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Flow-Through Shares: Investing in a Volatile Market

Published: 12/01/2008

By Christopher B. Norton, Jennifer Traub

During a time of market volatility, investors may be reluctant to part with their money, however, there may still be some appetite where tax deductions or credits exist. Corporations which qualify as “principal business corporations” can issue flow-through shares which provide a form of tax-assisted financing. Flow-through shares must generally be ordinary common shares issued pursuant to an agreement between the issuer and the initial subscriber which requires the issuer to incur and renounce certain expenses which qualify as Canadian exploration expenses ("CEE") or Canadian development expenses ("CDE"), subject to certain limitations, to the subscriber. The expenses incurred by the issuer and renounced to the subscriber allow the subscriber to claim certain tax deductions and credits which effectively reduces the cost of the investment to the subscriber. Since there are tax benefits available to the initial subscriber, flow-through shares are normally issued at a premium to ordinary common shares. Expenses which have been renounced to investors cannot be claimed by the issuer.

This summary is limited to flow-through shares issued by corporations engaged in the mining industry, although flow-through shares can also be issued by corporations engaged in oil and gas exploration or in the development of certain renewable energy projects.

Investors would generally be entitled to claim a 100% deduction for CEE renounced to them or a 30% deduction on a declining balance basis for any CDE renounced to them.

In a typical flow-through share financing, an investor would be entitled to claim a tax deduction in the year of investment equal to 100% of the amount invested and possibly an additional 15% investment tax credit. Some provinces also provide additional tax credits to individual investors.

Generally speaking, a “principal business corporation”, as it relates to the mining industry, is a corporation the principal business of which is any of, or a combination of, mining or exploring for minerals, or processing mineral ores for the purpose of recovering metals or minerals. A principal business corporation can also be a corporation all or substantially all of the assets of which are shares or indebtedness of one or more principal business corporations that are related to the corporation.

There is no requirement that a principal business corporation be a corporation incorporated in Canada, but structuring a flow-through offering by a foreign corporation raises a number of technical issues and may not be feasible depending on the facts.

CEE, as it relates to the mining industry, would generally be:

1. any expense incurred (other than an expense incurred in drilling or completing an oil or gas well or in building a temporary access road to, or preparing a site in respect of, any such well) for the purpose of determining the existence, location, extent or quality of a mineral resource in Canada, including any expense incurred in the course of:

   • prospecting,
   • carrying out geological, geophysical or geochemical surveys,
   • drilling by rotary, diamond, percussion or other methods, or
   • trenching, digging test pits and preliminary sampling,

   but not including

   • any Canadian development expense (as defined in the Income Tax Act (Canada)), or
   • any expense that may reasonably be considered to be related to a mine that has come into production in reasonable commercial quantities or to be related to a potential or actual extension thereof,
2. any expense incurred for the purpose of bringing a new mine in a mineral resource in Canada into production in reasonable commercial quantities and incurred before the new mine comes into production in such quantities, including an expense for clearing, removing overburden, stripping, sinking a mine shaft or constructing an adit or other underground entry.

CDE in the mining context would generally be:

1. any expenses (other than an amount included in the capital cost of depreciable property) incurred in sinking or excavating a mine shaft, mine haulage way or similar underground work for a mine in a mineral resource in Canada built or excavated after the mine came into production, and
2. the cost of any right or interest in certain Canadian resource property, including rights to prospect, explore, drill or mine for minerals in a mineral resource in Canada.

As noted above, there are some limitations on the CEE and the CDE which a corporation can renounce. In particular, a corporation cannot renounce CDE that constitutes the cost of a Canadian resource property.

The flow-through rules also include a look-back rule which allows an issuer to renounce certain CEE which it intends to incur in a particular year to investors who subscribed for flow-through shares in the prior year. This rule allows investors to claim a deduction in the year in which they make the investment and acquire the flow-through shares even though the issuer does not actually incur the expenses until the subsequent year. In the mining sector, this look-back rule would only apply to the type of grass-roots CEE which is described in paragraph (a) of the discussion regarding CEE above.

A company which renounces CEE to flow-through shareholders using this look-back provision will be subject to a special tax for the period commencing in February of the year of the renunciation to compensate the government for the accelerated tax deduction made available to the investors. The monthly tax is generally equal to the balance of funds at the end of the month in respect of the renunciation that have not been spent on qualifying CEE, multiplied by a prescribed interest rate. The interest rate is equal to 1/12th of the annual interest rate prescribed for the purposes of determining refund interest. In addition, if funds remain unspent at the end of the year of the renunciation then there is an additional tax levied for December equal to 1/10th of the unspent balance at the end of December.

Publicly listed flow-through shares are sometimes used by investors as a tax effective means to fund charitable gifts they may wish to make. The combination of the tax deductions and credits associated with the initial investment in the flow-through shares, coupled with the tax credit for a charitable gift and the special tax relief available for donors in respect of any capital gains arising in connection with a gift of publicly listed flow-through shares, can substantially reduce and even eliminate the out-of-pocket cash cost of the charitable gift for a donor.