Flow-through shares utilize specific provisions of the Income Tax Act (“Act”) to allow for the “flow-through” of exploration expenses from resource companies (typically oil and gas, mining and base metals) to individual investors.

Many junior resource companies are not profitable and the exploration expenses they incur on a yearly basis are “wasted” in that they are not offsetting any taxable income. In addition, exploration is very expensive and these companies constantly require capital to fund their exploration activities. Flow-through shares meet these companies’ needs. The junior companies issue flow-through shares to raise capital and then renounce their exploration expenses such that the exploration expenses “flow-through” to individual investors monetizing the resource company’s income tax deductions. On a personal income tax basis, flow-through exploration expenses can be deducted against all sources of income on your tax return. Most importantly, the Canada Revenue Agency (“CRA”) condones flow-through investments both as public and income tax policy. Flow-through share are a great way for individuals to save tax.

How much to allocate to flow-through shares?

Most flow-through funds consist of a portfolio of small resource companies. These companies should be classified as “speculative” due to their size, liquidity and dependency on the price of oil or gold or copper, etc. and they should only be purchased if your portfolio allocation has room for a speculative element (subject to the income tax discussion below).

Are flow-through shares liquid?

Most flow-throughs have a lifespan of approximately two years which allows for the bulk of the exploration expenses to flow-through to the investors. After this two year time frame investors exchange their flow-through units for shares of a mutual fund on a tax-free basis. As the investor can redeem their mutual fund at any time, the exchange provides liquidity. Many advisors suggest utilizing a cycle of buying a flow-through every year and then selling the flow-through when it becomes a mutual fund and using those proceeds to purchase another flow-through. I have some concerns with this strategy from an income tax perspective, asset allocation perspective and pure investment strategy perspective. It would be my suggestion that one not blindly follow this strategy without ensuring it makes sense considering the various perspectives I just noted.

The Adjusted Cost Base (“ACB”)

Without getting into the nitty-gritty details, if you buy a flow-through for $10,000, you will typically receive $10,000 in tax deductions within two years, most of that total coming in year one. The income tax deductions reduce the ACB of the unit to nil. The ACB is then typically increased or decreased by any interest, dividends and capital gains/losses that the flow-through earns or realizes while you own the unit or mutual fund.

It is important to note that many financial institutions do not adjust their records for the exploration deductions and they continue to carry the limited partnership at the original cost ($10,000 in this example) in their records. Thus, care must be taken to ensure you do not use the incorrect adjusted cost base information when reporting a sale on your income tax return.

The numbers

The example below details the income tax advantages of purchasing a flow-through under three different scenarios (using Ontario tax rates). As you can see, if your flow-through maintains its $10,000 purchase price or increases in value, you end up at least $2,321 to the good. The chart below also reflects the downside protection you are afforded with a flow-through. As per the $7,000 valuation example, the flow-through can drop almost 30% in value and you still break-even because of the income tax deductions. Where you have capital losses (especially losses you will most likely never utilize) a flow-through becomes even more attractive as the capital losses can be applied to reduce the income taxes on the capital gain. Thus, a flow-through can in some cases be purchased to essentially manufacture capital gains to utilize against capital losses.

What’s new?

In prior years, many advisors suggested donating your flow-through shares once they became a mutual fund, as for income tax purposes where there was a donation of a public security to a charity, the capital gain was eliminated. In addition, upon the donation of the flow-through, a charitable donation receipt would be issued. The June 6, 2011 budget however restricted the exemption on capital gains from flow-through shares for the donation of any flow-through shares acquired after March 21, 2011. The proposed legislation will limit the exemption from capital gains for any flow-through acquired after March 21, 2011 to only the capital gain over the initial cost of the shares. Using the examples above, the only situation where a benefit would be obtained is the example where the fund was sold for $15,000. In this case, $5,000 ($15,000-$10,000 original cost) of the capital gain would be eliminated.

The above illustrates that there are various aspects to consider before purchasing a flow-through share.