What on Earth are Flow-Through Shares?

Out of RRSP room and itching for a tax deduction?

Well, you could use Flow-Through Shares (FTSs).

I'm not saying you should - but you could.

• What are they?
• What are the benefits?
• What are the risks?
• Who should use them?

Here we go.

1. What are they?

Companies in the mining and renewable energy industry must raise money for exploration and development.

But they are usually small, risky, and unprofitable businesses and have business expenses they can't use for tax purposes.

Enter FTSs.

The companies issue shares from their treasury at a premium to investors.

In exchange, they "flow through" their exploration and development expenses to the investor since the company can't use them.

The investor gets a tax deduction and the company raises capital.

A win-win.

The company has 24 months (soon to be 36 months) to use your money for qualifying expenses.

But you get the tax deduction when you buy them - before they've even spent the money.

These expenses are Canadian Exploration Expenses (CEEs) or Canadian Development Expenses (CDEs).

You can buy FTSs directly or through a fund or limited partnership.

The latter lets you diversify your FTS portfolio, which can reduce your investment risk.

In either case, the shares are locked up for a couple of years, meaning you can't sell them even if you want to.

Some funds have special features like added liquidity - some even let you sell the next day, completely eliminating the market risk.

These features come at an additional cost, and there could be tax risk since you're isolating the tax benefits.

The jury is out on that.

FTSs have a long history in Canada, going back to 1970, and they are written right into the income tax act.

It's an incentive the Government provides to encourage investment in these sectors.

They recently eliminated oil and gas flow throughs in an effort to meet climate goals.

1. What are the benefits?

When you buy FTSs, you get a tax deduction equal to the cost of the purchase.

Say your income is $250k, and you buy $50k of FTSs.

You get a $50k deduction and pay tax only on $200k of income.

Just like an RRSP contribution right?

Not so fast.

Because you got a deduction for the full cost of the shares, the adjusted cost basis (ACB) is $0.

That means when you sell the shares, the full market value is considered a capital gain.

Only half of your capital gains are taxed though, so it's pretty tax efficient.

You might also get additional Federal and Provincial tax credits.

The Mining Exploration Tax Credit (METC) is only available when companies are engaged in grassroots exploration projects.

If it qualifies, it's a 15% non-refundable Federal tax credit, going up to 30% this year.

Some provinces also offer the METC.

In BC, for example, it's 20%.

In Ontario, it's 5%.

Remember - a tax credit reduces your taxes owing, whereas a deduction reduces the income on which you pay tax.

But the METC is weird.

When you claim it, you must add it to your income the following year.

Say you got a $10,000 METC for 2023.

That's a $10,000 reduction in your tax bill.

But in 2024, you must add $10,000 to your income and pay tax on it at your marginal rate.

The METC can also be carried back up to 3 years or forward up to 20 years.

And it's only available for individuals.

While you can buy FTSs in your corporation, you won't get the METC - but you'll still get the deduction for buying the shares.

Whether this makes sense to do in your corporation depends on the type of income you're earning.

Active income is lightly taxed relative to passive investment income.

So a deduction against active business income is less valuable.

Note you wouldn't buy these in an RRSP or a TFSA since you wouldn't get the deduction.

So these are useful only in personal non-registered accounts, corporate accounts, and trusts.

And again, only individuals can get the added tax credit bonus.

You can also use FTSs for charitable giving.

In addition to the tax benefits we've already discussed, you can donate your FTSs shares to a registered charity.

Doing so gets you a charitable donation tax credit, reducing the cost of the gift by 80%-90%.

So overall, buying FTSs converts your income into capital gains, and you might get significant tax credits on top of that.

Sounds amazing right?

If we left it there, it would be.

But remember, you just bought a risky stock that you can't sell for 2 years.

1. What are the risks?

Like any investment, the risk is that you could lose some or all of your money.

And since you're buying a highly speculative investment in an unprofitable, undiversified company - that risk is real.

So the tax benefits can be lost to market risk.

You can also encounter another problem: Alternative Minimum Tax (AMT).

The details are beyond the scope of this post (I'll write a post on this for next week), but if you reduce your taxable income too much, CRA says "lol" and calculates your taxes differently.

AMT isn't the end of the world - if you pay it, you can recover it over the next 7 years as long as you have taxable income.

But it can be a nasty surprise if not accounted for beforehand.

So make sure your accountant is involved if you're buying FTSs.

1. Who should use them?

High-income earners with a diversified portfolio, a penchant for risk, and a strong stomach.

They are often used to offset a one-time income spike, like a performance bonus or a property sale.

The tax benefits are real, but so is the market risk.

Here's a cool chart showing the net cost of $1,000 of FTSs in each province.

I rarely recommend them, but there are cases where it makes sense.

If you're comfortable with the market risk and want to reduce your tax bill - it's worth a conversation.