Survival of flow-through debatable under tax reform

The investment community appears divided over how recent tax reform provisions will affect the future of flow-through share financing for mineral exploration. Analysts are scratching their heads over new rules which limit the ability of investors to shelter their flow- through shares from capital gains tax.

A recent analysis by Richardson Greenshields of Canada, reported in the Globe and Mail’s Report on Business, does a good job of distorting the issue instead of explaining it.

The analysis calculates returns now and in 1990 for flow-through investors in the top bracket. It concludes that a return now of 57% will dwindle to only 4% in three years as a result of tax reform provisions.

While the analysis correctly takes into account the elimination of earned depletion (causing the overall tax writeoff to drop to 100% from 133% for every dollar invested), it presumes capital gains tax will soon be payable on the proceeds of all sales of flow-through shares.

However, tax experts have told The Northern Miner that most investors in flow-through will continue to be able to claim capital gains exemption. (Capital gains tax is levied on profits from the sale of shares and bonds, among other assets.)

The Richardson analysis states that “investors can currently sell their flow-through shares and claim exemption from capital gains taxes on the proceeds of that sale (provided the investor’s lifetime exemption, to be set at $100,000, has not been used up).”

True enough.

But it adds that “for investments made after Jan 1, 1988, the proceeds of sale will not be eligible for this exemption.”

Not necessarily true.

According to tax reform provisions regarding “investment losses,” the degree to which flow-through shares can be sheltered from capital gains tax will be limited after 1987. But the tax will only apply to investors who have cumulative “investment losses” in excess of their investment income. Deductions for Canadian Exploration Expense (cee), which flow through to the investor, contribute to investment losses.

However, most people who buy flow-through shares are high- income earners who are able to offset any investment losses with various sources of investment income (from dividends, interest on bonds, etc.), says Henry Pawlak, an income analyst with the Finance Department (Tax Policy Branch).

“These investment loss rules essentially take all your investments — positive and negative — and put them in one pot. Included in that pot are some of the cees. Beginning in 1988, if that pot is negative on an ongoing basis and you realize a capital gain, a reduction will occur in the lifetime capital gains exemption of $100,000 which you could claim in that year for flow- through share investments. But you won’t be able to claim the exemption if you have negative investment losses.”

Mr Pawlak describes the new provisions as “an attempt to prevent the conversion of income into tax- free capital gains.

“What we’re saying is that cees and other things will continue to be deductible. But if you realize a capital gain, you can only claim the exemption above the investment loss that you have incurred since 1988.”

He rejects the Richardson paper for presuming the flow-through investor with a capital gain has investment losses in excess of positive income from other investments. Robert Parsons, tax expert for the Prospectors and Developers Association of Canada, is also skeptical of the analysis.

“The statement by Richardson Greenshields (that proceeds from the sale of flow-through shares will no longer be eligible for exemption from capital gains tax) is a gross over-simplification. There are a great many investors out there with substantial investment income who will continue to be eligible for the capital gains exemption with respect to flow-through investment. All that’s required is that they be able to cover their cee deduction with investment income — then they’re away to the races.”

Both Ray Goldie and Arnold Hochman, authors of the Richardsons analysis, do not agree that most flow-through share investors are able to offset most investment losses with various sources of income.

Neither does Gerry McGrath, vice-president finance of cmp Funds Management, one of the five major flow-through funds for raising exploration dollars.

“The Finance Department is living in a dream world if it thinks the average flow-through investor has sufficient investment income to offset his cee. The average purchase in 1987 deals was $16,000. That means one’s investment income, before carrying costs, would have to exceed $16,000 in order to claim capital gains exemption for flow- through investments — which is unusual.

Mr McGrath describes the average flow-through investor as either self-employed or professional with taxable income in excess of $63,000. He agrees that the investor usually has other income sources but not enough to offset his cee.

He agrees with Messrs Goldie and Hochman when they say tax reform will end up killing flow- through.

Basil Kalymon, a University of Toronto professor and author of an extensive analysis of flow-through, isn’t so sure. He believes most flow- through investors have diverse portfolios of investments and, therefore, enjoy substantial investment income. But he warns that the benefit of flow-through shares as a tax shelter will nevertheless be reduced as a result of tax reform.

In addition to the phase-out of earned depletion, bad omens include the planned cutback in tax- free capital gains to $100,000 (from a planned $500,000) and the increase in the rate at which capital gains are taxed, Prof Kalymon says. Currently any gains that are higher than the $100,000 exemption are taxed at a rate of 50%. The Finance Department wants this increased to 66 2/3% in 1988 and 75% for 1990 and beyond.

Mr Hochman argues that tax reform provisions have seriously reduced the two components which make up an investor’s rate of return: tax savings and net capital gain after paying capital gain tax.

“When selling flow-through shares in 1990, capital gains will be taxed at a much higher rate than today (75% compared to 50%). So, in most cases, the investor ends up paying far more capital gains taxes and the value of his tax deduction is worth less.

“Furthermore many investors will have used up the capital gains exemption in full by 1990, so that the impact of higher capital gains tax payable at that time is significant.”

Messrs Hochman and Goldie admit they erred in their analysis by not taking into account whether or not the investor has a net investment loss (a revised version is in the works). But they stand by their conclusion that flow-through will likely die by 1990.

The Richardson report also suggests that a rush of financings in 1987 may raise more than $1 billion.

“The net result of the tax reform package, therefore, could be to create a short-lived, irresponsible boom in mineral exploration, to be followed by a return to the depressed conditions of the early 1980s.”