Flow-through investments are common shares in energy, mining or other natural resource companies. Flow-throughs got their name as a result of the obligation of the issuer to "flow-through" to investors certain tax deductions generated from the company's exploration program.
To promote mining and the overall development of natural resources in Canada, the federal government has made available certain tax deductions for investments in this sector via flow-through shares.
Flow-through shares are issued by Canadian companies in the energy or mining sectors to raise funds for exploration, and give investors considerable tax breaks and the opportunity for capital appreciation based on new discoveries and rising commodity prices.
Flow-through shares were first introduced by the federal government in 1954 to allow transfer or “flow-through” of tax credits between corporations. Since 1972, the Tax Act has allowed exploration companies to transfer or flow-through specific type of exploration expenses (Canadian Exploration Expenses (CEE), and Canadian Development Expenses (CDE)) on Canadian properties to individual investors. Resource companies typically have substantial upfront exploration costs and little or no revenue eliminating the need for the tax deductions they would incur as income-generating companies.
The sale of flow-through shares allows an exploration company to receive cash from investors to finance their exploration costs, and to ‘flow-through’ its tax deductions to investors giving investors tax benefits from exploration expenses.
There are two types of flow-through share investments:
Regular flow-through shares – provide 100% federal and provincial tax deductions for exploration expenses. For e.g. an investor with a marginal tax rate of 46% who purchases $10,000 in flow-through shares will garner a tax benefit of $4,600, cutting the real cost of the investments to $5,400. When the shares are sold, the 50% inclusion rate on capital gains will mean a tax hit of 23%. In addition to benefiting a taxpayer in the current taxation year, these tax deductions can be carried back 3 years and carried forward 7 years.
Super flow-through shares – provide the 100% tax deduction as regular flow-throughs and an additional 15% federal Investment Tax Credit for Exploration (ITCE) for grass roots mining exploration expenses incurred in Canada to investors anywhere in Canada (It applies only to mining of metals and minerals, and not for extraction of oil and gas).
In addition, some of the provinces and territories offer their own tax credit, ranging from a 5% refundable tax credit in Ontario to 20% and 10% non-refundable tax credits in British Columbia and Manitoba respectively. Quebec, effective March 2004, offers a 150% tax deduction of the cost of certain qualifying exploration expenses in specified locations. The provincial tax credit only applies if the investor is resident in the province and the exploration occurs in the same province. These tax credits can be carried back 3 years and carried forward 10 years.
Typically, investors in the top marginal tax bracket would receive the most benefit from a flow-through investment. However, most investors, regardless of their income level, would likely receive some benefit from investing in flow-though shares. Still, flow-through shares are not for everyone. The resource sector is cyclical by nature, commodity prices are subject to fluctuation, and exploration is risky. If the exploration firm comes up empty-handed and its stock price plummets, even the hefty tax deduction might not be sufficient to cover the investor’s losses. Therefore, investors in the top marginal tax bracket are best positioned to take advantage of flow-throughs or those investors who have received a lump sum that would boost their taxable income in any given year, and have already used up their RRSP contribution room.
Flow-through shares are usually issued in the fall to attract investors who are actively looking for last-minute tax deductions, or early in the year when people realize they have missed tax savings. While flow-through shares can be purchased directly from resource companies, they are more commonly purchased as units in a limited partnership, which operates much like a mutual fund. The latter option makes the shares more accessible, as well as reduces the risk through diversification. Some funds may contain mostly junior resource companies with spotty track records, while others focus more on major publicly traded companies.
Resource companies often issue flow-through shares at a premium compared with their common shares. This is because they take into account that there will be a tax benefit to the buyer. But if the premium is too high, it is harder to realize returns. Experts agree that when the premium reaches 30%, there is no benefit to investors. Flow-through shares have no initial liquidity. To reap the benefits of the tax deduction, investors must hold the shares for 18 to 24 months, after which they may sell them. In the case of a Limited Partnership, the units are typically rolled into a resource-based mutual fund.
