What are the benefits and risks of flow-through shares?

Flow-through shares are special shares issued by oil and gas and mining exploration companies.

These shares are a tax shelter and special tax incentives are offered. This is one way the federal government encourages resource exploration and development on properties in Canada. Under the Income Tax Act, the company can give up some of its resource expenses that it would normally deduct from it's taxable income. The company passes along or "flows-through" the rights to these claims to investors who buy the shares. If you buy the shares, you can deduct these expenses from your taxable income to cut your tax bill. The specific deductions you receive depend on the classification of the company's income and expenses. Canadian exploration expenses, for example, are fully deductible from your income. The cost base of your shares is considered to be nothing if there are sufficient expenses flowed through to you to offset what you paid. When you eventually sell, all of the proceeds - not just your gain - would then be taxed as capital gains. Capital gains are taxed at 50% of your marginal tax rate. So if you're in the 50% tax bracket, your marginal tax rate on these proceeds would be 50% X 50% = 25%. Let's look at the after-tax result from buying $1,000 of these shares under three scenarios. We'll assume the expenses are in fact fully deductible and that you're in the 50% tax bracket.

1. The shares increase in value by 20%:   The original investment is $1,000, and you sell for $1,200. So your net investment value = $500 (tax saving) + $1,200 (selling price) - $300 (capital gains tax) = $1,400. This is a net after-tax gain of 40%.

2. The shares lose 50% of their value after you buy:   The original investment is $1,000, and you sell for $500. Your net investment value = $500 (tax saving) + $500 (selling price) - $125.00 (capital gains tax) = $875.00. You have a net after-tax loss of 12.5 %.

3. The share price stays the same.   The original investment is $1,000, and you sell for $1,000. Your net investment value = $500 (tax saving) + $1,000 (selling price) - $250 (capital gains tax) = $1250. This is a net after-tax gain of 25%.

Advantages

• The tax advantages - an immediate tax deduction and long-term tax deferral -- are the big attraction, particularly for people in the top tax bracket.
• Since the share prices are linked to commodity prices, they may offer a hedge against inflation.

Disadvantages

• It's generally high-risk junior resource companies that issue these shares. Any company willing to renounce these expenses, in most cases, probably isn't in a taxable situation. This suggests there's a higher risk that you may lose all or some of your capital if you buy these shares. If a company is in a taxable position, it likely wouldn't give up its exploration expenses.
• The stock prices of all resource companies, not just juniors, are very volatile anyway because of the ups and downs of energy and mineral prices.
• Typically, these shares are issued without the buyer receiving a prospectus. So there may be steep minimum purchase requirements ranging from $25,000 to $150,000. You may not be able to sell them for a year or more under your province's securities rules.
• These shares are generally issued at a higher price than the company's regular shares. This reflects the tax benefits.

Are flow-through shares a suitable investment for you? This depends on a wide range of issues. What are your investment objectives? Are you comfortable with the risk? Commodity prices will have a big effect on the share price. The risk would be greater when commodity prices have peaked and less when they have bottomed out.

Before investing, take a close look at the track record of the promoters, the engineering and the geological expertise available to the company. Consider the kind of exploration that's to be done. Obtain details on the expected tax affects of the expenses. Find out how this would affect your taxes. Buying the flow-through shares of an individual company isn't the only way to invest in flow-through shares. You could also put your money into a fund that buys a variety of these shares. This is similar to a mutual fund, and offers less risk through diversification. Also, these funds are more suited to small investors since they may require an investment of as little as $5,000. Before making any kind of investment, make sure you fully understand its pros and cons. You shouldn't let tax benefits steer you into a poor investment. Consider seeking professional investment and tax advice.