Tax Angles AMT effects on flow-through

Bill C23, tabled in the House of Commons on Nov 7, contains measures to implement the alternative minimum tax (AMT) announced in December, 1985. When this bill is passed, the AMT measures will become effective as of Jan 1, 1987.

This article deals with AMT as it affects flow-through share investments. The resourceful investor should be aware that among items that will not be considered deductible under the AMT system are Canadian Exploration Expense (CEE), Canadian Development Expense (CDE) and the depletion deductions that typically arise from these investments.

Further, AMT means that certain types of income cannot be effectively sheltered from tax. With the approach of year-end many different flow-through investments are available to shelter income. The resourceful investor will want to ensure the effectiveness of the shelter is not reduced due to AMT. Basic rules

Basically, the AMT system requires that the investor prepare a second alternative minimum tax calculation in addition to his normal income tax calculation.

Under the AMT system, AMT is determined by multiplying the AMT taxable income by a flat federal rate of 17%. With provincial tax, the combined AMT tax rate can vary between 25% and 28% depending on the applicable surtaxes and the province of residence of the taxpayer.

If AMT is less than the basic federal tax otherwise determined, it has no effect on taxes payable. If AMT is greater, however, it becomes the basis of federal tax payable.

AMT taxable income differs in many respects from taxable income calculated under the regular system. The gross-up and credit rules do not apply to dividend income. Many tax deductions are not available while certain amounts not normally taxable are included in computing AMT taxable income.

Amounts which are not deductible include:

* losses arising as a result of CEE, CDE and depletion deductions with

respect to oil and gas or mining investments,

* RRSP and pension contributions,

* capital gains exemption claimed,

* the $1,000 dividend and interest deduction,

* the $1,000 pension deduction,

* losses arising from CCA on MURBs and films.

Amounts not normally included in income which must be added to AMT taxable income include, the non-taxable half of taxable gains other than those subject to the capital gains exemption, capital dividends and the non-taxable half of bonus interest on Canada savings bonds.

In addition, certain amounts are deductible in calculating AMT taxable income including the basic AMT exemption of $40,000, personal exemptions, medical expenses, charitable donations, and adjusted non-capital and capital losses of other years. Complicates decisions

The introduction of AMT makes the valuation of a flow-through share investment more complicated, particularly where the investor has already invested in other tax shelters or has income sources that may result in AMT being applicable.

The resourceful investor will do a separate AMT calculation to ensure that the tax savings represented in a prospective investment in fact will materialize given the investor’s own particular circumstances. AMT is a significant income tax consideration that should be taken into account when evaluating the potential returns on a flow-through share investment.

The consequence of over- sheltering will be an additional cost in the investment associated with AMT. On the other hand if the investment and other risks associated with a particular flow- through share tax shelter are favorable, an investor may choose to purchase the shelter and avoid this additional AMT burden caused by over-sheltering by not claiming the full amount available to him in his CEE or Mining Exploration Depletion pool.

The basic exemption of $40,000 ensures that most individuals will not be affected by AMT. AMT in excess of regular tax in a particular year can be carried forward up to seven years to reduce regular tax if it exceeds that calculated under the AMT system for those years. Sheltered from AMT

Consider a situation where the resourceful investor has realized $100,000 of capital gains through the sale of flow-through shares in 1986.

The capital gains exemption has already been utilized to the cumulative limit. Under the regular tax calculation this $100,000 gain would generate $50,000 of taxable capital gain which would be subject to tax.

At a 50% combined marginal income tax rate, the tax liability would be $25,000. The investor considers a new flow-through share offering that generates $50,000 of resource deductions and promises tax savings of $25,000.

Would this investment in fact produce the expected tax relief? The answer is no. The results of the investment would simply be to convert all or a portion of the regular tax liability to an AMT liability, depending on the extent to which the $40,000 AMT exemption has been used to cover other items not deductible for AMT purposes.

If the full amount of the exemption has been otherwise utilized, the result is as follows:

Regular Tax Regular Tax AMT

(Before Shelter)(Sheltered)(Sheltered)

Taxable capital gain $50,000 $50,000 $100,000

Resource and depletion deductions — 50,000 —

Taxable income 50,000 NIL 100,000

Tax rate 50% 50% 25%

Taxes payable 41,000 NIL 25,000

This situation arises because a capital gain receives a tax preference; the effective regular tax rate on the whole amount of the gain is the same as the AMT rate. Since the CEE and depletion claims are not deductible for AMT purposes the total tax remains the same.

Exactly the same situation arises in respect of dividends received from taxable Canadian corporations, where the gross-up and credit mechanism reduces the effective regular tax rate. Conclusion

Many investors will find the $40,000 basic exemption in computing income subject to AMT solves any AMT problem. However, where this is not the case, as a rule of thumb an investor can only shelter roughly one-half of his fully-taxed income with resource deductions from flow-through shares and not incur any additional AMT tax liability.

Items of income that are entitled to preferential treatment under the regular tax system cannot be fully sheltered from AMT. The resourceful investor will take this factor into account in making his investment decision. Mr Playfair and Mr Dent are tax partners at Clarkson Gordon, Toronto.