Editorial Capital gains should reflect reality

With the wave of a hand Finance Minister Michael Wilson has swept away the Canadian Exploration Incentive Program (CEIP), a system of grants upon which many mineral exploration companies had based their plans for the immediate future. No one should mourn the passing of CEIP. It was an awkward system, reluctantly put in place, half-heartedly administered and never fully accepted by the industry. Furthermore, it was an anachronism, referred to in the budget papers as “the last remaining subsidy to business that is open ended and demand driven.” With the federal government’s deficit becoming such a critical problem, CEIP clearly could not continue.

At the same time, there’s no doubt that the mineral exploration industry has been treated shabbily by the federal government in this budget. Even though the writing was on the wall for CEIP, the way it was handled was completely insensitive to hardships the industry already faces. Junior companies in particular had taken the government at its word that it would be given six months’ notice prior to any changes being made to the CEIP program. Under the guise of budgetary secrecy, that warning was not given and the government now says it will merely change the law so that the six months’ notice is not required.

Apart from how easily Ottawa seems to be able to dismiss the exploration industry, however, there is a real failure on the part of the ministry to recognize reality. This industry has always relied on incentives to investors to compensate for the high-risk nature of mineral exploration. Ideally, that incentive is market-driven with no government intervention, simply the potential for high capital gains.

But the government has taken away that incentive, too, through its capital gains tax.

If the government has any intention of maintaining a healthy minerals industry, an industry that currently generates about $17 billion (excluding mineral fuels) in export earnings each year, it must recognize that mineral exploration today is essential. To carry out that exploration, the industry needs to raise money from investors, but investors have to see some reward commensurate with the risk of investing before they’ll put up their cash.

A “handout” such as those offered in the CEIP grants is not the answer. It was the taste of welfare in such grants that made CEIP difficult for many in the industry to swallow, so much so that even though the government originally expected to hand out $210 million through CEIP in 1989 it now expects that only $160 will be spent.

What should be considered is a means of renewing that original incentive for investing in mineral exploration — the opportunity for capital gains. A good place to start might be in adjusting the cost base of flow-through shares.

Currently, flow-through shares are deemed to have a purchase value of zero, regardless of what the investor paid. So, even if an investor realizes a capital loss when he sells his shares, he’s taxed as if it were a capital gain.

For example, given a 45% tax rate, $100 invested in flow- through has an after-tax cost of $55. If the shares are later sold for $90, the rules now say the entire $90 should be treated as a capital gain. With an adjusted cost base, however, the capital gain would be $35 — the difference between the after-tax cost and the sale price.

If the rules were rewritten to reflect reality, that there is in fact a cost for flow-through shares, the capital gain upon which the investor is taxed would be reduced. That, in turn, would reduce the risk of investing in mineral exploration and go some way toward finding those deposits the mining industry will need in years to come.

The idea of an adjusted cost base for flow-through shares is not new. The Prospectors and Developers Association of Canada has advocated such a change since 1988 when Ottawa announced it was ending the Mineral Exploration Incentive Program.

Ottawa has always said that an adjusted cost base to alleviate the capital gains tax burden on mineral exploration investors was too generous on top of other incentives. Now, however, with MEDA and CEIP gone, it makes no senses for Revenue Canada to continue the fiction that flow-through shares have no cost.

In a letter to the PDAC earlier this year, Wilson said he was willing to consider such a change. We urge him to do so, and quickly.