CEIP incentive program is not very well understood

Of the two incentives, the industry seems comfortable with the Canadian exploration expense (CEE) deduction of 100%. However, the much newer Canadian exploration incentive program (CEIP) does not appear to be well understood. Th e CEIP grant can be passed on to investors or retained by the company or some combination of both. However, when the issuing corporation retains a CEIP grant instead of passing it on to the investor, unintended inequities may result.

CEIP was generally designed as a replacement for the 33 1/3% mining exploration depletion allowance (MEDA) deduction which, when combined with CEE, provided for an aggregate deduction of 133 1/3%. The basic features of CEIP are:

1. it is tax-free;

2. it reduces CEE on a dollar- for-dollar basis; and

3. it is equal to 30% of qualifying CEE to a $3-million yearly maximum shared by associated corporations. 100% CEIP flow-through

Let us assume that Investor A, with a combined federal and provincial tax rate of 50%, subscribes for $1,000 of Corporation A’s flow- through shares. CEE and CEIP are to be fully renounced by the company in favor of the investor. As a result, Investor A should expect a $700 CEE deduction and a $300 tax-free CEIP grant. His after-tax investment would be only: $1,000 — {$300 + 50% ($700)} = $350

As intended, this result roughly parallels the former MEDA regime since under it Investor A would have the following after-tax investment: $1,000 — {50% x $1,333} = $333 100% CEIP retention

If the $300 CEIP grant is retained by Corporation A, it would only have $700 of CEE to renounce to Investor A. Therefore, Investor A’s after-tax investment would be relatively unattractive, i.e.: $1,000 — {50% x $700} = $650

To make the situation more attractive, the CEIP legislation provides a mechanism involving a seemingly odd gross-up factor of 1.428 of the share subscription proceeds. What this means is that Corporation A may expend a further $428 which it could obtain from loans or its working capital. The effect of this is to permit Investor A to receive a CEE renunciation equal to its share subscription proceeds of $1,000. The explanation for this is as follows:

1. The CEIP grant would be 30% x $1,428 = $428. It could be used by Corporation A to repay or replenish the source of the gross-up funds.

2. The CEE available to be renounced to Investor A would be equal to the CEE otherwise available ($1,428) less the CEIP grant ($428) which is $1,000. (That explains why the maximum permissible gross-up is the odd factor of 1.428.)

Investor A’s after-tax investment would be: $1,000 — {50% x $1,000} = $500 100% CEIP flow-through versus 100% CEIP retention

In either of the two cases above, we have seen that $1,000 in share subscription proceeds gives Investor A $1,000 in tax “goodies.” In the case of a full CEIP flow-through, Investor A receives a $700 CEE deduction and a $300 CEIP grant. In the case of a full CEIP retention supplemented by a full gross-up, Investor A receives a $1,000 CEE deduction. (Obviously, the after- tax result to Investor A in the former situation is preferable to the latter. As a result, there would usually be a greater share premium if CEIP is flowed through.)

50% flow-through

What happens when CEIP is to be shared, purportedly on a 50/50 basis, by Corporation A and Investor A?

From Investor A’s point of view, he would logically expect a tax result halfway between a 100% CEIP flow-through and a 100% CEIP retention. Specifically, he might expect $1,000 in tax “goodies” consisting of 850% CEE deduction and a $150 CEIP grant.

In this case, the gross-up amount would be $1,214 being an amount halfway between the $1,000 subscription proceeds and a full gross- up of $1,428. The $1,214 in exploration expenses would result in the following:

1. A CEIP grant of 30% x $1,214 = $364;

2. A CEE renunciation of $1,214 -$364 = $850;

3. In order to provide $1,000 in tax “goodies” to Investor A, a CEIP renunciation of $150; and

4. A CEIP grant remaining with Corporation A of $364 — $150 = $214.

It is therefore highly unlikely that the CEIP grant of $364 is to be shared equally by Corporation A and Investor A since it would give each $182. This would leave Investor A with tax “goodies” of $850 of CEE and $182 of CEIP for a total of $1,032, or $32 more than its share subscription proceeds. On the other hand, Corporation A would receive $32 less than it needs in order to repay or replenish its source of CEIP gross-up proceeds.

In short, what is likely intended by an “equal” sharing of CEIP grants is a sharing in the ratio of 150:214 in favor of, respectively, the flow-through shareholders and corporation. Conclusion

The practice of sharing CEIP 50/50, which appears common in the mining industry, may give rise to unintended results by excessively enriching the shareholder at the expense of the corporation. Corporations and their flow-through share investors should appreciate the interrelationship between CEE and CEIP and ensure there is a careful drafting of the flow-through share subscription agreement to bring about equitable results. All too frequently, this may not in fact be the case.

Michael Robison, Q.C., is counsel for the law firm of McCarthy & McCarthy in Calgary. He has lectured extensively on flow-through share financings.

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