Flow Through Shares

Are you looking for a major tax deduction? Are flow through shares right for you?

Flow through shares have been available to Canadian investors for many years. Historically, the government has always provided tax breaks to companies who engage in exploration activities. In doing so, the government is promoting economic activity that, if successful, will create tax revenue in the future. Ned Goodman, of Dynamic funds, set up some of the first flow through partnerships in the 1980s and allowed companies to pass those tax deductions through to individual investors. The CMP and CDR resource flow throughs have posted impressive after tax returns over the years. Since those early days, the number of investment companies offering flow through shares has increased dramatically and we are able to offer many prospectus-based flow through limited partnerships to our clients.

As an individual investor, flow through shares are of course primarily attractive due to the tax deduction. Here is an overly simplified example:

For a $20,000 investment, you typically receive a full $20,000 income tax deduction and thus reduce taxes by say, $9,000 (individual tax rates will vary but we recommend only highest marginal tax rate investors consider flow throughs). Immediately the investment declines in value after issuing costs and the fact that the underlying resource issuers were paid a premium for their shares in order to relinquish their tax deductions. And there are management fees for the two year life of the investment. Let's be overly pessimistic and assume a 30% reduction in value to $14,000.

The flow through will typically be illiquid for 2 years and eventually rolls into a mutual fund run by the issuing company. At that point, the fund will likely have a very low cost base for tax purposes (let's assume $1,000 from income the limited partnership receives over the 2 years). The investment would still have a market value of $14,000 if the underlying resource stock prices had not moved in 2 years. So assuming a $1,000 cost base, a $13,000 capital gain would result when you sell for $14,000, with a $3,000 capital gain tax cost owing. So net cash realized 2 years later is the same $11,000 that was the after initial tax investment. The ROR after tax in this case is 0%, because the underlying resource stocks didn't change in value, and the benefit of the full income tax deduction was offset by the issuing costs plus the (lower) capital gains tax owing at the end. If however, the underlying resource stocks move up (or down) in the 2 year period, the after tax return can be magnified up (or down) significantly. We could also consider the opportunity to have that extra $9,000 invested over the time instead of giving it to the government right away, but let's leave that as a side benefit. Clear as mud? The documents linked below under "More on flow throughs" have more details and various return calculations.

From the rough example above, the big benefit on flow through shares is if you have unclaimed capital loss carry forwards. In that case the loss would offset the capital gain on the sale of the flow through, so even if there is no change in the resource sector, clients can see a tax benefit as there would not be tax owing upon the sale of the flow through proceeds. Please note that the proceeds of flow throughs purchased after March 22, 2011 are no longer eligible to be donated to charities without incurring capital gains tax. This was a significant benefit of flow throughs that was eliminated in the 2011 budget.

Individual flow through years wind up being like the years for good or bad wines. Virtually all the flow throughs issued in the year 2007 when resource prices had hit record highs, had major losses when redeemed in 2009. But investment vintages like 2005 or 2009 wound up showing great returns. (There are also single issuer flow throughs that typically roll over in 4 months, but have much higher risk since you are investing in just one company at a time, instead of a diversified portfolio of resource stocks.) Investing over a few years and a few issuers is a good way to smooth out those ups and downs.

Here are some after-tax rates of return on some of Canada's oldest Flow Throughs:

We generally only recommend flow through shares to higher income, higher net worth clients. We suggest a minimum investment of $5,000. Investing in flow throughs to offset around 10%-20% of income can be a good target. They become even more attractive if you have unused capital losses. We would also recommend you have a good accountant to help you through the extra paperwork that holding a few flow throughs will generate at tax time. And remember, the flow through is not liquid for 2 years.

Lastly, this type of investment would be most appropriate if you already have resource stocks in your portfolio (most Canadians do). So, we might be inclined to reduce your resource holdings by the same amount, and simply convert your resource equity investments to tax advantaged resource equity investments.

We currently have 8 flow through issuers available. Please contact us if you would like to explore (pun intended) adding resource flow throughs to your portfolio.

More on flow throughs

 



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