Flow-through shares: a history

The recent success of so-called “flow-through” shares may make them seem like a new idea in Canada but this financing device found its way into the business lexicon here roughly 50 years ago with company-to-company “flow-through” shares. It took another 18 years before the federal government decided to encourage individuals to help junior oil and gas companies fund grassroots exploration by allowing companies to transfer unused income tax deductions to investors under a flow-through share agreement.

In the early 1970s, oil exploration in Alberta was heating up, and junior oil and gas explorers had little or no revenue but millions in capital expenses that someone figured could be passed on to investors. In 1972, the federal government introduced flow-through shares at a deduction rate of 20% per year over five years. Under this scheme, without taking into account any gains in share value and at a marginal tax rate of 50%, an investor putting $100 into flow-through shares would be risking $90 of his own money in the first year. In each subsequent year, he would receive an additional $10 until it tallied to $50, or the maximum amount an investor could lose on a $100 investment. This is what made flow-through work: it reduced the risk for investors, thereby encouraging them to take a speculative position in junior companies.

Two years later, in 1974, the deduction rate jumped to 30%, and by 1976, flow-through shares reached a 100% deduction, or much the same version we’re familiar with today, minus added incentives.

At that time, junior miners were slow to adopt flow-through as a financing tool, and it took the better part of a decade before they began to follow their oil and gas cousins. The movement started to gain momentum in 1981 when the feds started taxing proceeds from the sale of flow-through shares as capital gains, or profits obtained from buying or exchanging a long-term asset used to operate a business.

In 1984, the Canadian government, in an effort to put some wind in the sails of mineral exploration, added the 4-year Mining Exploration and Depletion Allowance (MEDA) to its base flow-through shares. MEDA provided investors with a 33.3% tax deduction above the 100 cents on the dollar that flow-through provided. For instance, if an individual invested $100, and that company performed mineral exploration eligible for MEDA, at a marginal tax rate of 50%, the investor would ultimately expose $33.33 of his own money. If the value of the shares increased, it was considered gravy, but if they were worth nothing at the end of the day, the investor lost only $33.33.

MEDA stimulated the economy at a time when metals prices were reasonably robust. Mining companies of this era also benefited from the federal government’s introduction, in 1985, of the tax-free $100,000 life-time capital gains allowance, which meant proceeds from the sale of flow-through shares would go untaxed (up to $100,000). Investors did not need to be told twice. After a slow start in 1984 and 1985, MEDA helped raise more than $1 billion in both 1986 and 1987. But its success also proved to be its demise.

Under the MEDA system, companies had until the end of February to spend money raised in the previous year. This prompted excessive non-compliance — not fraud, per se, but contractors could be found issuing receipts for February work performed in late spring. “The work got done, but it certainly wasn’t done in compliance. But nobody ran off to Mexico with the money either,” explains David Comba, director of issues management with the Prospectors & Developers Association of Canada (PDAC). “What people remember from the mid-1980s was that there was a tremendous amount of money not well spent because you were in a flat-ass panic to get it spent. Geologists were drilling holes without having had time to log the core properly, and they were spotting the next hole without really understanding what they got in the last hole — so it was very inefficient.”

The feds soon killed MEDA, but original flow-through shares lived on.

In 1988, the federal government replaced MEDA with the Canadian Exploration Incentive Program (CEIP), effectively a 30% grant. CEIP was short-lived, though, as the government spent more administering the program than it reaped in benefits. CEIP was axed after less than a year.

For the next 12 years, flow-through shares — without any added incentives — would be the only device helping investors help juniors raise funds, albeit with one significant difference: the look-back rule. Under this caveat, companies had a calendar year in which to spend the money they raised the year before. Thus if a company raised money in 2004, expenses incurred until the end of 2005 were eligible for flow-through financing, minus a relatively small penalty. This meant no more non-compliance, but it didn’t really matter by the late 1990s, when juniors had little money to spend.

Fast forward to the fall of 2000 and low metals prices across the board. In October of that year, the government launched the 3-year Investment Tax Credit for Exploration (ITCE), or “super” flow-through shares. The program has since been extended twice.

ITCE is a credit equal to 15% off the bottom-line portion of federal income tax for eligible grassroots mineral exploration expenses. Four provinces provide a “top-up,” otherwise known as an additional incentive, which works in harmony with the federal flow-through program. British Columbia gives a credit worth an extra 20% off the bottom-line portion of provincial income tax; Saskatchewan, 10%; Manitoba, 10%; and Ontario, 5%. Quebec supplies a deduction versus a credit, but it works out to be the most generous flow-through scheme of all the provinces. For instance, on a $100 investment, the investor would risk roughly $28 of his own money.

The PDAC, which lobbied the federal government on behalf of mining to extend the “super” flow-through buying period, estimates that the ITCE program has helped raise more than $800 million for mineral exploration in this country since October 2000 and resulted in slightly less than two mineral discoveries per month.

The recent federal budget extended the ITCE by one year. The buying period for shares eligible for the ITCE will end Dec. 31, 2005, 12 months longer than first planned.

“I think flow-through has been very important to the mining industry in Canada,” says Ron Gagel, CFO of Toronto-based Aur Resources. “It stimulates exploration in Canada, which means more discoveries, which means more jobs.”