combining incentives in the Income Tax Act in order to pay little or no tax in a given year.
The AMT applies a flat 15% tax rate to “adjusted taxable income” above $40,000. The taxpayer pays the AMT or regular tax, whichever is higher, but any AMT paid can be carried forward for up to seven years and recovered to the extent that regular taxes exceed AMT in those years.
Under changes proposed in the 2023 federal budget, the AMT rate will rise to 20.5%, but the exemption amount also will rise to an estimated $173,000 for 2024 and be indexed annually thereafter. The carry-forward period remains seven years.
Capital gains will be fully included in income under the proposed rules, up from 80% under the existing AMT regime, as will all benefits from employee stock options. The capital gains inclusion rate for donations of publicly traded securities will rise to 30% from zero, matching the rate for capital gains eligible for the lifetime capital-gains exemption.
Certain deductions and expenses, as well as most non-refundable credits, will be limited to 50%.
Draft legislation released on Aug. 4 specified that non-refundable credits limited to a 50% deduction will include the pension tax credit, the disability tax credit transferred from a dependent, certain tax credits transferred from a spouse, and the tuition tax credit transferred from a child or grandchild.
The draft legislation also indicated that donations of property other than publicly listed securities — such as land or private company shares — would be 100% included in income, up from 50% under current rules.
Finally, the draft legislation increased the AMT inclusion rate for gains from listed personal property and capital gains allocated by trusts to beneficiaries to 100% from 80%. Correspondingly, the draft legislation would permit trusts to deduct 100% of capital gains allocated to beneficiaries from their AMT base, up from 80%.
All changes to the AMT would take effect in 2024.