Flow-Through Share Offerings Explained - February 27th 2005
September through December is typically the most active period for Canadian oil and gas producers and mining companies to turn to flow-through share offerings in order to raise capital. Flow-through offerings can provide benefits for both companies and investors. In this article I will give a brief overview of flow-through offerings along with some of the advantages associated in participating.
Flow-through offerings are generally available only to those who invest in the oil and gas or mining industries. The Canadian Income Tax Act permits participants in this form of financing to share in the tax deduction for certain exploration and development expenses incurred by the issuing corporation. Thus, not only is the investor able to purchase a block of company paper, but he/she can utilize the tax deduction to offset other sources of income and pay less income tax. The investor can also benefit from the fact that the entire deduction can usually be claimed in the year of investment rather than in the subsequent year when the company actually spends the capital. The one downfall is that the shares generally have to be held for a 4 period (except short-form flow-through offerings). There is also generally a minimum investment level and sophistication level which participants have to comply with.
Flow-through shares significantly reduce the risk of investing in resource stocks by allowing investors to recover a substantial portion of their original investment through income tax savings. For instance, an individual in a 50% tax bracket who invests $20,000 in a flow-through offering is really only risking $10,000 since he receives $10,000 in tax deductions. This creates extra incentive for investors to purchase Canadian resource companies benefiting both the company raising the capital and the investor. Of course, investors should ultimately be seeking for flow-though offerings in solid, fundamentally undervalued resource companies with significant upside rather than just for tax-savings but the tax savings in and of themselves can be quite enticing.
One must keep in mind that for income tax purposes, the cost of a 100% flow-through share is always nil. The full proceeds upon disposition of the shares are subject to income tax as a capital gain which is currently taxed at 50%. This again can benefit investors as tax deductions associated with the flow-through shares are used to offset income that is fully taxable, while only 50% of the subsequent capital gain is actually taxable.
Example 1: Mr. Deduct is tired of paying an extraordinary amount of tax as he makes $140,000 per year and is in a 50% tax bracket. In order to reduce his taxable income, Mr. Deduct purchased 100,000 flow-through shares in company ABC at $0.40 per share. This will reduce his taxable income to $100,000 and will save him $20,000 in tax. One year later Mr. Deduct decides to sell his ABC shares at $0.50 per share. His capital gain will therefore be (100,000 shares at $0.50 = $50,000) Note that the full proceeds of the sale are recognized as a capital gain instead of just the capital appreciation since the $40,000 deduction was already claimed in the year of purchase. Mr. Deduct will therefore pay tax on 50% of the capital gain or $25,000. As he is in a 50% tax bracket his tax bill will be $12,500. Mr. Deduct therefore received $50,000 from the sale of his shares, minus the original investment of $40,000, minus the tax owed of $12,500, plus the tax saving of $20,000. He ends up making $17,500.
Example 2: Using the above example, let's say that Mr. Deduct ended up selling his shares at $0.40 (the same price he paid for them). In this case he would still have $20,000 in tax savings but his capital taxable gain would be 50% of $40,000 or $20,000. In a 50% tax bracket this would equate to tax of $10,000. Mr. Deduct would therefore receive $40,000 from the sale of his shares, minus the original investment of $40,000, minus the tax owed of $10,000, plus the tax saving of $20,000. He ends up making $10,000 even though he sold the shares for the same price he paid for them. In fact the shares would have to be sold at below $0.27 before Mr. Deduct would actually lose money.
Investors will have to determine what tax bracket they are in to determine the level of tax savings available to them by participating in flow-through share offerings. As a general rule, the following list represents the at-risk capital for investors in different tax brackets (or in other words investors can sell at the following discount to purchase price before actually losing any capital with taking tax savings into account):
50% tax bracket - 66% of original investment
40% tax bracket - 75% of original investment
30% tax bracket - 81% of original investment
20% tax bracket - 89% of original investment
Please note that the above examples are for Canadian investors only and do not take into account provisions such as alternate minimum tax which may affect some investors. As such, investors should contact a professional financial planner or accountant before participating in flow-through share offerings.