If your income is subject to high taxes and you are looking for effective methods of decreasing your annual tax bill, you may want to add flow-through shares to your portfolio. There aren't many legitimate tax shelters for high-income earners, let alone the potential for lucrative returns - but that's the investment objective of flow-through shares.
What are they? A flow-through share is simply a common share of an oil and gas or mineral exploration company that normally trades on an exchange. It is referred to as "flow-through" because the company enters into an agreement with a limited partnership to flow certain tax deductions from that company's capital expenditure program through to the limited partnership.
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.
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. "Super" flow-through shares - shares in qualifying junior mining companies engaged in grassroots mineral exploration) may be eligible for up deductions up to 120% of the investment.
While shares can be purchased from resource companies, they're more commonly purchased as units in a limited partnership, which operates similar to a mutual fund. The latter option makes the shares more accessible, as well as reducing the risk through diversification.
In order to realize the tax benefits you must hold the investment for a period of time - usually 24 months, after which you may sell them. Due to the upfront tax deduction, the ACB (adjusted cost base) is low or zero - meaning that when redeemed, all proceeds are treated as capital gains, which are taxed more favourably than interest income. In the case of a Limited Partnership, your other option after the two-year hold period is to transfer them into a mutual fund without triggering any tax consequences - in effect, deferring the tax until you sell the mutual fund.
Typically, flow-though shares appeal to investors in a high marginal tax bracket who seek tax deductions to reduce taxable income because their RSP's are maxed out or they want to avoid OAS clawbacks. They also appeal to investors who want to defer tax and convert fully taxable income in the current year into capital gains taxed at a later date.
Be warned, however, flow-through shares are not for everyone. As witnessed in the last year, the resource sector is cyclical by nature and exploration is risky. As with any investment in small-cap companies, market values can fluctuate widely - and since the investments are concentrated in the resource sector, there is further potential for volatility.
Shea Sanche is an independent financial advisor with Raymond James Ltd. in Thompson. His column appears every third Friday. You can contact him with suggested topics or questions by email at [email protected]. Consult with a financial advisor or tax specialist before making financial decisions. Raymond James Ltd. is a member of CIPF.
