Innovation

Gimme shelter: flow-through shares

Written by Camilla Cornell

There aren’t many legitimate tax shelters for high-income entrepreneurs, let alone many that offer the potential for lucrative returns. But that’s the promise of flow-through shares. Issued by Canadian companies in the energy or mining sectors to raise funds for exploration, flow-throughs give investors juicy tax breaks and the opportunity for capital appreciation based on new discoveries and rising commodity prices. “And when one of them gets a hit,” says John Archer, an investment adviser with RBC Dominion Securities in Montreal, “it can really be an investment home run.”

Here’s how they work. Resource companies typically have huge upfront exploration costs and little or no revenue. That means they don’t need the tax deductions they would incur as income-generating companies. To finance that exploration, they’ll issue shares and allow the tax deductions to “flow through” to investors.

So, what kind of tax savings can you expect? Flow-through shares offer federal and provincial tax deductions of 100% of the investment. An investor with a marginal tax rate of 46% who purchases $10,000 in flow-through shares will garner a tax benefit of $4,600, cutting the real cost of the investments to $5,400. When the shares are sold, the 50% inclusion rate on capital gains will mean a tax hit of 23%.

Investors who purchase “super” flow-through shares (shares in qualifying junior mining companies engaged in grassroots mineral exploration) may be eligible for an additional 15% tax credit.

Still, flow-through shares are not for everyone. “The resource sector is cyclical by nature, and exploration is risky,” says Archer. “You need to have the income, the assets and the fortitude to withstand a little portfolio volatility.” If the exploration firm comes up empty-handed and the stock tanks, even that hefty tax deduction might not cover your losses. You’re best positioned to take advantage of flow-throughs if you’re in the top marginal tax bracket or have received a lump sum that will boost your taxable income in any given year, and have used up your RRSP contribution room.

Flow-through shares are typically issued in the fall to attract investors who are actively looking for last-minute tax deductions, or early in the year when people realize they’ve missed tax savings. While shares can be purchased from resource companies, they’re more commonly purchased as units in a limited partnership, which operates much like a mutual fund. (Several Canadian firms operate flow-through funds, including Front Street Capital and Middlefield Resource Funds, both of Toronto.) The latter option makes the shares more accessible, as well as reducing the risk through diversification.

When choosing a fund, consider the portfolio’s mix. Some may contain mostly junior resource companies with spotty track records, while others focus more on major publicly traded companies, says Ross Young, principal with Calgary-based Secure Capital Management, which specializes in alternative investments. Seek out managers who have a history of getting good returns, too.

Resource companies often issue flow-through shares at a premium compared with their common shares. “They take into account that there will be a tax benefit to the buyer,” says Young. “So, if their regular stock trades at $1, they [might] issue the flow-through shares at $1.25.” But if the premium is too high, it’s harder to realize returns. Experts agree that when the premium reaches 30%, there’s no benefit to investors.

If you buy a flow-through fund, examine its fee structure. Some funds charge a sales commission (typically, about 6%) of the original investment, plus upfront or ongoing management fees and/or a performance bonus. Other partnerships charge a small annual management fee (say, 1%) or none at all, and then take between 10% and 50% of the profits in excess of a certain return on investment.

Young warns, however, that flow-throughs have no initial liquidity. To reap the benefits of the tax deduction, you must hold the shares for 18 to 24 months, after which you may sell them. (In the case of an LP, the units are typically rolled into a resource-based mutual fund.) “I wouldn’t recommend that flow-through shares make up any more than 15% of a portfolio,” adds Young. “Not unless you’re heavily involved in the resource industry and you only want to invest in an industry you know.”

Originally appeared on PROFITguide.com