Going with the flow

(September 2005) While income trusts have dominated the headlines for the past three years, a more obscure resource play has been performing quite well throughout the commodities rally: flow-through shares.

It’s a vehicle that allows investors to convert regular income into capital gains, using a perfectly legal strategy. Moreover, it’s a tax break the government actually wants investors to use. Perhaps flow-through share investing owes its relative obscurity to the fact these investments aren’t suitable for most middle-class retail clients. Such caveats, however, didn’t stop the proliferation of hedge funds.

How They Work

To encourage exploration for fossil fuels and minerals, the CRA offers a 100% deduction for capital spent on prospecting, called the Canadian Exploration Expenses (CEE) credit. To qualify for the credit, exploration companies must spend capital investments within two years of receipt. A similar credit is also available on capital spent on the development and processing of resources — the Canadian Development Expenses credit. But since less risk is involved, it only covers 30%.

It’s usually very small companies that undertake exploration, and income may only be generated when crews actually find resources. Sometimes years pass between profit postings, so these firms require a constant inflow of capital to continue exploration. With low or no revenues, these tax credits remain unclaimed, and they are in fact some of the most valuable assets owned by these junior firms.

Since these companies’ earnings often aren’t attractive to investors, the CRA has granted them the use of special share issues that allow the CEE tax credit to “flow through” to investors. In exchange for an investment of $10,000, for example, the exploration firm provides the investor with the 100% tax credit, in effect sheltering the initial investment. The conversion to a capital gain will follow upon disposition.

Flow-through shares are almost exclusively offered by private placement. The most common strategy for participation in the flow-through market is the limited partnership (LP) route. Available by offering memorandum to qualified investors, LPs offer some of the same key advantages provided by mutual funds.

However, advisors need to understand that due to the limited supply of flow-through offerings, competition between LPs can be fierce, and they are often not able to place 100% of their capital in the investment vehicle. Therefore, they’ll often invest the remainder in common equity in the same sector. The 100% tax credit for investors applies only on the amount placed in flow-through shares. So if only 70% of the initial capital pool is placed in flow-through shares, the investor tax credit portion is 70%.

The holding period for an LP is usually about two years, matching the time limit for the exploration company to spend the cash. During this period, there is no formal market for LP units. Once this vesting period has elapsed, the partnership is usually converted into a mutual fund, with LP units exchanged for mutual fund units that can be bought or sold. With the initial tax benefits now passed on to the investor, the flow-through shares held by the LP serve as common equity in the exploration company.

The investor’s adjusted cost base (ACB) for their new fund holding is based on the percentage of the initial investment it was able to write off using the exploration tax credit. For example, if the LP was successful in deploying all capital into flow-through shares, the write-off would be 100% and the ACB on the fund is zero. If the investor was only able to write off 80% of the initial $10,000 investment, the ACB will be $2,000.

The balance of the value is considered a capital gain and the investor faces only the 50% inclusion rate, cutting his or her tax liability in half. The higher the initial deduction, the larger the capital gain and the greater the tax saving. Hence, the product is especially attractive for investors with a large capital loss carry-over, as they can apply the gain against the loss and face no tax.

Scott Ellison, a certified financial planner with Rudderham, Norwood, Ellison Investment Counsel in Halifax, says a person who has capital loss carry-forwards can take advantage of the tax credit immediately. “You’d effectively be able to use all your capital loss carry-forwards and not pay any tax on the gain, and have income deduction in the year you purchase the structure,” he explains.

Alternative Strategy

While the LP structure is the most common method for participating in the flow-through market, Ross Young, principal of Secure Capital Management in Calgary, constructs his own portfolio of flow-through shares for his clients. The majority of his business is focused on safer investment strategies aimed at preserving wealth. But with his location in the heart of oil country, several of his clients tend to request additional exposure to the resource sector.

Private oil and gas exploration firms seeking funding will sometimes buy out publicly traded, but essentially defunct firms listed on the TSX Venture Exchange. These are largely failed tech companies left over from the heyday of the Internet bubble. Young says this is easier and faster than filing for a new listing, and allows the private company to raise capital by issuing stock.

“They have a drilling program they want to fulfill, so they’ll raise enough capital to do that, but roll the assets into a public company,” Young explains. “The money will go into the public company, and then on those specially issued shares, they’ll get the flow-through tax benefits.”

He says this strategy gives investors better liquidity, as there is usually only a four-month hold on trading, effectively reducing one of the major drawbacks of the LP structure. Further, the resulting tax benefits allow publicly traded flow-through shares to generally be issued at a premium of 10% to 20% over their last price before the conversion to the flow-through structure.

Downside Protection

Investors in a lower-tax bracket would see their downside protection dramatically slashed, so flow-through share investing is most appropriate for high-net-worth investors.

Between the initial CEE deduction and the break on capital gains, investors have almost 30% downside protection on their investment. In Ontario, for example, assuming the investor is in the highest marginal tax bracket of 46% and they invest $10,000 into the flow-through LP, the 100% deduction will garner them an initial tax benefit of $4,600 — lowering their investment risk to $5,400.

When the assets are eventually disposed of, the 50% inclusion rate on capital gains will mean a tax hit of 23%, assuming the investor remains in the same tax bracket and the value of the fund does not change. If the value of the assets falls even by as much as 30%, to $7,000, the investor will only face capital gains tax of $1,771, leaving him with a post-tax balance of $5,229.

Aside from the obvious tax benefits for high-net-worth investors, understand that flow-through shares are very speculative ventures. There is a real risk the underlying companies will not find anything of value on the properties they explore. They are not intended as a core holding and their main attraction is the tax benefits. That said, some flow-through LPs have provided investors with handsome gains over the past few years, as prices for oil and gas have soared.

Before investing in flow-through LPs, ensure investors consider the outlook for the particular sector involved. The offering memorandum will usually indicate which sector it will seek investments in, but until the offering has closed, the general partner cannot guarantee it will find adequate investment opportunities in this field.

Most consumer tax software is unable to handle the complexities of the credits involved in these products, so clients will likely need the help of a professional advisor or a tax preparation service. But flow-through LPs are really only suitable for high-income clients, so odds are they already have assistance.

Flow-through shares are only offered through private placement, so the investing public generally does not have access to individual offerings — nor should they, given the risky nature of the exploration business.

A flow-through limited partnership offers the investor greater safety because it diversifies among several flow-through share offerings.

This article originally appeared in the September issue of Advisor’s Edge. Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(09/20/05)

Steven Lamb