Flow-through investing can benefit different types of investors
At this time of year investors think about taxes so it’s not surprising to see several flow-through share offerings on the market. Flow-through shares are one of the last legitimate tax-assisted investment vehicles available to Canadians that can help save or defer taxes.
Flow-through shares were originally designed to expand Canada’s natural resources sector. Canadian resource companies in the mining, oil and gas, and renewable energy and energy conservation sectors can raise capital through flow-through share offerings and use the proceeds to finance exploration and development activities.
The concept is fairly straightforward. Early-stage Canadian resource companies can fully deduct certain exploration expenses, which transfer or “flow through” to their investors who then use these special deductions against their own income. The deductibility can be up to 100% of the amount invested.
Investors gain an immediate tax deduction in the year they invest in flow-through shares. This reduces income taxes and, when the investor eventually sells the position, any gains are capital gains and taxed more favorably than income. If the investor has capital losses from previous years, they can be used to offset or eliminate the gains on the disposition.
There are many flow-through share offerings and choosing can be time consuming. One of the simplest methods of gaining exposure is to invest in a flow-through limited partnership (FTLP), a portfolio of flow-through shares actively managed by professionals. Administration is simplified and the diversification provided by an FTLP spreads the risks.
It’s best to purchase FTLPs early in the year. The better FTLPs open for purchase early in the year as it improves the probability of allocating 100% of investors’ funds to quality resource issuers. The investor who waits increases the chance of purchasing a product that went to market based on investor demand but contains lower quality flow-through issuers.
FTLPs that open for purchase later may also find there are not enough flow-through issues to place 100% of investors’ funds. If all of the investors’ capital cannot be placed, they won’t get a tax deduction on 100% of their initial investment and the intended purpose of the flow-through investment will not be met.
Flow-through investing is most beneficial for high-income earners who are taxable at the highest marginal tax rate, or those who expect to be taxable at lower rates in the future. Recipients of large taxable lump sums, such as an inheritance, can use the FTLP to shelter the payment from taxes.
Retired seniors whose income is above the Old Age Security clawback threshold may be able to use flow-through investing to reduce taxable income and maximize OAS benefits. However, there is risk and seniors should very carefully weigh the suitability of these investments relative to their particular personal circumstances.
Investing in the resource and development sector involves risk and anyone contemplating flow-through shares, whatever their tax situation, should be risk tolerant. Many of the companies will be small cap with low market liquidity and no history of earnings. If a company fails in its goals, there is a potential for losses to outweigh tax savings. Be sure you fully understand the associated risks before embarking on this kind of investing.
Kim Inglis, CIM, PFP, FCSI, AIFP is an Investment Advisor & Portfolio Manager with Canaccord Wealth Management, a division of Canaccord Genuity Corp., Member – Canadian Investor Protection Fund. www.reynoldsinglis.ca. The views in this column are solely those of the author.