Tax Angles Flow-through phase-out

It is finally becoming widely recognized that Mr Wilson’s tax reform proposals will gradually reduce the tax advantages of flow- through shares so that, when the reform measures are fully implemented in 1990, flow-through shares will be a mere shadow of the vibrant financing mechanism that exists today. The proposed timetable for the withdrawal of tax incentives is as follows: Jan 1, 1988

* Reduction of top marginal tax rates reduces the tax relief obtained by deducting cee and mining exploration depletion allowance (meda).

* Capital gains exemption is capped at $100,000.

* Taxable capital gains eligible for the exemption are reduced by “cumulative net investment losses,” which include cee and meda claimed after 1987.

* Two-thirds of capital gains (rather than one-half) realized after 1987 are included in income as taxable capital gains. June 30, 1988

* Mining exploration expenses incurred after this date earn meda only at the rate of 16 2/3% of eligible expenditures. Jan 1, 1990

* Three-quarters of capital gains realized after 1989 are included in income as taxable capital gains.

There are compelling reasons for the resourceful investor to consider investing in mining exploration flow-through shares in 1987, provided the expenses will be incurred or deemed incurred (by way of the 60-day clawback) in 1987. The tax relief will be obtained at today’s high marginal tax rates and the cee and meda deductions in 1987 will not count as “cumulative net investment loss” that will cause future claims for the capital gains exemption to be deferred.

There are, or will be, a whole host of new flow-through share vehicles, generally in the partnership format, being or to be offered to meet the anticipated demand by investors for this product. Increased risk

We are concerned that the tight deadlines for raising funds (Dec 31) and carrying out the exploration work (Feb 29, 1988) will give rise to increased risk to investors. First, the expected rush to bring product to market will be the third such rush this year; there have already been the pre-budget and pre-tax- reform splurges.

There may be a question as to how many worthwhile programs planned by viable exploration companies remain to be funded. Unless promoters are very diligent, the quality of the product offered may not be as high as in previous periods.

Secondly, with the short-term frame for incurring expenses, companies may well have to carry out programs in an inefficient manner. Besides the inevitable waste of funds, this may reduce the chances of exploration success.

Thirdly, time and other pressures may cause less attention to be paid to the question as to whether particular expenditures in fact qualify for the cee and meda deductions. That is, the situation may give rise to increased tax risk. Effect complex

Finally, the effect of the tax reform proposals on an individual investor can be quite complex. Investments might be made without sufficient analysis of all the tax consequences.

The prudent investor will not rush into a flow-through share deal without carrying out the appropriate tax and investment analysis. In particular, we advise that:

1. You prepare or have prepared an analysis of the tax consequences of the proposed investment based on your own particular circumstances, including your 1988 tax position, paying special attention to the alternative minimum tax.

2. You consider the extent to which tax risk is minimized. That is, what assurance do you have that the tax deductions promised will, in fact, be forthcoming. In a flow- through fund you need to know that expenditures will be incurred in time and will qualify for the cee and meda deductions and that the administrative requirements will be met. In particular, is there to be a review of each exploration program to ensure it qualifies for cee and meda? Is there then a review of actual expenditures prior to payment? In the case of a junior exploration company it may be prudent to have the auditors of the company or an independent third party involved in this review.

3. Most important of all, you must consider the investment merits of the proposal. The income tax incentives only reduce the amount you have at risk. The recovery of the after-tax investment and the generation of after-tax income will depend on the performance of the underlying share investments. You must be comfortable with the investment risk.

Don’t get us wrong: the right flow-through share investment can still yield a substantial real return to the resourceful investor. But be careful in your evaluations. Mr Playfair and Mr Dent are tax partners with Clarkson Gordon, Toronto.