Flow-through units are considered an attractive means of financing some of Canada’s exploration and development expenditures. The units are issued on the condition that the issuing resource company flow-through the tax deductions relating to exploration and development. In many cases the deductions may be as high as the purchase price of the flow-through units. The Income Tax Act has special provisions that stipulate how flow-through units must operate.
Individuals in the 43.7 per cent marginal tax bracket are more likely to seek this form of tax shelter. A flow-through may also be a useful tool for tax deferral. It is not without its risks and is generally only suitable for certain types of investors, including:
- High marginal tax bracket (whether consistently high income or short term spikes in income)
- Able to withstand a capital loss (it is possible that the investor may realize few benefits outside of the immediate tax deduction)
- Long-term time horizon (flow-through units are generally considered illiquid and have restrictions regarding resale)
- Sophisticated investor (able to read through the prospectus and understand the structure and merits of the underlying investment)
- Limited exposure (assumes investor has a risk adjusted position size and is not over-exposed to flow-through structures)
The following are some strategies for flow-through units:
The most obvious reason for purchasing flow-through units is to obtain a tax deduction in the current year. This tax deduction effectively provides downside protection on the investment. If an individual invests $10,000 in flow-through units and receives $4,370 back in taxes then the at-risk amount is $5,630.
The deduction provided initially effectively reduces the adjusted cost base of the investment and may convert the ultimate income to a capital gain.
Upon rollover of flow-through units to a mutual fund the investor has the ability to defer tax by continuing to hold units of the mutual fund. Alternatively, investors may sell units of the mutual fund, pay tax on the capital gain, and with the remaining proceeds purchase more flow-through units. These options allow the investor to have some control over when to recognize the amount into income.
Tax deductions obtained from a flow through share investment may be used to offset one-time spikes in income due to retirement arrangements, severance packages or extraordinary gains from the sale of property or securities. If the investment is made during the high income year, the deduction will serve to offset this income. If the investment is made subsequent to the high income year, it may trigger a loss in the year – this loss can be carried back up to three years to a higher income year. When a loss is carried back, taxes previously paid are recovered.
Upon rollover of flow through units into a mutual fund, the investor may make an “in-kind” contribution of the mutual fund units into their RRSP. This will result in a deemed disposition and realize a capital gain up to the value of the investment at the time the RRSP contribution is made (an investor is not advised to do “in-kind” contributions to an RRSP if a security is in a loss position). Provided the investor is able to receive an RRSP tax deduction then an additional tax deferral is possible.
Carry Forward Losses
Some investors may have existing capital losses. Fortunately these capital losses can now be carried forward indefinitely to offset future capital gains. Purchasing flow-through units will provide a deduction today and could generate a capital gain in the future. If an investor has existing investments with unrealized losses then those losses may be realized by selling the investment. The proceeds from the sale may then be used to purchase flow-through units. The benefit of this is that the investor obtains an immediate deduction and will have accumulated losses available when the flow-through units are ultimately sold.
Reducing Claw back
Investors that are having certain government benefits clawed back may want to consider certain tax efficient strategies. Investors who purchase units of flow-through units may reduce net income below the thresholds and may either avoid the claw back or have it reduced. Additionally, these investors may also want to factor in the impact of a possible higher income down the road. Investors could always offset any additional income by purchasing subsequent flow though units.
Some investors may want to explore the opportunities available by donating flow-through shares rather than making regular cash donations. Donors may be surprised that they may have to put up less cash to realize the donation amount.
There are very few high quality flow-through units. When they come out they are in high demand. Generally advisors will know those clients that are most suitable for flow-through units. Communicating changes in your circumstances to your advisor may allow your advisor to evaluate whether flow-through units are right for you.
Before implementing any strategies discussed in our columns we recommend that you speak with your financial and tax advisors.