Every mining, oil and gas, and renewable energy company in Canada has been faced with the same dilemma during the early stages of their existence: How can they raise enough money from investors and entice them to purchase their stock without an established revenue stream?
The Canadian Government offers certain tax incentives and benefits for investors of these resource companies, specifically to encourage people to invest. These incentives and benefits are derived from what are commonly referred to as flow-through shares (FTSs).
What is a flow-through share?
A FTS is a share which permits a resource company to pass along its development and exploration expenses to an investor. Investors are then able to deduct these expenses from their personal income tax returns.
The theory behind FTSs is simple. Generally, when resource companies are in the development or exploration stage of their life cycle, they are not generating any revenue. Without any revenue, these expenses are of no immediate value to the company and would be pooled together to be carried forward to be used in a year where the company has taxable income. As an incentive for investors to fund these operations, which may likely not result in any revenues until a much later date, holders of FTSs are able to utilize what would otherwise be corporate deductions against personal income. It is a win-win situation – the corporation receives much needed capital to fund its operations and the investor receives a tax deduction for the amount it invests.
In addition to a tax deduction, investors may also receive a non-refundable Investment Tax Credit (ITC). This ITC will depend on the nature of the expenses renounced to the investor and is equal to 15% of the eligible expenses renounced. Depending on the province in which the expenses were incurred, the specific expenses and the type of investor, there may also be an additional provincial ITC.
FTSs – the specifics
Once a company’s FTSs have been authorized, the resource company can renounce its development and exploration expenses, making them available for the investor to deduct.
There are two types of expenditures that can be renounced by a resource company. The first are Canadian Exploration Expenses (CEE), fully-deductible by an investor in the year they are renounced. The second are Canadian Development Expenses (CDE), which are deductible by investors at a 30 per cent declining-balance basis beginning in the year they are renounced.
The CEE or CDE that are renounced and claimed as a deduction by an investor cannot exceed the cost of the investor’s original investment. Additionally, the adjusted cost basis (ACB) of an investor’s investment will be reduced dollar for dollar by the amount of the expenses renounced to them. Finally, any ITC claimed by an investor will be considered taxable income for the following year.
For example, if you purchase $10,000 of FTSs in a particular year, you would be entitled to claim a deduction of $10,000 in your personal income tax return (deductible against all sources of income) and a Federal ITC of $1,500 (assume no provincial credit in this example). The ITC of $1,500 would be considered taxable income in the following year and you would pay tax on this benefit. The ACB of the investment would be reduced to $nil and any proceeds received on the eventual sale of the shares would result in a capital gain (taxable at 50%).
However, if the investor does not have a significant amount of taxable income from other sources, the deduction of the renounced CEE or CDE can result in the person being liable for Alternate Minimum Tax.
Is it worth investing in FTSs?
The main benefits of investing in FTSs are the tax savings from the write off of the investment over a short period of time, generally within the first year, and the corresponding ITC. For an investor in the highest marginal tax bracket, a FTS investment of $10,000, would result in roughly $6,000 of tax savings. This would reduce the ultimate cost of the investment from $10,000 down to $4,000. Ignoring the time value of money, as long as you thought you would be able to sell the shares down the road for more than $5,461, you would make money on the investment.
FTSs might be right for you if:
- You are paying tax at the highest marginal tax bracket;
- You are looking for immediate tax savings;
- You have enough savings and a well-diversified portfolio to take on the associated riskier investment.
FTSs might not be the right investment for you if:
- You are not in the highest marginal tax bracket;
- You do not have any portfolio savings or investments;
- You are risk adverse when it comes to investing.
Next steps?
Do you think FTSs might be the right fit for you? Reach out to both your investment advisor as well as your accountant. Your investment advisor will be able to confirm whether this type of investment would complement your existing portfolio, and your accountant would be able to quantify the potential tax savings.
This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article. Please note that this publication should not be considered a substitute for personalized tax advice related to your particular situation.
