Minimum tax pares back the advantages associated with certain deductions, credits and tax shelters that reduce taxable income. The tax rules were designed to ensure that high income earners must pay at least a minimum tax (also known as alternative minimum tax). Only individuals can be subject to minimum tax, not corporations. Under tax law, an individual includes living people as well as trusts, such as testamentary or family trusts.
Note that the minimum tax does not apply in the year a person dies. Also, individuals (other than trusts) and graduated rate estates are entitled to a basic exemption from minimum tax of $40,000.
How the calculations work
The details of the calculation are found on Form T691 for individuals, and Schedule 12 for trusts. The following is a simplified breakdown:
- Calculate taxable income the usual way.
- Add back preferential items for minimum tax purposes.
- Add 30% of capital gains. This means that 80% of capital gains are subject to the minimum tax calculation.
- Deduct the gross-up on dividends. This means that only the actual amount of dividends is subject to the minimum tax calculation.
- Deduct $40,000 (the basic exemption amount), if applicable.
- Deduct personal credits, if applicable. Note that the dividend tax credit is not included in the calculation of minimum tax.
- Calculate federal income tax owing in the usual way.
- If the amount at the end of step 6 is greater than the amount in step 7, then minimum tax is payable.
Note that provincial minimum tax is generally calculated by multiplying the federal minimum tax amount by the provincial minimum tax rate.
If minimum tax applies, the amount paid becomes a carry-forward credit that is available to be claimed by the taxpayer to reduce taxes otherwise payable for the subsequent seven tax years. If the minimum tax carry-forward is unused at the end of the seven years following the year the minimum tax was paid, then the carry-forward is wasted (and the minimum tax becomes a permanent tax cost).
Here are three examples of minimum tax.
John is a sole shareholder of a Canadian-controlled private corporation and owns common shares. He decides to declare an eligible dividend of $50,000 to himself as remuneration from the corporation. John also decides to sell the family cottage in the same year and realizes a capital gain of $200,000. To minimize his tax bill, he chooses to make a $50,000 RRSP contribution.
John will have to pay minimum tax of $3,400 in addition to tax otherwise owing of $22,800 (total tax bill of $26,200). However, if John only claims $20,000 of his RRSP deduction, he will not pay minimum tax. Although he will pay more regular tax ($34,200), he has deferred his RRSP deduction to a future year. This may make sense if John can claim his RRSP deduction in a year when he has more taxes otherwise payable, or if John is concerned that he won’t be able to use the minimum tax carryover in future years.
The Smith Trust was established many years ago on the death of Mr. Smith. The trust is a testamentary trust but not a graduated rate estate. The trust earned the following income:
- Taxable capital gains—$24,000
- Eligible dividends—$15,000
- Interest income—$3,000
The trust also deducted investment management fees of $5,000 and a non-capital loss carry-forward from a previous year of $17,000, which is applied against this year’s taxable income.
The trust will owe minimum tax of $860, for a total tax bill of $3,150.
The trustees can choose to only claim $13,400 of non-capital loss carry-forwards, thereby eliminating the minimum tax, while still preserving loss carry-forwards for future tax years of $3,600. However, the total tax bill is more, at $3,950. If this is unpalatable, the trustees can pay the minimum tax and use the minimum tax carryover in future.
The Taylor Trust is an inter vivos trust. The trust sells shares of a qualified small business corporation, so that Jennifer, a beneficiary of the trust, can claim the capital gains exemption of $800,000. Jennifer has no other taxable income, as she is just finishing her university degree. However, she will have taxable income next year once she begins her full-time job.
Jennifer was able to claim the capital gains exemption, thereby avoiding “regular” tax, but she will have to pay minimum tax of approximately $40,000. She will have seven years to apply the minimum tax carryover to her future taxes payable.
Minimize minimum tax
Here are strategies to either stop minimum tax from applying or to use up a minimum tax carry-forward amount:
- Reduce or defer discretionary deductions to future years. For example, consider reducing capital cost allowance claims or RRSP deductions to increase taxable income that is subject to regular tax.
- For owner-managers active in the business of a privately owned corporation, consider advising your client to take some salary from the corporation, instead of only dividends.
- Consider adjusting the client’s investment portfolio so that more of the investment income is comprised of interest or other income that is taxed at the full rate.
- If your client is planning to claim the capital gains exemption on the disposition of qualified property, first calculate whether minimum tax may apply, and undertake appropriate planning as needed.
With careful planning, the effects of minimum tax can be reduced or avoided entirely.
What preferential items can trigger minimum tax?
- Capital gains (since only half of a capital gain is subject to taxation)
- Dividends (while dividend income is grossed up to get to the taxable amount, a dividend tax credit can be claimed)
- Losses and deductions (such as carrying charges) related to tax shelters and limited partnership interests
- Losses resulting from, or increased by, claiming capital cost allowance on rental properties
- Losses from resource properties
- Stock option deduction
- Deduction for employee home relocation loan
- Federal political contribution tax credit
- Investment tax credit
by Stephanie Dietz, CPA, CA, CFP. She specializes in tax and estate planning at Stephanie Dietz Professional Corporation. email@example.com