Tax Angles Flow-through must be retained

In a recent address to the Canadian Tax Foundation, the minister of finance, Michael Wilson, alluded to a proposed general curtailment of tax preferences that enable some high income earners to reduce their taxes.

The message in Mr Wilson’s address reinforced the direction outlined in the October, 1986, department of finance release titled, Guidelines on Comprehensive Tax Reform. The present income tax system is criticized for having high marginal tax rates with a narrow tax base because of selective writeoffs and deductions. Since the finance department’s release on tax reform and Mr Wilson’s address to the Canadian Tax Foundation, there have been rumors circulating in the mining and financial community that use of flow- through shares could be curtailed or eliminated.

The government should not take a wholesale approach to eliminating tax preferences. Some are worthwhile — others, less so. Flow- through shares have contributed to a resurgence of mineral exploration in Canada. They have created jobs, and have led to new wealth- creating mineral discoveries that will add to our economic base in the future.

It is time for the mining industry to make sure the government knows the facts and acts in a way that will encourage further resource development.

Flow-through shares are so named because the issuing corporation flows the tax benefits from certain mining expenditures through to the subscribers. Generally, these expenditures are exploration costs and are completely deductible in the year incurred. Flow-through shares are more attractive than conventional common shares; both to the issuing corporation and to the subscriber.

The issuing corporation receives more capital than on a conventional share issue because it can demand a premium for the tax benefits that flow through to the subscribers. The subscriber, on the other hand, has equity participation and receives a tax deduction which reduces the cost of the investment.

The flow-through share concept has been in existence for more than 30 years. The popularity in the concept has increased significantly in the past five years. This popularity is largely credited to the changes to the tax treatment of flow-through shares. Prior to the Nov 12, 1981, budget, flow-through shares issued after July 31, 1976, and before Nov 13, 1981, were deemed to be inventory to the investor acquired at nil cost.

The proceeds on disposition of these shares gave rise to ordinary income, 100% taxable to the investor. The Nov 12, 1981, budget changed this for flow-through shares acquired after Nov 12, 1981. These shares are now generally treated as capital property with nil cost. The proceeds on the disposition of these shares accordingly gives rise to a capital gain, one half of which is taxable.

For mining exploration expenses incurred after April 19, 1983, flow- through shares receive an additional incentive. The related earned depletion is deductible up to 25% of the investor’s income from any source, not just resource income.

The popularity of flow-through shares was further increased by the introduction of the capital gain exemption effective for net capital gains realized after Dec 31, 1984. For investors at the maximum tax rate, who se flow-through shares qualified as capital property and the unused capital gains exemption available, the return on investment was increased significantly. Benefits of flow-through shares

Flow-through shares have contributed significantly to Canada’s growth in the mining industry. In 1985 alone, approximately $250 million out of $470 million spent in exploration, was raised through various flow-through share financings. In 1986, this figure is expected to be approximately $350-$400 million out of an estimated $550 million of mining exploration. Many jobs have been created in northern Ontario and Quebec as a result of this increased exploration activity.

The majority of flow-through share financing is being spent by mining companies in search of gold. Over the past three years, 53 discoveries have been made, where exploration financing included flow-through share financing.

If flow-through shares are so successful in creating jobs and generating economic growth and employment, why would this financing mechanism be cancelled? We believe the only reason that flow- through shares could be eliminated is as part of a wholesale reform to make the tax system “neutral” by eliminating tax preferences. What is the tax preference in this case?

The ability to write off 100% of Canadian Exploration Expense?

The availability of bonus deduction for mining exploration depletion?

The ability to transfer the benefits of these deductions to subscribers for flow-through shares?

Given the high risks associated with grassroots exploration, a 100% writeoff does not constitute a tax preference, but merely reflects economic reality. The bonus deduction for mining exploration depletion is a tax preference, but a necessary preference that recognizes the need for continuous reinvestment in exploration, given the wasting nature of mineral resources. In our view, the ability to transfer the benefits of these deductions is not a tax preference but instead, is a needed mechanism that provides some measure of tax equity as between the taxable producer and the non-taxable explorer. At what cost?

If the government moves to eliminate flow-through shares, it would be acting contrary to its over-all objective of encouraging economic growth in the mining industry by creating employment. It would reduce our ranking in the international markets because less funds would flow to exploration, with fewer new discoveries. This would lead to a decrease in exports.

Furthermore, the elimination of flow-through share financings would curtail equity financing for many mining companies and result in a withering away of much of the junior resource sector. The cost would be too great.

The ability to transfer the tax benefits of mining exploration expenses using the flow-through share mechanism is simply too important to the long-term health of the Canadian mining industry.

Mr Playfair and Mr Deut are tax partners at Clarkson Gordon, Toronto.