Editorial Throwing out the baby with the bathwater

The following guest editorial on the vital subject of flow-through financing was written by John Playfair and Barry Dent, tax partners at Clarkson, Gordon, Toronto, and authors of a regular tax column in The Northern Miner.

Our federal government has sustained a number of self- inflicted foot wounds in recent months. To appease our neighbors to the south, we have taxed our own softwood lumber exports. The recent budget continues to increase the tax receipts from individuals while corporate tax revenues remain flat.

Now we are about to embark on major tax reform for the second time in as many decades. It is likely that this reform will give rise to more (not fewer) complexities in the tax system and impose a whole new level of tax on business revenues, thus increasing administrative costs. Unless the reform proposals are very carefully thought out, there is the potential for disaster.

Flow-through shares survived the February budget and appear to be firmly in place for the rest of 1987. However, there are two grounds for concern as to their continued existence after this year.

The first concern is the tax reform process itself. It is the government’s stated intention to broaden the tax base by eliminating or reducing tax preference deductions and thus permit a general reduction of income tax rates.

There have been broad hints that all of the tax preferences available to the mining industry are “on the table;” these include the earned and mining exploration depletion allowances, the benefit obtained where the resource allowance exceeds provincial levies, the 100% deduction available for pre-production development, the fast writeoff for new mine fixed assets and the acceleration of deductions arising from the flow-through share mechanism. In order to survive tax reform, the government will have to be convinced that a particular deduction is critical to the industry’s ongoing success.

The second concern is that, regrettably, there appears to be an increasing number of tax avoidance transactions being structured around flow-through shares. Some of these are pure tax schemes where “investors” seek only to reduce their income taxes and have no ongoing interest in a resource company.

Some deals we have seen look surprisingly like the so-called R & D “quick flips” where tax writeoffs are effectively sold to a group of investors. If these schemes proliferate, recent history suggests the government might over-react and damage the whole flow-through system in an attempt to halt perceived abuses.

The government should reflect carefully before making any changes to flow-through shares. Legitimate flow-through share financing has been a tremendous boon to the exploration industry over the past few years. Productive jobs and increased reserves of precious metals and oil and gas have been the result.

We recommend strongly that the government retain the flow- through share financing mechanism. If it is to be restricted, individuals making direct investment in common shares should still have access to flow-through treatment. These are bona-fide high risk investments which merit some form of tax incentive.

The existing rules already contain a number of safeguards to ensure that only funds actually spent on qualifying exploration give rise to a flow-through deduction. There are specific provisions to deal with inflated costs and related party charges. If diligently applied by Revenue Canada, these rules can be very effective in limiting arrangements that abuse the legislative intent.

If there is a need to weed out those who flip their shares, or rely on various put and call arrangements to limit their involvement to a pure tax recovery exercise, then all that is required would be the imposition of a mandatory holding period to ensure genuine investment intent. The basic structure is too important to dismantle.

Sure the rules, and their administration, can be tightened up. But please, Mr Wilson, don’t throw out the baby with the bathwater.