Tax Angles Flow-through was in trouble

The Tax Reform proposals, when taken as a package, would have dealt a crippling blow to flow-through financing for junior mining companies:

1. The reduction in marginal tax rates would make any tax shelter financings less attractive.

2. The availability of the capital gains exemption, especially important since flow-through shares have no cost base, was capped at a lifetime limit of $100,000 of capital gains.

3. The portion of a (non-exempt) capital gain included in income as a taxable capital gain increased to 66 2/3% in 1988 and is to increase to 75% in 1990.

4. Taxable capital gains after 1987 must be included in income (not eligible for the exemption) to the extent of the taxpayer’s Cumulative Net Investment Loss (CNIL) account — and 50% of CEE claimed after 1987 is added to the CNIL account.

5. The bonus deduction for Mining Exploration Depletion Allowance (MEDA) was to be reduced from 33 1/3% to 16 2/3% for expenses incurred after June 30, 1988 and to CNIL for expenses incurred or deemed incurred after 1989.

Even without the proposed reductions in MEDA, the economics of investing in flow-through shares deteriorated drastically after 1987, and would have deteriorated even further after June 30, 1988. (See hard copy for tables.)

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There was still room for the flow- through funds to offer a reasonably attractive investment package, provided the CEE was to be incurred by June 30, and thus earn MEDA at 33 1/3% of eligible expenditures. However, the proposed reduction of MEDA to 16 1/3% for expenses incurred after June 30 together with the general malaise in the markets generally, meant there was virtually no activity in arranging financing for work to be done after June 30.

The exploration industry, and business organizations and communities dependent upon that industry, increased their efforts for government action to preserve the effectiveness of this financing vehicle, and on May 3 the government announced two changes (N.M., May 9/88). Extended for individuals

First, the MEDA bonus is to remain at 33 1/3% in respect of grassroots mining exploration expenses incurred directly or indirectly by individuals in the period July 1- Dec 31, 1988. Qualifying expenses will include those incurred under flow-through share agreements or through a partnership, and will include expenses actually incurred in January and February, 1989, but deemed incurred in 1988 under the claw-back provisions applicable to certain flow-through share arrangements. Accordingly there should continue to be room for the flow- through funds and individual companies to offer a reasonably attractive investment package to individuals to fund exploration in the period July 1, 1988, to March 1, 1989. With the uncertainty as to the government’s intentions removed, let’s get on with it. New grant system

The longer-term incentive is to be a system of grants under the new Canadian Exploration Incentive Program (CEIP). This program will provide incentives of 30% on up to $10 million a year of eligible expenses incurred by qualified companies that finance grassroots mineral exploration and/or oil and gas exploration by issuing flow- through shares.

CEIP is to begin on Jan 1, 1989, for mineral exploration and on Oct 1, 1988, for oil and gas exploration — being the date when grants under the existing Canadian Exploration and Development Incentive Program are to be reduced from 33 1/3% to 16 2/3%.

The program is to provide up to $3 million in incentives per corporation or associated group of corporations for each calendar year, based on 30% of eligible expenditures to an annual ceiling of $10 million in expenditures. The incentive rate is to remain at 30% for at least two years, to the end of 1990.

To be eligible for CEIP grants, the exploration expenses must be incurred pursuant to a flow-through share agreement, and the investor and the issuing corporation must deal at arm’s length. The corporation incurring the expenses is to apply for the grant and may elect to flow the incentive payment through to the investor. An investor that is a partnership will be able to act as a conduit for its members in respect of grants it receives.

In the case of mining exploration, expenses eligible for CEIP grants will be expenses that would earn MEDA under the present rules. (Expenses eligible for CEIP will not earn MEDA.)

It seems likely that investors will require that the CEIP grants be passed on to them. In this case, the grant system should provide marginally better economics to the investor than the present MEDA rules. (see hard copy for tables)

Note that the penalty of CNIL (being 50% of CEE claimed) is actually reduced under the proposed grant system. Further, it may be possible to obtain a tax timing advantage by not having the grant become receivable by the investor until the year subsequent to the year the CEE is incurred. In fact, it appears this will happen automatically whenever the 60 day claw- back rule applies to CEE.

From the government’s point of view, the proposed CEIP system allows the base-broadening thrust of tax reform to remain intact, while targeting an incentive specifically at exploration, specifically at flow- through share financing and with an annual cap for each corporation or associated group of corporations. Whether this incentive will be as effective as MEDA in raising financing for junior resource corporations remains to be seen. We will discuss some of the nitty-gritty details of the proposed CEIP system in our next article.

Right now, the task at hand is to line up the financing necessary for exploration programs to be carried out July 1, 1988-March 1, 1989. The extension of MEDA for individuals means there is still room to create investment packages favorable to both investors and mining companies, using rules that are understood by the market place.