Investing in flow-through shares

The following is the last of three excerpts from Resources Rock: How to Invest in the Next Global Boom in Natural Resources by Malvin Spooner, founder and president of Toronto-based Mavrix Fund Management, and Pamela Clarke, a former correspondent with The Economist Intelligence Unit in Europe. The book is published by Insomniac Press and sells for C$21.95.

Buried deep in the Income Tax Act there’s a clause that says: “A principal-business corporation may deduct, in computing its income for a taxation year, the lesser of (a) the total of such of its Canadian exploration and development expenses as were incurred by it before the end of the taxation year….”

What you need to know from the clause is that most junior energy and mining companies spend all of their money on exploration programs, and usually have little or no revenue. Because they have virtually zero income, they’re not able to use all the tax deductions that they’re entitled to as a resource exploration company. Mining companies are allowed to deduct prospecting, drilling, geological or geophysical expenses, but if they don’t have any revenue, then these deductions remain unclaimed or “wasted.”

In a rare moment of generosity, the federal government decided to allow exploration companies to give up those tax deductions and pass them on to people who can use them. These deductions, sold as shares, are called “flow-through shares” because they transfer the tax deductions from the company to the investor. In other words, the government allows a tax deduction that would usually only be granted to an exploration venture to be passed on, or “flow-through,” to their investors. It’s a win-win situation as the company gets the money to finance their exploration work while investors can claim up to 100% of their investment as a tax deduction.

The government created this program as a means of encouraging people to invest in resource exploration companies. That’s nice of them, but given our incredibly high tax rates, it’s a good idea to understand how investing in exploration-either in flow-through shares, or in shares of a limited partnership that owns a portfolio of flow-through shares-can help you lower your taxable income.

Limited Partnerships — Investors can buy flow-through shares directly from a company, or own them indirectly by purchasing units in a limited partnership specially created to buy shares in a portfolio of several junior exploration companies.

Buying units in a limited partnership can be beneficial for individual investors because it gives them the tax deduction from the flow-through shares, in addition to reducing their investment risk. A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor could afford to purchase on his own. Therefore, investors in a limited partnership end up owning shares in a basket of startups, rather than just in one venture.

Given that a lot of exploration companies could go bankrupt or walk away from their projects, buying shares in several of them minimizes the risk that you could lose your entire investment.

Tax Credits — How good are flow-through shares as a tax deduction? Are they worth it? The answer varies from one investor to another, but as long as the exploration company — or companies if they’re in a portfolio owned by a limited partnership — spends all the money they raised from selling flow-through shares on eligible exploration expenses, then almost the entire amount invested in the shares can be deducted.

A word of caution: don’t let the tax appeal of flow-through shares affect your decision-making skills as an investor. Remember that even though the tax deductions alone are beneficial, you’re still investing in the riskiest side of the resource industry. It is possible for you to lose all your money if the exploration team repeatedly comes up empty-handed.

On the other hand, investing in an exploration startup by means of flow-through shares does mitigate the risk of losing your investment. Depending on your marginal tax rate, the after-tax cost of buying the flow-through shares (or portfolio of flow-through shares) is virtually cut in half, compliments of the government. And there’s more good news. In the Economic Statement and Budget Update of October 18, 2000, the Minister of Finance announced a temporary, 15% investment tax credit (applied to eligible exploration expenses) for investors in flow-through shares of mineral exploration companies. Oil and gas exploration companies were excluded.

This announcement introduced a credit, known officially as the Investment Tax Credit for Exploration (ITCE), which reduces an investor’s federal income tax for the taxation year during which the investment is made. Although deemed “temporary,” the federal government announced in its February 2003 budget that the ITCE is extended by at least one more year.

The ITCE is a non-refundable tax credit that can be carried back three years or carried forward 10 years. So if you invest in flow-through shares (of mining exploration companies only) today, you can use the deduction any time up until 2014, or back to 2001. Keep in mind, however, that the ITCE has to be reported as income in the year after you claimed the tax deductions from the flow-through shares.

The only downside is that when you sell your investment, or trigger a “deemed disposition” (which means the government thinks you’ve unloaded the investment even if you haven’t actually sold it), then you’re on the hook for capital gains tax. That’s not so bad, as capital gains tax rates are better than regular income tax rates.

Taxing Example — Let’s look at how these tax credit programs can help you reduce your taxes. For example, if you live in Ontario and your annual taxable income is $300,000, and you’re taxed at the highest marginal tax rate of 46.41 %, then you’d pay $139,230 in tax. Of course, to make it simple, we’re unrealistically assuming there are no personal exemptions or other allowable deductions and that all income is taxed at the same rate.

If you invested $50,000 in flow-through shares, and the entire amount qualified as a CEE, then 100% of your investment could be deducted from your taxable income. Your taxable income is reduced to $250,000 and you now owe $116,025 in taxes-a savings of $23,205! That’s a nice chunk of change that stays in your pocket.

It can get even better. If your investment in flow-through shares is with companies that are exploring for metals and minerals, you’ll get an additional tax credit of $7,500. That extra credit would cut your total tax bill down to $108,525. In a perfect world, you could save yourself $30,705 in taxes. Serious money by any standards. In addition to these federal government programs there are several provincial flow-through initiatives that we won’t address here as they vary tremendously from one province to another.

Flow-through shares are starting to sound like they’re the best discovery since Chuck Fipke dug up some diamonds in the Northwest Territories. As wonderful as they are, keep in mind that since money is made and taxes are paid in the real world, things aren’t always as rosy as simplified examples in a book on investing.

Before buying into the example above remember that:

Taxes Vary: Everyone pays taxes on a sliding scale, so not all of your income is taxed at the top marginal rate.

Diversify: Your entire portfolio should never be solely invested in just mineral exploration stocks-diversification is advisable even for investors with an incredibly high tolerance for risk

No Guarantees: An exploration company is obligated to spend 100% of the money it receives from selling flow-through shares on expenditures that qualify for tax deductions, but if for some reason it doesn’t, then you can’t claim 100% of the deductions. The bottom line is that there are many variables that will influence the impact of flow-through shares on your tax situation. Investment advisors can provide details on the limited pa
rtnerships or flow-through shares that are available in the market today. Ask them to help you research and screen limited partnership funds.

Since tax breaks in Canada are few and far between, try to take advantage of any and all legitimate ones. Given that the outlook for some resource sub-sectors is better now than it’s been in years -and if you’re able to stomach the risk that comes with investing in pure exploration companies-then you could save yourself some money by investing in flow-through shares.