Note: The rules and law may have changed since this article was first published. It is provided for archival purposes but you should consult with your lawyer for the current state of the law
It is almost impossible to avoid hearing about the latest and greatest tax saving opportunity. Some legitimate ways of paying less tax are well-known, but another option is not as widely utilized – investing in flow-through shares.
Flow-through shares are a type of common share issued by certain Canadian mining, oil & gas and natural resource companies engaged in exploration or development activities. FT shares are exactly the same as other common shares of the company, but for one important characteristic – extra tax benefits to shareholders.
Resource companies in the exploration stages have huge up-front costs. The expenses incurred for exploration and development can be deducted against the company’s income. But because most junior resource companies generate little profit for the first several years, they cannot use all of the deductions to which they are entitled. This is where the benefit to the shareholder arises.
The Canadian government created a scheme allowing the tax deductions for qualifying exploration and development activities to flow-through from the company to the shareholder. It’s a win-win situation. The resource company gets the capital it needs to explore, and the shareholders can use otherwise wasted deductions against their personal taxable income.
FT shares are an enticement for Canadians to provide equity financing to higher-risk junior resource companies, which in turn keeps these companies exploring and developing, which in turn benefits our Canadian economy.
FT shareholders can claim the entire amount invested. For example, if an individual purchased $10,000 in flow-through shares, he or she could claim the full $10,000. If this investor is in the 40% tax bracket, his or her tax bill would be reduced by $4,000. Only the original shareholder can claim the tax benefit, even if he or she has sold the shares by the time the claim is made. The deduction can be claimed in the year the investment is made rather than the following year when the company actually spends the capital.
With the tax benefit, FT shares reduce the risk of investing in junior resource companies. The tax benefits can offset some of the potential losses, allowing the shareholder to lose a portion of his or her investment and still come out even.
Risks and Disadvantages
Why don’t all taxpayers include flow-through shares in their portfolios? As with an investment in any type of security, the investor could lose it all. This risk is heightened because the prospects and assets of junior resource companies offering FT shares are more uncertain. The company could make a major discovery, but they could drill a dry hole. The tax benefit will not likely be sufficient to cover the loss if a company goes under.
In addition, FT shares come with requirements under the Income Tax Act (Canada) for use of proceeds and renunciation of expenses, and Canada Revenue Agency will audit compliance. The Income Tax Act includes general and “look-back” rules regarding the timeframes in which companies have to both incur and renounce expenses. The details of these requirements are best left to another article, but if the company does not spend the flow-through money correctly or comply with the timeframes, the deduction can be denied.
FT shares must be issued pursuant to a written agreement where the issuer agrees to incur expenses and renounce them in favour of the subscriber. The agreement should include terms and dates regarding renunciation, the minimum investment required and the exemptions that the subscriber will need to satisfy before being allowed to invest.
Potential investors must review the subscription agreement to ensure the appropriate representations and warranties of the company are present. If a potential investor is asked to subscribe for FT shares without being presented with a subscription agreement, this is a deal-breaker, as the shares would not actually be considered FT shares under the legislation.
FT shares are best-suited to investors with considerable risk tolerance who have already maximized their RRSP contributions. In any event, FT shares should not be purchased simply to avoid tax. An investor should want to invest in the company regardless of the type of share offered. In other words, if the investor would not buy common shares of the company, he or she should not buy FT shares either. Regardless of the type of security, another well-known adage always applies…don’t invest what you can’t afford to lose.