Resourceful Investing: Flow-Through Shares
By: Steve Elliott
Many people think that flow-through shares are complicated. But with a little explanation I believe the concept is simple. The Government knows that approximately 90% of new businesses fail in the first 5 years, and of the 10% that make it, around 90% of those fail the next five years. In order to keep these resource-based businesses running, and helping the Canadian economy maintain and create lots of jobs, the government allows these corporations to transfer their expenses to individuals, rather than face the more likely scenario of these businesses never getting into production and being able to offset their expenses. In the mining world, most junior companies are generally in exploration for at least 10 years before getting into production and actually starting to see a profit. This makes it very tough for these companies to raise money and stay in business over this time because they have poor cash flow.
Flow-through shares are shares issued in mining, oil & gas, renewable energy and energy conservation sectors (e.g., solar energy) here in Canada, and have been around since the 1950s. These companies do not have to be Canadian to issue flow-through shares, but they must generate a Canadian Exploration Expense (CEE) or Canadian Development Expense (CDE) on Canadian soil to qualify under CRA guidelines.
A flow-through share is simply a common share of an eligible company. These companies can either be private or public. MineralFields has always bought publically traded companies for its limited partnerships. The name “flow-through” is attached because the resource company enters into an agreement with the shareholder to ‘flow through’ to the shareholder the tax credits the resource company has created from exploration. These are tax deductions that are generated from the company’s capital expenditure programs. Typically, a flow-through share purchase arrangement has the following characteristics:
- Up to 100% tax deductible; and addition all federal and provincial tax credits may apply
- Typically, flow-through shares are bought from shares in treasury as a private placement, and these shares are subject to re-sale restrictions typically for a period of four months after;
- A detailed subscription agreement (including investor indemnification) that covers the resource company’s obligations to ensure the expenditures are made in accordance with the Canadian Income Tax Act
Why is the Canadian Government the only government in the world that offers these types of incentives for its taxpayers? Let’s talk first specifically about the mining industry. Canadian taxpayers invest close to $1.0 billion dollars on average in flow through shares every year. So from a tax perspective, the government gave up about $400 million dollars last year alone. But the royalties the government received was approximately $1.1 billion on top of the tax revenue from the 350,000 Canadians that now have jobs in the industry. A recent report showed that for every dollar that the government spent on flow-through shares there was a $2.60 direct economic benefit. Canada has become a world leader in mining, thereby attracting many highly educated and skilled people. Having a solid and vibrant Canadian mining industry also attracts close to 40 billion dollars per year in the mining sector from foreign countries.
Canada offers many competitive advantages when it comes to resource based investing. First, we have two highly recognized, low cost stock exchanges here. Our Canadian markets are also known for their capital market integrity, and investor protection. Canada as a whole also has a highly educated population and favorable immigration policies.
The economic stability that is derived from having a strong exploration program here in Canada is essential when it comes to foreign trade. Many of the BRICS (Brazil, Russia, India, China and South Africa) nations are seeing a rapid increase in consumption, and BRICS nations comprise about 40 percent of the global population. These 5 countries also take up about 30 percent of the world’s land mass. Currently, China ranks second only behind the United States for market size, while, India ranks 4th, Russia is 8th, Brazil is 10th and South Africa is 25th. These nations accounted for 55% global GDP growth from 2000-2008. Where these nations fall behind is in business sophistication, innovation, infrastructure and higher education according to a Global Competiveness Report from 2010-2011 (Source: World Economic Forum).
In 2000, the BRICS nations were at about 16% of the world’s GDP and today these nations are closer to 30%. What do these nations have to do with flow-through shares? Many of the elements and minerals that Canadian companies are mining are being consumed in these fast developing countries. China currently consumes 53% of all the cement in the world and 45% of all steel. That’s a lot of infrastructure going up in the second largest market in the world. Yet, they only rank 50th in the world in infrastructure, so they have a long way to go. The other BRICS nations rank between 47th and 86th in infrastructure. Meaning these nations will be consuming a lot of our minerals and mining production for years to come.
That being said, Canada has become a hotbed for mining operations. We have more publicly traded mining companies than any other country in the world, also continuing to attract some of the best resource-based talent in the world.
I had the privilege to check out the PDAC (Prospectors and Developers Association of Canada) conference this year in Toronto. This annual international convention & trade show is the largest mining investment show in the world. They host domestic and foreign investors and companies, related top ranked professionals (geologists, economists, portfolio managers, etc.) and mining experts. It was an eye opener even for me. I would recommend it to anyone who is unclear on the world mining industry or just looking to learn more about mining.
Currently, the government in Canada allows investors to take advantage of an additional 15% federal tax credit when they invest in mining exploration, on top of the 100% CEE tax deduction. This is an individual tax credit and not eligible to corporate investors. But, this credit may not be around forever. It is currently renewed until March 31st, 2013. And we feel that when the mining industry stabilizes the government may not continue with the 15% federal tax credit, thus eliminating our Super Flow-Through share LP’s.
Other types of tax shelters – outside of mining flow-through -- generally deal with tax loopholes that may or may not get attacked by Canada Revenue Agency (CRA). While mining tax shelters are encouraged by the government, they still contain a bit of risk to the investor. Flow-through investments are very attractive for higher income earners, as well as people that have large registered accounts, whether that be RRSPs, LIRAs or LIFs. Corporations are also able to invest in Flow-Through Limited Partnerships and benefit from the 100 % CEE tax deduction, but they are not eligible for the additional federal or provincial tax credits. Because these investments generate a capital gain on sale, half of the proceeds are a credit to your capital dividend account and could be pulled out of your corporation personally on a tax-free basis. One other strategy we have been seeing is utilizing flow-through investments to offset existing capital losses. There are several other tax minimization strategies that make use of flow-through.
I hope that this brief article has helped make the murky world of flow-through shares a little clearer. Even if you’re feeling like an expert please consult with a tax professional when looking at these strategies.
Sources for this article:
Flow-through shares for the innovation sector May 2012 Author Richard S. Sutin http://www.cra-arc.gc.ca/tx/bsnss/tpcs/fts-paa/menu-eng.html Prospectors and Developers of Canada Association www.pdac.ca