Flow-Through Shares: A Primer and More
The provisions of the Income Tax Act (Canada) (the ITA) relating to flow-through shares have a long history. In their current form, they permit a "principal-business corporation" (the eligibility criteria are described below) to renounce expenses that the corporation would otherwise treat as Canadian exploration expense (CEE) or Canadian development expense (CDE) to purchasers of shares so that the purchasers can claim the relevant deductions instead of the corporation. However, as is often the case with tax incentives, while the principle is easy to state, the devil is in the details. Although flow-through shares can be issued by corporations engaged in oil and gas exploration or in the development of certain renewable energy projects, this note is limited to flow-through shares issued by corporations engaged in mining or exploring for minerals.
While many investors (and others) think that flow-through shares are a separate and distinct class of shares in an issuer’s capital, they are in fact simply common shares that are issued to investors accompanied by separate contractual rights to certain tax advantages.
Benefits and Effects of Flow-Through Shares for Issuers and Investors
Effect of Renunciation; Consequences of Acquiring or Issuing Flow-Through Shares
In general, CEE or CDE renounced by a principal-business corporation to an investor will be treated as CEE or CDE, as the case may be, incurred by the investor as of the effective date of the renunciation. As described below, flow-through share offerings may be made more attractive by providing for renunciation of CEE to investors effective in the tax year in which the investment is made, even though the CEE will be incurred by the issuer in the following year. Note that only the first holder of the share is entitled to the benefit of the renunciation. It is not necessary that the first holder actually hold the share on the effective date of the renunciation or the date that the renunciation is made. Conversely, a subsequent holder of the share will not be entitled to the benefit of a renunciation.
From the investor’s perspective, the cost of a flow-through share is deemed to be nil. Such nil cost will be averaged with the adjusted cost base of any identical shares of the issuer owned by the investor. In particular, a common share of a principal-business corporation issued under a flow-through share agreement is identical to a common share of the principal-business corporation acquired in any other manner.
From the principal-business corporation’s perspective, the amount that may be added to the paid-up capital of its shares on issuance of a flow-through share is generally reduced by 50% of the amount renounced in respect of the share.
Why Do Issuers Like Flow-Through Shares?
If a principal-business corporation is in a loss position, the issuance of flow-through shares is a means to monetize tax deductions that cannot otherwise be used immediately.
On the other hand, if the principal-business corporation is paying current taxes, it will seek to extract a premium compared to a conventional issue of common shares. In any event, flow-through offerings are generally priced higher than conventional offerings (or, in the alternative, issued at the same price but with conventional shares being issued as part of a unit that includes a warrant or similar "sweetener").
Why Do Investors Like Flow-Through Shares?
Investors receive the benefit of deductions for CEE and/or CDE that shelter income at the investor’s marginal tax rate. These tax savings reduce the money at risk of the investor.
The entire sale proceeds of flow-through shares, assuming that the flow-through shares are capital property, will be taxed as a capital gain (because, as described above, the cost of the flow-through shares is generally nil). In a simple example, if the share could be sold for the issue price, the investor benefits from (i) a deferral of tax (because of the "up front" deduction for CEE/CDE), and (ii) an absolute tax saving by taking a deduction for CEE/CDE at the investor’s marginal rate yet paying tax on the same amount at capital gains rates on the sale of the share.
In addition, if the flow-through share is capital property to the investor, any capital gain on the disposition could be sheltered with any available capital loss carry-forwards.
Investors can also substitute donations of certain flow-through shares to registered charities for cash donations. Under recent changes to the ITA, if the flow-through shares are listed on a designated stock exchange (which includes the Toronto Stock Exchange and Tiers 1 and 2 of the TSX Venture Exchange) and are gifted in kind to a registered charity, the investor will be treated for tax purposes as having disposed of the shares for their adjusted cost base (so no capital gain or loss will be realized) yet will receive a charitable donation receipt for the full value of the shares.
The Essential Elements
As detailed below, the essential elements for a share to be a flow-through share under the ITA are:
- it must be issued by a "principal-business corporation" pursuant to a written agreement under which the issuer agrees to incur CEE and/or CDE and renounce it in favour of the investor,
- the incurring of CEE and/or CDE and renunciations must be within prescribed periods, and
- it cannot be a "prescribed share."
Expenses That Can be Renounced
In the mining context, CEE includes:
- expenditures made for the purpose of determining the existence, location, extent or quality of a mineral resource in Canada (grassroots CEE), and
- expenses 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.
In the mining context, CDE includes:
- expenses in sinking or extending 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
- the cost of certain Canadian resource property, including rights to prospect, explore, drill or mine for minerals in a mineral resource in Canada.
CEE is generally eligible for a 100% deduction, while CDE is generally eligible for a 30% deduction on a declining balance basis.
The issuer of a flow-through share must be a "principal-business corporation," defined as a corporation, the principal business of which includes mining or exploring for minerals. A principal-business corporation also includes a corporation, all or substantially all (interpreted by the Canada Revenue Agency to be at least 90%) of the assets of which are shares or debt of "related" principal-business corporations. This permits a holding company to qualify as a principal-business corporation and issue flow-through shares to investors; however, as the holding company will not incur CEE or CDE directly, it will be necessary for it to enter into a "back-to-back" flow-through share arrangement with an operating subsidiary in order that the subsidiary renounce CEE or CDE to the holding company that it in turn can renounce to investors.
Agreement in Writing
A flow-through share is a share issued pursuant to an agreement in writing between the investor and the principal-business corporation under which the principal-business corporation agrees to incur CEE and/or CDE at least equal to the consideration for which the share is to be issued. In addition, the principal-business corporation must agree to renounce, in prescribed form, CEE and/or CDE to the investor in an amount not greater than such consideration. The definition of flow-through share also contemplates that rights to acquire shares (for example, special warrants exchangeable for flow-through shares) can qualify as flow-through shares, but this complexity is ignored for the purpose of this note.
The maximum period that flow-through agreements can provide for incurring CEE or CDE is for the period that begins on the date the agreement is made and that ends 24 months after the end of the month in which the agreement is made. The renunciation must be made not later than the end of February of the year following the year in which the 24-month period ends.
Periods in Which CEE/CDE Must be Incurred and Renounced
The first general rule is that only CEE or CDE incurred after the flow-through agreement is entered into between the issuer and the investor can be renounced.
A second general rule is that expenditures cannot be renounced as of a date earlier than they were incurred by the principal-business corporation (although an important exception is described below). For example, if a flow-through agreement was made on January 1, 2008, the principal-business corporation could renounce on June 30, 2008, effective as of May 31, 2008, expenditures made by the principal-business corporation from January 1, 2008 to May 31, 2008. However, it would not be possible to renounce on June 30, 2008 expenditures to be incurred after June 30.
There is, however, an exception to the second general rule that is commonly used to make offerings of flow-through shares more attractive to investors. This "look-back rule" provides that CEE to be incurred in a calendar year can be renounced as of December 31 of the preceding year (thereby allowing investors to deduct the CEE for their preceding tax year filings). A number of conditions must be satisfied. For example, in the case of an agreement pursuant to which expenditures to be incurred in 2009 are to be renounced effective as of December 31, 2008, the conditions would include the following: (i) the consideration for the share must be paid by the investor to the principal-business corporation on or before December 31, 2008 (although it is not necessary that the share in fact be issued by that date, and the payment can be deposited by the principal-business corporation in escrow), (ii) the expenditures to be incurred must be "grassroots CEE," (iii) the investor and the issuer must deal at arm’s length for tax purposes throughout 2009, and (iv) in January, February or March, 2009, the principal-business corporation must renounce the expenditures as of December 31, 2008. Note that, in this example, if the principal-business corporation relies on the "look-back rule," it will effectively be subject to an interest charge to the extent that it does not incur all of the expenditures by the end of February 2009 and will be subject to a significant penalty if it does not incur all of the expenditures by December 31, 2009. If all of the expenditures that were to be incurred in 2009 are not in fact incurred by December 31, 2009, the CEE renounced to the investor will be reduced to the amount actually incurred.
The Shares Cannot be Prescribed Shares
The definition of flow-through share excludes a "prescribed share." The prescribed share definition is lengthy and complex and there is relatively little case law or administrative guidance as to its interpretation. The thrust of the prescribed share definition is that a flow-through share must be a "garden variety" common share and the investor must be fully at risk for his or her investment. Accordingly, redeemable preferred shares, shares that carry a fixed dividend entitlement, shares issued where there are arrangements to protect an investor from loss, etc. will be prescribed shares and cannot be flow-through shares. Terms for proposed offerings must therefore be carefully reviewed to ensure that any "bells and whistles" to be offered to investors do not inadvertently result in the loss of flow-through benefits to investors.
The prescribed share rules, however, do allow some agreements to sell the share at fair market value without tainting the share. Fair market value is to be determined without regard to the effect of the agreement (i.e., without regard to any increase in value that the liquidity afforded by the agreement creates). The rules also allow the investor to be indemnified by the principal-business corporation for the amount of taxes payable by the investor (but, it is important to note, not interest and penalties) if a renunciation by the principal-business corporation pursuant to the flow-through agreement is reduced or is not made.
Filing of Prescribed Forms
The flow-through share rules envisage numerous forms being filed by the principal-business corporation, including a form relating to the entering into of the flow-through agreement and a form relating to each renunciation.
If the investor is a partnership, forms must be filed by the partnership in respect of the CEE/CDE it allocates to its partners.
Not a Tax Shelter
Note that a flow-through share is specifically excluded from the definition of "tax shelter," so that it is not necessary for a promoter to obtain a tax shelter identification number or comply with other requirements applicable to tax shelters. The carve-out does not, however, extend to partnerships established to acquire a portfolio of flow-through shares. Such partnerships may be tax shelters, depending on the facts (so that a tax shelter identification number may be required in respect of the interests in the partnership, even if not required for the flow-through shares in which the partnership will invest).
Investors who are individuals may qualify for a 15% non-refundable federal tax credit in respect of certain flow-through mining expenditures renounced under a flow-through agreement. The 15% credit reduces the amount that the investor can claim as CEE and must be included in income in the following year if sufficient CEE is not incurred in the following year.
Individual investors resident in Ontario may qualify for a 5% investment tax credit against their Ontario taxes for mining expenditures renounced to the investor that qualify for the 15% federal credit if the expenditures are incurred in Ontario.
Individual investors resident in Québec may be entitled to additional deductions in their Québec tax returns in respect of certain CEE incurred by a principal-business corporation in Québec and renounced to the investor. Depending on the circumstances, 125% or 150% of the CEE renounced will be treated as CEE of the investor. In addition, for Québec tax purposes, in certain cases part of the capital gain realized by the investor on the sale of the flow-through shares may be exempt from tax. Despite these additional benefits for individual investors in Québec, however, issuers are often reluctant to renounce expenditures such that they qualify for the additional deduction. The principal reason is that, for Québec tax purposes, a corporation that renounces the expenses will lose the benefit of certain refundable tax credits. In addition, if the investor is a limited partnership and not all of the members of the partnership are Québec residents, the additional deductions are not relevant to the members outside Québec yet the corporation loses the refundable tax credits on the entire amount renounced. On the negative side for investors, for Québec tax purposes, up to 50% of CEE deemed to be incurred outside Québec may be added back to an investor’s income if the investor does not have sufficient eligible investment income, thereby partially offsetting the deduction for CEE.
CDE CEE flow-through shares Income Tax Act investor mining Prescribed Forms tax shelter