Editorial Fix flow-through’s Achilles heel

The following guest editorial from the Prospectors and Developers Association of Canada is based on a brief on flow-through share financing presented recently to the Minister of Finance in Ottawa. The brief confronted some serious misconceptions about the flow- through mechanism.

Contrary to widespread belief, flow-through is not a recent phenomenon. The tax legislation for flow-through has been around since 1953. It is only in the past few years, though, that the use of flow-through has increased noticeably. There are a number of reasons for flow-through’s enhanced popularity. First, depressed metal prices and lean cash flows experienced by Canadian producers have forced the seniors to curtail exploration spending. The juniors have tried to fill the gap in exploration activity, and have financed a substantial portion of their exploration programs with flow-through.

Second, recent modifications to the tax rules have made investment in flow-through shares more attractive for investors who are not in the resource business. Despite the new and important role of the juniors, the level of exploration activity in Canada in 1986 is still expected to be less than it was in 1980.

The PDAC brief addresses another incorrect notion about flow-through. It is widely believed that the income tax legislation created flow-through. In fact, though, the income tax rules relating to flow-through represent recognition of, and reaction to, a particular type of financing arrangement which has long been commonplace in the industry. For decades, investors have been providing exploration funds to cash-tight juniors: the only way the typical junior could compensate the investor was by way of share capital.

And finally the PDAC drives home the point that a flow- through share issue is not a “tax shelter” or tax preference. The income tax regulations ensure that the investor is at risk with respect to his investment; far-reaching rules make sure that there are no guarantees or other assurances that would reduce or eliminate the investor’s risk. Further, it must be remembered that the company issuing flow-through shares gives up forever, in favor of the investor, the tax deductions associated with the exploration program. The flow-through share rules do not create tax writeoffs; they transfer tax deductions from one taxpayer to another. And, the “minimum tax” rules see to it that the flow-through will not cause any undue strain on the public purse.

There is a four-fold argument for retaining flow-through in its present form.

First, the exploration industry is labor intensive, and any tinkering with the flow-through rules could easily jeopardize jobs of some 20,000 Canadians estimated to be employed directly in mineral exploration. It is estimated that more than 75% of flow- through funds are paid out in wages.

Second, flow-through shares work. The mobilization of risk capital attributable to flow-through has led to the discovery of dozens of new mines in Canada, creating new jobs, additional tax revenues, and new sources of foreign exchange.

Third, flow-through serves to provide balance in Canada’s economic and social fabric. The northern and other frontier regions within the country rely heavily on a healthy exploration industry. It is unrealistic to believe that manufacturing and services industries will provide the same economic and social base in these regions as the exploration industry currently provides. Further, by allowing the juniors to compete favorably with senior producers, flow- through encourages growth of new companies in the exploration sector.

Fourth, flow-through lends an element of equity to the tax system, by providing a mechanism whereby tax rules which are available to senior companies in the industry may also be made available to taxpayers who fund exploration programs which are conducted on a junior company’s property.

The case for retaining flow-through is a strong one. Flow- through’s Achilles heel is the public perception that flow-through is just another tax shelter. It is in the best interest of all Canadians that this perception change.