Investors are revisiting the risks and rewards of flow-through shares (FTS) for clients following the introduction of a new tax benefit in the recent federal budget aimed at boosting the green economy.
Last month, the federal Liberal government introduced the Critical Mineral Exploration Tax Credit (CMETC), a 30-per-cent credit for investors who purchase FTS from companies exploring metals and minerals such as copper, nickel and rare earth elements needed to advance clean energy technologies. The government also said it will phase out FTS for companies that explore for fossil fuels by March 31, 2023.
“[Ottawa] is taking away from the oil, gas and coal sector and giving extra benefits that didn’t previously exist to the new form of flow-through shares that they want to see specific to the mining of critical metals,” says Ethan Astaneh, wealth adviser at Nicola Wealth Management Ltd. in Vancouver.
Canadian resources companies use FTS to issue new equity to investors at a higher price than they would normally receive, typically to raise money for exploration and development, says Steve Suarez, a mining tax law specialist and partner in the Toronto office of Borden Ladner Gervais LLP.
He notes investors are willing to pay a premium for FTS because they can claim deductions and credits that reduce their taxes.
Basic FTS allow an investor to claim deductions for Canadian exploration expenses (CEEs) and Canadian development expenses (CDEs) incurred by resource companies and flowed through or “renounced” to the person subscribing for the FTS, Mr. Suarez says.
CEEs acquired are immediately 100 per cent deductible to the FTS investor, while CDEs are 45 per cent deductible in the first year, with the remainder over time, he says. Also, he notes that many FTS offerings are structured so that the type of CEEs renounced to investors qualifies for a further 15-per-cent mineral exploration tax credit “claimable by individual investors, increasing the premium such investors are willing to pay the company issuing them and reducing its cost of capital.”
The 2022 federal budget announced a new 30-per-cent CMETC for qualifying CEEs renounced to FTS investors over the next five years.
Mr. Astaneh of Nicola Wealth says FTS are best suited for investors in the highest tax bracket – as long as they understand the risks.
“If you have limited [registered retirement savings plan (RRSP) contribution] room and limited other deductions available to you, and you want to bring your taxable income down, flow-through shares are a reasonable option to consider provided the risk profile is suitable for you,” he says.
The main risks are the investment losing value, but he notes that can be offset by the significant tax break.
“In effect, it’s like making an RRSP contribution from the perspective that it functions like a deduction,” he says. “As long as that speculative investment combined with the tax benefits is delivering a positive after-tax outcome, it provides an advantage.”
The other risk is that the company whose shares are bought might not use the funds for purposes that are eligible for flow-through to the investor, which he says is rare but has happened.
“It’s not a fun experience when you receive a letter from the [Canada Revenue Agency] five years after you’ve bought a flow-through share saying, ‘We’re having a look at it now and it turns out that company didn’t apply all its expenses properly.’”
Some investors also choose to buy FTS to make a charitable donation, often through specific companies that provide the charitable vehicle. Some Canadian companies that do FTS donation finance include Sprott Capital Partners LP, PearTree Securities and Wealth Creation Preservation & Donation Inc. (WCPD).
WCPD says its clients buy the public flow-through shares and then donate them immediately to charities of their choice and receive another 100-per-cent tax deduction for the donation. The charities then sell the FTS immediately at a discount to an institutional buyer or liquidity provider for cash.
WCPD says the cash is the value for the charitable tax receipt. The liquidity provider takes on the stock market risk, not the donors or the charity.
Peter Nicholson, founder and president of WCPD in Ottawa, says the FTS market has picked up alongside a recovery in commodities in recent years and the new CMETC is expected to increase it further.
“Advisors who haven’t done flows in 10 or 12 years because of the bear market are saying, ‘I think now is the time to start revisiting it,’” he says.
Mr. Nicholson notes the CRA has offered a 100-per-cent tax deduction on FTS since 1954 to fund drilling and exploration. The tax incentive recognizes the role mining plays in the economy, including jobs for Indigenous peoples.
WCPD says it doesn’t facilitate FTS related to coal, gas and oil exploration.
Warren MacKenzie, head of financial planning at Optimize Wealth Management in Toronto, doesn’t have clients with FTS currently but has in the past. He says advisors and investors should understand how they work before they buy.
“Flow-through shares provide an immediate tax deduction for the amount invested,” he says. “However, later, when the security is sold, its cost will be deemed to be zero, so 100 per cent of the proceeds would be taxed as a capital gain.”
That compares to a regular investment in which a capital gain would only exist if the investment is sold for more than what it costs, Mr. Mackenzie explains.