With energy and metals prices flying high, resources-based flow-through shares are becoming increasingly attractive to investors.

Issued by Canadian companies in the energy or mining businesses to fund exploration, the shares offer investors juicy tax breaks, as well as the potential for capital appreciation based on new discoveries and rising commodity prices.

“Flow-throughs are extremely valuable as a tax-planning tool, and even more attractive when you layer in the potential for future positive returns,” says Dennis da Silva, managing director of the resources group at Middlefield Capital Corp. in Toronto, a major participant in the flow-through share market. “Aside from RRSPs, flow-through shares are one of the few legitimate tax shelters available to Canadians. They are not a loophole, but a government-sanctioned product designed to encourage exploration by resources companies.”

But flow-throughs are not suitable for every investor. Because potential price gains depend on the success of exploration programs, they are viewed as investments for those who can deal with a fair degree of risk. And potential investors should take note that the hot resources sector has created a lot of new issuing activity, with some shares of dubious quality.

“Not all flow-through opportunities are created equal, and it’s important to examine carefully the merits of individual offerings,” says da Silva. “As flow-through shares have become more popular, there have been a lot of new entrants to the market. There’s a wide range in quality, in terms of the operators and access to promising properties for drilling.”

Flow-through

shares came into being because of the fact that most junior energy and mining companies need to finance exploration programs and often have little or no revenue. They are therefore unable to use the tax deductions to which they would normally be entitled; for example, prospecting, drilling, geological and geophysical expenses are deductible expenses. Instead of these unclaimed deductions going to waste, they are packaged with new shares to finance exploration projects. A key difference between flow-throughs and regular shares is that the proceeds of flow-throughs must be spent specifically on exploration.

The deductions “flow through” to investors, who can use them against their own income, whatever its source. As long as the company spends the amount raised from selling flow-through shares on exploration, virtually the entire amount of the flow-through share purchase price can be deducted by the investor in the year the shares are purchased.

The resultant tax savings reduce the amount of money that investors are out of pocket. For investors in the top tax bracket, the cost of buying flow-throughs is cut by about 45%, because of the full deductibility of the share price from taxable income. Investors should have taxable income of $65,000 or more, after their personal deductions and RRSP contributions have been claimed, for flow-through shares to make sense.

As well, if the company drills its holes and comes up empty-handed, the value of the shares might fall so low that the tax advantages are eroded, says Dwight Potter, senior vice president of BMO Nesbitt Burns Inc. in Toronto. These shares are most appropriate for Canadians in the top income tax bracket who can fully benefit from the tax write-offs, and who can withstand the exposure to speculative resources stocks without throwing their overall risk/ reward balance out of whack.

Typically, the exploration expense deductions associated with flow-through shares reduce the investor’s initial cost base to zero for tax purposes. The proceeds realized from the eventual sale of the shares are taxed as a capital gain rather than regular income.

For example, if an investor in the top tax bracket bought $10,000 worth of flow-through shares, he or she would reduce taxable income and by $10,000 and pay $4,500 less in taxes that year. If the shares, which have been assigned a cost base of zero, were later sold at the original price, the capital gain would be $10,000, with income taxes amounting to approximately $2,200 — which is “pretty good mathematics,” according to Randy Oliver, president of Calgary-based Hesperian Capital Management Ltd. and a flow-through share expert. By essentially converting regular personal or business income into capital gains, investors realize significant tax savings, as only 50% of capital gains are subject to taxes.

If disposition can be deferred to a year in which the investor is taxed at a lower marginal rate, the benefits can be enhanced. For example, the shares could make sense for someone with a high-paying corporate job who is planning to retire or phase out to a lower-paying consulting job within the next couple of years.

@page_break@Recipients of large lump sums of taxable income in a particular year, such as a large sales commission bonus or a job-loss compensation package, or those investors with unused capital losses can also benefit from the tax deferral of owning flow-through shares and the conversion of regular income to capital gains.

The tax benefits enhance returns and also offer downside protection. An investor with a 45% marginal tax rate breaks even if only 71% of the amount invested is recovered by disposition, Middlefield’s calculations show.

Although many flow-through shares are sold directly by issuing companies to the public, others are held as part of a diversified portfolio within a flow-through limited partnership. The advantage of a partnership is that an experienced general manager may have access to better deals than an individual investor, as well as access to private placements. The lifespan of a partnership is usually about two years to allow for maximum deduction of exploration expenses. Typically, there is a minimum investment requirement ranging from $5,000 to $10,000.

“A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor,” says Mal Spooner of Mavrix Fund Management Inc. in Toronto, manager of several flow-through limited partnerships. “Investors end up owning a basket of start-ups, rather than just 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 of losing the entire investment.”

Hesperian’s Oliver, manager of the Norrep flow-through limited partnerships, says rising investor demand in recent years has driven up the price of flow-through shares, which typically sell at a premium to the issuing company’s regular stock. Some shares are now being issued at a premium of up to 35%. If the premium is too high, it’s harder to make money on the stock — even with the generous tax write-offs.

Oliver, who doesn’t like to see a premium of more than 28%, usually holds about 30 flow-through issues within Norrep’s partnerships to provide risk diversification.

“Resources are hot, and deferring taxes is hot,” says Oliver. “The combination can create a potentially dangerous package. Investors that you wouldn’t expect are now buying into the product. And at the same time as demand is increasing, it’s getting harder to find good, quality flow-throughs selling at a reasonable premium.”

Flow-through investors should keep in mind that many flow-through shares represent ownership in unproven exploration companies. If those companies were making any revenue from their properties they would use the deductions themselves. That’s not to say an exploration company won’t have wells or mines in production several years out, but the shares are speculative, Oliver says.

“[Flow-through] shares are subject to normal risks inherent in junior resources equities, including fluctuations in commodity prices, interest rates and capital market conditions,” da Silva says. “Returns in flow-through shares are dependent upon the price at which the shares are ultimately sold by the investor.”

Many flow-through share partnerships offer investors the option of converting their flow-through partnership units into holdings in a mutual fund after the partnership unwinds. In this way, investors can retain the same zero cost base and continue to defer taxes until the time is right to sell the mutual fund units.

If the mutual fund is part of a corporate structure that allows tax-free switching among different mutual funds within the same corporate structure, an investor can move into a mutual fund with no exposure to resources and continue to defer taxes “until the cows come home,” Spooner says.

For example, Middlefield’s flow-through limited partnerships are typically converted after two years to shares of Middlefield Growth Class Fund. From there, investors can switch tax-free among Middlefield’s nine “class” funds while retaining the same cost base. Mavrix and Norrep offer similar mutual fund conversion opportunities.

“After the rollover, investors can switch from resources into an income fund if they prefer, which completely changes the risk profile of the holding,” says da Silva.

Some investors may choose a strategy of redeeming their flow-through partnerships after two years and reinvesting the proceeds in a new partnership with the same tax advantages.

By continually rolling over into a new flow-through issue, the $10,000 flow-through investor would generate tax savings of $2,200 every two years, and recover most of the cost of the original investment after five years. IE