The Basics of Flow Through Investing.
Flow through shares, or flow through investing, is a complex investment vehicle available to Canadians who wish to invest in the resources sectors. They were created in the 1950’s as a way to encourage energy exploration and development in Canada. This strategy can offer investors a powerful tax advantage, but as all good things, it doesn’t not come without some significant risk.
What is Flow Through Investing?
Canadian companies in the resource sector (mining, oil etc.) are incentivized by the government to both develop existing energy resource and explore new energy resources. This incentive allows for certain companies to fully deduct exploration and development expenses. In effort to raise capital for exploration, these companies offer a special type of common share known as a flow through share. These shares allow companies to pass on, or flow through, the allowable deductions to investors.
How Does the Tax Deduction Work?
When you purchase a flow through share you become eligible for the related tax deduction. There are two different deductions available from flow through shares: the Canadian Exploration Expense (CEE) and the Canadian Development Expense (CDE). The CEE and CDE deductions are flowed through to investors each year by the energy company’s corporation. The investors can then apply these deducts to their income on their tax return. Typically, investors can deduct the full amount of their investment.
Investors need to be aware of the tax consequences of flow through shares as they can be significant. Once the 2-year holding period comes to an end, flow through shares are eligible to rollover into a mutual fund on a tax deferred basis. At this time the shares become accessible to the investor and can be liquidated. When the mutual fund is sold a capital gain will be triggered. As the ACB of these shares are $0, this can result in a substantial tax bill. Careful planning is required.
What Are the Risks?
Flow through shares are considered to a be a tremendously high-risk and speculative investments. Typically, these shares are issued by new, unestablished companies that hope to be successful in the resource sectors and need capital to fund their exploration ventures. This makes them suitable for high network individuals with established and diverse investment portfolios.
One of the main risks associated with these investments is their lack of liquidity. There is generally a mandatory holding period of 2 years for the shares. In this time there is no way to access your capital or sell your investment, no matter how well or poorly it is doing. Investors need to be prepared to give up access to their cash, as well as be prepared to potentially lose it.
Flow through investing can be an exciting and tax advantaged investment opportunity for the right investor. However, it is essential to understand the risks involved. As always it is best to work with a trusted financial professional to determine if this investment is appropriate for your portfolio. Let’s schedule a meeting.