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Part 2: Tax Evaluations and Research Reports

Flow-Through Shares: A Statistical Perspective

Introduction

Flow-through shares are a financing mechanism that helps mining, oil and gas and clean energy generation corporations raise capital for the exploration and development of natural resources in Canada, and also supports the deployment of clean energy technology. When purchasing a flow-through share, an investor receives both a common share of the issuing corporation and certain tax benefits. Flow-through shares are a long-standing feature of the Canadian tax system. 

Flow-through shares occupy an important place in equity financing in Canada: from 2007 to 2012, approximately $1.4 billion per year in public equity for the oil and gas, mining and clean energy sectors was raised via flow-through shares. While they are available to all corporations incurring eligible expenses, flow-through shares assist primarily junior exploration companies whose access to other sources of financing may be limited. Through the flow-through share regime, the Government provides significant support for the exploration and development of natural resources: during the 2007 to 2012 period, federal tax expenditures associated with public and private issuances of flow-through shares, in addition to the Mineral Exploration Tax Credit (an incentive for investment in certain mining flow-through shares), averaged $440 million per year. This support is complemented by additional incentives to flow-through share investors that are provided by certain provincial governments. 

A formal evaluation of flow-through shares was published by the Department of Finance Canada in 1994. This paper provides an update of certain key results of the 1994 evaluation using stock market data from 2007 to 2012 as well as tax data. The first three parts provide background information, descriptions of trends in exploration and development spending, as well as descriptive statistics on the characteristics of flow-through share issuers and investors. The fourth part analyzes flow-through shares from the point of view of the parties to the transaction:

  • Resource companies issue flow-through shares to transfer tax deductions to investors in exchange for a premium over the market price of the corporation’s common shares. This paper analyzes the average flow-through share premium received by corporations.
  • Investors in flow-through shares receive a common share of the issuing corporation, in addition to certain tax benefits. This paper discusses the investment performance of flow-through shares.
  • The federal government forgoes tax revenues in the form of tax benefits to investors. This paper provides estimates of federal tax expenditures and how the tax benefits are allocated between flow-through share issuers and investors.

Background

The current flow-through share regime was introduced in 1986, but previous forms of the regime have been allowed by the Income Tax Act since the 1950s.1 A flow-through share is a newly issued common share of a corporation that is accompanied by an agreement to transfer for tax purposes certain expenses to an investor, up to the price paid for the share. An investor who purchases a flow-through share may deduct the transferred expenses when calculating taxable income. Individual investors who invest in a mining flow-through share may also be eligible for investment tax credits, including the federal 15% Mineral Exploration Tax Credit2 and certain provincial investment tax credits.3 Some of these generous tax attributes are partially recaptured over time: when the flow-through share is subsequently disposed of by the investor, the full proceeds of the disposition are recognized as a capital gain as opposed to only the appreciation in share value. In addition, the value of any applicable investment tax credits is generally included in income in the following year.

The tax rules do not require that investors hold the flow-through share for a certain period in order to access the tax benefits. However, many flow-through share agreements include a clause that restricts the investor from selling the shares within a specified time period, which may range from 4 months to as many as 24 months. These clauses are aimed at preventing downward pressure on share prices when investors seek to sell the shares after taking advantage of the tax benefits. In addition, many flow-through shares are issued via private placement. In general, securities regulations require a 4-month hold period for shares issued under a private placement.

There is no tax benefit that directly accrues to the corporation as a result of issuing flow-through shares. In fact, to the extent that a corporation eventually becomes profitable, the inability to use the expenses transferred via flow-through shares to reduce taxable income implies that the tax burden would be higher once the corporation becomes profitable than it otherwise would have been. The following expenses may be renounced to investors via flow-through shares:

  • Canadian Exploration Expenses (CEE)—deductible at 100%;
  • Canadian Renewable and Conservation Expenses (CRCE)—deductible at 100%; and
  • Canadian Development Expenses (CDE)—deductible at a 30% rate on a declining-balance basis.4

Under the general rule, expenses must be incurred by the corporation within 24 months after the flow-through share agreement has been entered into, and they must be renounced before March 1 of the year that follows that 24-month period. An important exception to this general rule is the “look-back” rule, which allows the corporation to transfer the expenses effective as of the year in which the flow-through share agreement is entered into, but before actually incurring the expenses. Under this rule, the company is required to incur the expenses before the end of the following calendar year. In the event that a company issuing flow-through shares does not incur the exploration or development expenses it undertook to incur within the prescribed timeframe, it is required to adjust the renunciation made to flow-through share investors. In addition, the company is required to pay a charge equal to 10% of the balance of unexpended renunciations. This charge recognizes the costs incurred by the Government in reassessing the investors. It also deters companies from renouncing expenses in excess of the amounts they will actually incur and thus reduces the likelihood that investors will unexpectedly be denied the deductions they previously claimed.

Trends in Exploration and Development

This section considers exploration and development activity since the 1970s, first in the mining sector and then in the oil and gas sector.

Mining Sector

Chart 1 compares trends in inflation-adjusted exploration and deposit appraisal expenditures in Canada in the mining sector to mineral and metal prices from 1972 to 2012, as well as the mining stock index. 

As shown in Chart 1, exploration and deposit appraisal spending in the mining sector has been volatile. It was relatively low in constant dollar terms in the 1970s, before increasing at the beginning of the 1980s. After that it fell steeply and remained relatively subdued through the 1990s and early 2000s. The period since 2004 has generally been characterized by historically strong exploration and development spending. Available preliminary data for 2012 suggests that exploration spending has softened more recently.

Mineral and metal prices are known to be an important factor in investment decisions in the mining sector. Throughout the period from 1972 to 2012, trends in exploration and development spending were closely correlated with mineral and metal prices. Exploration and development spending by “junior” mining companies5 seems to be particularly susceptible to price fluctuations, growing significantly during upswings and declining when prices fall. 

Trends in equity raised via mining flow-through shares (for which data are only available starting in 1996) generally follow closely exploration and development spending, mineral and metal prices, and the mining stock index.

Chart 1
Mining Exploration and Deposit Appraisal Expenditures and Equity Raised
via Mining Flow-Through Shares, 1972 to 2012

Chart 1 - Mining Exploration and Deposit Appraisal Expenditures and Equity Raised via Mining Flow-Through Shares, 1972 to 2012

Notes: Figures for exploration and deposit appraisal expenditures include a narrower range of expenses than those eligible for flow-through shares. Data on equity raised via mining flow-through shares are only available starting in 1996. All data have been adjusted for inflation and are expressed in 2008 dollars.

Sources: Natural Resources Canada; Bank of Canada; Department of Finance Canada.

[Chart 1 - Text Version]

Oil and Gas Sector

Chart 2 compares inflation-adjusted exploration and development expenditures in the conventional oil and gas sector to energy prices from 1972 to 2012. It shows that spending declined throughout the 1980s and remained relatively low throughout most of the 1990s. Since 2000, exploration and development activity has generally been strong, tracking upward trends in energy prices. 

Fluctuations in oil and gas flow-through share offers are less strongly correlated with expenditures on exploration and development drilling and commodity prices than in the case of mining flow-through shares.

Chart 2
Conventional Oil and Gas Exploration and Development Drilling and Equity Raised via Oil and Gas Flow-Through Shares, 1972 to 2012
Chart 2 - Conventional    Oil and Gas Exploration and Development Drilling and Equity Raised via Oil and Gas Flow-Through Shares, 1972 to 2012

Notes: Data on equity raised via oil and gas flow-through shares are only available starting in 1996. All data have been adjusted for inflation and are expressed in 2008 dollars.

Sources: Canadian Association of Petroleum Producers; Bank of Canada; Department of Finance Canada.

[Chart 2 - Text Version]

Descriptive Statistics and Analysis

This section analyzes available tax data on flow-through share issuers and investors, in addition to stock market data that pertains to publicly listed common shares issued by mining, oil and gas and clean energy generation companies (collectively, “resource companies”) on the Toronto Stock Exchange (TSX) from January 2007 to December 2012 and the TSX Venture Exchange (TSX/V) from January 2009 to December 2012. In general terms, the TSX serves senior equity markets while the TSX/V is focused on more junior companies and the public venture equity market. Resource companies account for approximately 60% of the number of companies listed on the TSX and TSX/V.6 

Flow-Through Share Issuers

This section provides a statistical overview of the importance of flow-through shares as a financing instrument for resource companies. 

Proportion of Eligible Expenses Financed via Flow-Through Share

A first measure of the relative importance of flow-through shares for resource companies is the proportion of total eligible expenses that is funded via this mechanism every year. Table 1 (which is based on corporate income tax return data from 2007 to 2012) shows the proportion of total Canadian Exploration Expenses (CEE), Canadian Renewable and Conservation Expenses (CRCE) and Canadian Development Expenses (CDE) incurred during that time period that were renounced via flow-through shares.

Table 1
CEE, CRCE and CDE Incurred From 2007 to 2012 Renounced to Investors
  CEE/CRCE CDE
 

  Renounced
($ millions)
Total
($ millions)
% of Total
Renounced
Renounced
($ millions)
Total
($ millions)
% of Total
Renounced
Oil and gas 3,690 23,200 16% 360 54,370 1%
Mining 5,390 19,030 28% 20 24,180 <1%
Clean energy1 110 650 17% n/a n/a n/a
Total 9,190 42,880 21% 380 78,550 <1%
Note: n/a = not applicable.
1  The clean energy sector is composed for this purpose of corporations that incurred CRCE.
Source: Department of Finance Canada.

Table 1 illustrates that flow-through shares account for a large share of the funding for CEE incurred from 2007 to 2012: about one-fifth of all eligible expenses. The reliance on flow-through shares is higher in the mining sector, where flow-through shares financed on average 28% of CEE incurred during the period, versus 16% in the oil and gas sector. Clean energy companies also rely significantly on flow-through shares to finance their clean energy projects (17% of CRCE incurred every year). Conversely, the proportion of CDE financed via flow-through shares is relatively low in the mining and oil and gas sectors (about 1% of eligible expenses or less).

Importance of Flow-Through Shares in Equity Markets

When financing new exploration and development expenses, companies may issue debt or equity, or rely on internal financial resources (e.g., cash flow). The choice between these types of financing mechanisms is influenced by a number of considerations that are specific to each company. Table 2 shows the role that flow-through shares play in equity financing for resource companies, using data from the TSX and TSX/V. It presents the average value of flow-through shares that are raised by exchange and sector. 7

Table 2
Average Annual Issues of Flow-Through Shares and Common Shares, by Sector and Exchange
Flow-Through Shares Total Common Shares
(Including Flow-Through Shares)
Flow-Through Shares as a % of Total



Number of Issues Value ($ millions) Average Size ($ millions) Number of Issues Value ($ millions) Average size ($ millions) Number of Issues Value
TSX
(2007–2012)
           
Mining 70 360 5 280 9,110 33 25% 4%
Oil and gas 30 340 11 80 4,270 53 38% 8%
Total 100 700 7 360 13,380 37 28% 5%
TSX/V
(2009–2012)
           
Mining 440 540 1 1,590 3,420 2 28% 16%
Oil and gas 70 120 2 260 1,810 7 27% 7%
Total 510 660 1 1,850 5,230 3 28% 13%
Source: TSX and TSX/V new financing data.

In interpreting Table 2, it should be kept in mind that flow-through shares only potentially apply to a portion of the financing needs of Canadian resource companies. For example, expenses incurred outside of Canada do not qualify as CEE, CDE or CRCE, and thus are not eligible to be financed using flow-through shares. Nearly 50% of the mining projects of TSX and TSX/V-listed mining companies are located outside of Canada, and more than 35% of oil and gas-listed companies operate outside of Canada.8

Table 2 shows that during the sample period flow-through shares accounted for 28% of the total number of new equity issues by resource companies. Flow-through shares also accounted for 5% of the total equity raised by resource companies on the TSX and 13% of the total equity they raised on the TSX/V—a weighted average of 7%.

  • The number of flow-through share issues and their value are higher in the mining sector in absolute terms than in the oil and gas sector. Mining companies account for about 44% of companies listed on the TSX and TSX/V, while oil and gas companies account for 10%.9 
  • In contrast, oil and gas companies listed on the TSX rely more on flow-through shares in relative terms than mining companies (38% of new issues compared to 25%), while the use of flow-through shares is nearly equal between the two sectors on the TSX/V.
  • Flow-through shares represent 16% of new equity raised in the mining sector on the TSX/V, compared to 4% on the TSX. This suggests that in the mining sector, junior companies rely more on flow-through shares for equity financing than larger companies. In the oil and gas sector, the difference is marginal.

Overall, flow-through share issues tend to be smaller than non-flow-through share issues on both the TSX and TSX/V: on average, $7 million is raised via new flow-through share issues on the TSX versus $37 million for ordinary common shares; the average flow-through share issue on the TSX/V raises about $1 million, compared to $3 million for other common shares.

While not presented in Table 2, TSX and TSX/V data show that clean energy companies play a very small role in the flow-through share market (less than 1% of flow-through share activity). Due to the relatively small role of clean energy companies in the flow-through share market, further statistics on the use of flow-through shares by clean energy companies are not presented in this analysis.

Cost of Issuance

Issuing equity, including flow-through shares, involves transaction costs, such as legal, accounting, underwriting, filing and brokerage fees. Comprehensive data on flow-through share issuance costs are not available. 

In order to provide a sense of the listing fees faced by flow-through shares issuers, issuing documents were examined for 60 of the largest offers (by sector and exchange) during the 2007 to 2012 period. The results of this analysis are presented in Table 3. Underwriting commissions varied from a low of 2.5% of gross proceeds up to 7.5% during the studied period. Commissions were comparable across mining and oil and gas companies, but junior companies in both sectors (i.e., those listed on the TSX/V) tended to pay on average 1 percentage point more than companies listed on the TSX. Overall, the average commission was 5.3% of gross proceeds for the flow-through share issues reviewed. The median commission was 6%. The analysis did not consider issuing costs for non-flow-through shares. 

Table 3
Observed Underwriters’ Commissions for Flow-Through Share Issues
% of gross proceeds
Overall TSX TSX/V
Average 5.3 4.8 5.8
Maximum 7.5 6.0 7.5
Minimum 2.5 2.5 5.0

In addition to the underwriters’ commissions, many of the documents reviewed reported additional listing fees. Fees do not seem to be correlated with the size of the flow-through share issue and were generally stated as fixed amounts ranging between $200,000 and $400,000. For smaller flow-through share issues, these additional fees may sometimes represent a significant proportion of the proceeds of issuing flow-through shares.

Flow-Through Share Investors

This section discusses the characteristics of flow-through share investors based on available tax data. 

Flow-through shares may be acquired by either individual or corporate investors. They may also be acquired indirectly via limited partnership structures. In general, limited partnerships pool investors’ funds and provide an opportunity to diversify risk by investing in several different flow-through share issues. Limited partnerships account for 50% of total flow-through share investment. Individuals account for roughly 90% of flow-through share investment via limited partnerships. 

Table 4 breaks down the composition of flow-through share investors by individuals and corporations. Individuals account for approximately 75% of investment in flow-through shares (45% is accounted for by individuals investing in limited partnerships). The participation of individuals in the flow-through share market is relatively high: by contrast, individuals accounted on average for 28% of the total value of public, private and mutual fund shares held from 2007 to 2012.10 This could be explained by the fact that individuals generally face higher marginal income tax rates than corporations;11 as a result, the transferred deductions represent greater tax savings to individuals in relative terms. In addition, individuals investing in mining flow-through shares may be eligible for related investment tax credits (e.g., the federal 15% Mineral Exploration Tax Credit), whereas corporations are not. Tax data show that from 2007 to 2012, 76% of CEE renounced by mining companies was eligible for the Mineral Exploration Tax Credit.

Table 4
Proportion of Total Flow-Through Shares Held by Type of Investor, 2007 to 2012
%
Type of Investor Proportion of Flow-Through Shares Held
Individual investors  
Direct investment 30
Via limited partnerships 45
Subtotal 75
Corporate investors  
Direct investment 20
Via limited partnerships 5
Subtotal 25
Total 100
Source: Department of Finance Canada.

Table 5 provides data on the taxable income range of individuals who invest in flow-through shares. It shows that 90% of flow-through shares purchased by individuals are acquired by those in the top two federal income tax brackets. The average combined federal-provincial marginal income tax rate of individuals investing in flow-through shares is estimated to be 42%. The role of high-income individuals in flow-through share investment is consistent with overall savings patterns in Canada, which show that individuals with income above $80,000 account for the majority of investment income earned by individuals in Canada.12 In addition, flow-through shares may be more attractive to high-income individuals since the value of tax deductions increases with investors’ taxable income. 

Table 5
Share of Renounced Flow-Through Share Expenses Claimed by Individuals,
by Taxable Income of Individual, 2007 to 2010
Federal income tax brackets Share of Total Renounced Expenses (%)
First tax bracket (less than $40,970) (15%) 2
Second tax bracket ($40,970 - $81,941) (22%) 8
Third tax bracket ($81,941 - $127,021) (26%) 11
Fourth tax bracket (over $127,021) (29%) 79
Total 100
Notes: Individuals were classified in a given year based on the federal income tax brackets applicable for that year. The tax bracket thresholds and tax rates indicated in the table are those applicable for 2010. Tax bracket thresholds are adjusted each year for inflation, while the tax rates indicated in the table have been in effect since 2007.
Source: Department of Finance Canada.

Geographic Distribution of Issuers and Investors

This section provides details on the geographic distribution of flow-through share issuers and flow-through share investors. Chart 3 illustrates the geographic distribution of the headquarters of companies that issue flow-through shares and flow-through share investors based on data from 2007 to 2012. The distribution of flow-through share issuers is based on where the companies that issue flow-through shares are headquartered. The distribution of flow-through share investors is based on the total value of CEE and CDE claimed by individual investors on their tax returns and their province of residence.

Chart 3
Provincial/Territorial Distribution of Flow-Through Shares (FTS) Issued and Renounced Expenses Claimed by Flow-Through Share Investors (%)
Chart 3 - Provincial/Territorial Distribution of Flow-Through Shares (FTS) Issued and Renounced Expenses Claimed by Flow-Through Share Investors %
Source: Department of Finance Canada.

[Chart 3 - Text Version]

Some 36% of flow-through share issues are made by firms headquartered in British Columbia, 27% by firms in Alberta and 22% by firms in Ontario. The proportion of flow-through share issuers in Quebec, Saskatchewan, the Atlantic provinces and the territories is lower than their share of exploration and deposit appraisal expenditures would suggest, while that of British Columbia stands out as being relatively high compared to the share of expenditures incurred in that province. Nearly all oil and gas flow-through shares are issued by companies headquartered in Alberta.

In general, the distribution of individual flow-through share investors reflects the provincial population distribution, with two notable exceptions: Quebec (10% of flow-through share investors, with about 23% of Canada’s population in 2012) and Alberta (23% of flow-through share investors, with about 11% of Canada’s population in 2012). 

The availability of certain tax credits for investments in mining flow-through shares (Ontario—5%, Manitoba—30%, Saskatchewan—10% and British Columbia—20%), as well as the “bonus” deduction available in Quebec, do not seem to have a large impact on the distribution of flow-through share investors across jurisdictions.

Value of Flow-Through Shares for Corporations and Investors and Tax Expenditure Estimates

Premiums Earned by Corporations

This section discusses the maximum premiums that investors would theoretically be willing to pay for flow-through shares, and provides estimates of observed premiums based on stock market data.

In essence, a flow-through share provides to investors:

  • A common share of the capital stock of the issuing corporation; and
  • Tax benefits, via an agreement to transfer expenses for tax purposes from the corporation to the investor, plus any applicable investment tax credits at the investor level.

The tax benefits of flow-through shares provide a saving to the investor in terms of reduced tax liability; as a result, investors may be willing to pay a premium for a flow-through share relative to the price that they would be willing to pay for otherwise identical non-flow-through shares. Effectively, the premium compensates the issuing corporation for the tax deductions that it renounces to investors.

Maximum Flow-Through Share Premium

The tax benefits of a flow-through share are known at the time of acquisition and depend on the investor’s marginal income tax rate, the availability of investment tax credits and other relevant tax attributes of the investor. The maximum premium that an investor may pay for flow-through shares, in theory, is equal to the tax benefits received by the investor.  

Table 6 provides estimates of the maximum premiums for an “average” individual flow-through share investor residing in Ontario, subject to a combined federal-provincial marginal income tax rate of 42% (i.e., the marginal income tax rate of an average flow-through share investor), and able to fully use the deductions. To simplify the analysis, it is assumed that the investor disposes of the flow-through shares in the same tax year that they are purchased, and that renounced expenses are CEE (equal to the price of the flow-through share and deductible at a rate of 100% in the year expenditures are renounced). 

Two scenarios are presented, depending on whether or not the investor is eligible for investment tax credits. In each scenario, the maximum premium is equal to the value of the tax benefits. Under these stylized assumptions, the estimated maximum premium ranges between 36% and 69%, depending on whether the investor is eligible for investment tax credits.

Table 6
Maximum Flow-Through Share Premium Under Stylized Assumptions
$ except when otherwise noted
Flow-Through Shares
Not Eligible for Investment
Tax Credits
Flow-Through Shares
Eligible for Investment
Tax Credits1
Value of underlying common share 100 100
Maximum flow-through share premium
(net value of tax benefits)
36% 69%
Price of flow-through share 136 169
Premium to market 36 69

Value of flow-through share tax deductions 57 71
Value of flow-through share tax credits 0 33
Income inclusion of tax credits2 0 (14)
Capital gains tax3 (21) (21)
Net tax benefits 36 69
1  Federal 15% Mineral Exploration Tax Credit plus the 5% Ontario Focused Flow-Through Share Tax Credit.
2  In practice, the income inclusion occurs in the following tax year.
3  Calculated as the capital gains tax payable on the value of the underlying common shares (i.e., the incremental capital gain due to the rule deeming the cost of a flow-through share to be nil for tax purposes).

It should be noted that the maximum premiums in Table 6 are illustrative only and that other stylized assumptions would lead to different theoretical premiums. For example, the maximum premium for a corporate investor subject to a combined federal-provincial general corporate income tax rate of 25% would be 16%. The maximum premium would also be lower than presented in Table 6 if the expenses being renounced were CDE rather than CEE, or if the marginal income tax rate in the province where an investor resides were lower than in Ontario. Conversely, the theoretical maximum premium would be higher for an individual in the top tax bracket; for example, for an Ontario resident subject to a combined 49.53% personal income tax rate the maximum premium would be 84%.

In practice, the selling price of flow-through shares is expected to equal the selling price of common shares, plus a premium that is situated between the maximum that an investor may be willing to pay and the minimum premium that a corporation may be willing to accept. 

Entering into a flow-through share transaction instead of simply purchasing regular common shares is of interest to investors because of the associated tax benefits. If the premium paid by an investor were exactly equal to the tax benefits received, the investor would be indifferent between buying a flow-through share or a common share of the corporation. In that situation, there would be no incentive to invest in the flow-through share and flow-through shares would therefore fail to facilitate the raising of capital for issuers. In order to provide an incentive to investors, flow-through share issuers must effectively share a certain proportion of the benefits with investors. 

For issuing corporations, entering into a flow-through share agreement is beneficial when it provides a premium over the market price that is of higher value than the corporation’s internal valuation of the tax benefits associated with renounced deductions. It may also be beneficial if the associated tax benefits attract incremental investment in the corporation’s equity. For corporations with no taxable income and no expectation of earning taxable income in the short to medium term, tax deductions are likely of little internal value.13 This would include many junior corporations that are focusing their activities on exploration. 

Estimated Flow-Through Share Premium

Table 7 presents estimates of flow-through share premiums that were observed on new equity issued on the TSX from 2007 to 2012 and on the TSX/V from 2009 to 2012, by sector and seniority.

When issuing new equity, corporations frequently “underprice” their new shares relative to the price on the secondary market for outstanding previously issued shares. The estimates of premiums paid for the tax benefits associated with flow-through shares are therefore complicated by the fact that it is not possible to observe at what price a corporation could have sold its shares in the absence of the flow-through share tax benefits. For example, as shown in Table 7, non-flow-through shares were issued at an average 5% discount to market in the sample set.

This analysis estimates the average premium to market for both flow-through shares and non-flow-through shares issued by mining and oil and gas companies. It then calculates an implied flow-through share premium that is equal to the percentage difference between the premium to market for flow-through shares and the (negative) premium to market for non-flow-through shares.

Table 7
Average Premiums on New Equity Issued on the TSX (2007–2012) and TSX/V (2009–2012)
%
Premium to Market1
 
 
Sector, Exchange
and Seniority of Issuers
Flow-Through Shares Non-Flow-Through Shares Implied Flow-Through
Share Premium2
Overall
  TSX—senior 24 -1 25
  TSX—junior 20 0 20
  TSX/V—Tier 1 18 -2 21
  TSX/V—Tier 2 12 -7 20

  Average 15 -5 21
Mining
  TSX—senior 19 -2 21
  TSX—junior 20 0 20
  TSX/V—Tier 1 19 -2 22
  TSX/V—Tier 2 12 -7 21

  Average 14 -5 20
Oil and gas
  TSX—senior 26 0 26
  TSX—junior 20 1 18
  TSX/V—Tier 1 12 -6 19
  TSX/V—Tier 2 13 -8 23

Average 17 -5 24
Note: “Tier 1” and “Tier 2” companies on the TSX/V correspond to senior and junior companies, respectively.
1  Premiums to market are calculated based on the five-day volume weighted moving average of closing prices on the day of the issue.
2  Implied flow-through share premium = ((1 + flow-through share premium to market) ÷ (1 + non-flow-through-share premium to market)) – 1.
Source: TSX and TSX/V new financing data and daily Trading Summaries.

The results of the analysis indicate that, on average, flow-through shares are issued at an average premium below the theoretical maximum premium for the average flow-through share investor that was derived in the previous section. The premiums across sectors, seniority of issuer and exchange range between 18% and 26%.

The results show that oil and gas flow-through shares command a slightly higher premium on average than mining flow-through shares (24% versus 20%), despite the fact that mining flow-through shares are often eligible for additional incentives (e.g., the Mineral Exploration Tax Credit). Of all categories, senior oil and gas companies listed on the TSX show the highest average premiums (26%). 

Table 8 shows that overall implied flow-through share premiums are fairly constant over time in spite of the significant market fluctuations that occurred during the 2007 to 2012 period.

Table 8
Issue Price Premiums for Resource Companies in Different Years
%
Premium to Market

 
Flow-Through
Shares
Non-Flow-Through
Shares
Implied Flow-Through
Share Premium
2007 24 -1 26
2008 29 8 19
2009 8 -10 20
2010 9 -10 21
2011 18 -3 22
2012 23 3 19
Note: Estimates for 2007 and 2008 are based on TSX data only.
Source: TSX and TSX/V new financing data and daily Trading Summaries.

Investment Performance of Flow-Through Shares

This section provides an analysis of the investment performance of flow-through shares for investors. It estimates the absolute returns to investing in flow-through shares, both before and after consideration of tax benefits. 

To analyze the investment performance of flow-through shares, it was necessary to make certain assumptions. The analysis assumes that the flow-through share investor is an individual with a 42% marginal tax rate (i.e., equal to the marginal tax rate of an average individual flow-through share investor). For the purpose of analyzing returns to mining shares eligible for federal and provincial investment tax credits, it is assumed that the investor is an Ontario resident and that the flow-through shares are eligible for both the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit. The shares are assumed to be held for two years and then sold at the market price. Capital gains tax is assumed to be paid immediately on disposition of the shares. The analysis does not account for the time value of money and the reported returns are for the two-year period (i.e., they are not annualized). An overall weighted average return is then calculated for each year based on relative issue sizes. 

The results of this analysis are presented in Table 9 and Table 10, which present two-year weighted average returns on flow-through shares issued on the TSX and TSX/V, respectively. The estimated returns are highly dependent on the market conditions during the time period analyzed. The period analyzed—2007 to 2010 for the TSX and 2009 to 2010 for the TSX/V—was characterized by significant share price volatility due to both the impact of the 2008 recession and significant fluctuations in commodity prices. To provide some context to the reported results, two-year average after-tax returns (using the same assumption regarding marginal tax rates as for flow-through shares) are calculated for the S&P/TSX Canadian Diversified Metals & Mining Index and S&P/TSX Canadian Energy Index. These results are also presented in Table 9 and Table 10.

As shown in Table 9 and Table 10, the pre-tax benefit returns on flow-through shares are frequently negative, although there can be considerable fluctuations in performance. These negative returns are partly driven by the premium paid for flow-through shares that, all else equal, would tend to reduce pre-tax benefit investment returns. Given the nature of flow-through shares, however, investors are more likely focused on post-tax benefit returns.

The tax benefits (not including the federal Mineral Exploration Tax Credit and provincial investment tax credits) improve returns for the average flow-through share investor by 21 percentage points. If the analysis assumed that the investor was in the top tax bracket, the impact would be even larger: for example, in the case of an Ontario investor in the top marginal tax bracket, after-tax returns would be approximately 25 percentage points higher than pre-tax returns. Conversely, those in lower tax brackets would see a smaller improvement in returns due to the tax benefits (for example, for an Ontario individual in the lowest tax bracket, returns would improve by around 10 percentage points). Table 9 and Table 10 show that, when tax credits are available, returns for the average flow-through share investor improve by an additional 11 percentage points, or 32 percentage points above the pre-tax scenario.

Although results vary from year to year, overall, pre-tax benefit returns for mining flow-through shares are higher than pre-tax benefit returns for oil and gas flow-through shares. This is also true in the case of post-tax benefits and especially so when the value of potential investment tax credits is taken into account: allowing for potential investment tax credits, mining flow-through shares provide higher average returns in every year but one (in 2010 on the TSX). In general, returns on the TSX are stronger than those on the TSX/V.

Table 9
Two-Year Weighted Average Return on Flow-Through Share Issues on the TSX
%
Year of Issue Mining Oil and Gas


Pre-Tax Benefits Post-Tax Benefits S&P/TSX Canadian Diversified Metals & Mining Index (After Tax)2 Pre-Tax
Benefits
Post-Tax
Benefits
S&P/TSX Canadian Energy Index (After Tax)2

No Tax Credits With Tax
Credits1
2007 -56 -35 -24 -13 -52 -31 -20
2008 10 31 42 53 -33 -12 -13
2009 20 41 52 77 4 25 16
2010 -37 -16 -5 -8 -23 -2 -9
Overall -22 -1 10 27 -31 -10 -6
1   Returns are based on the assumption that flow-through shares are eligible for the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit.
2   The return on the index is assumed to be comprised of capital gains taxable at the marginal tax rate of the average flow-through share investor. Sources: TSX and TSX/V new financing data and daily Trading Summaries; Statistics Canada; Department of Finance Canada.
Table 10
Two-Year Weighted Average Return on Flow-Through Share Issues on the TSX/V
%
Year of
Issue
Mining Oil and Gas


Pre-Tax
Benefits
Post-Tax Benefits S&P/TSX
Canadian Diversified Metals
& Mining Index (After Tax)2
Pre-Tax
Benefits
Post-Tax Benefits S&P/TSX
Canadian Energy Index
(After Tax)2

No Tax
Credits
With Tax
Credits1
2009 -16 5 17 77 -27 -6 16
2010 -41 -20 -9 -8 -36 -15 -9
Overall -33 -12 0 35 -34 -13 4
1  Returns are based on the assumption that flow-through shares are eligible for the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit.
2  The return on the index is assumed to be comprised of capital gains taxable at the marginal tax rate of the average flow-through share investor.
Sources: TSX and TSX/V new financing data and daily Trading Summaries; Statistics Canada; Department of Finance Canada.

The evaluation of flow-through shares published by the Department of Finance Canada in 1994 examined pre-tax and after-tax returns for selected flow-through share limited partnerships over the period from 1986 to 1990. Its findings were broadly in line with those presented in Table 9 and Table 10. As with the current study, there was year-to-year variation in the estimated returns, but the average pre-tax return was estimated to be negative 31%. Including the value of flow-through share tax benefits, average returns improved to 2.1%, indicating that flow-through shares improved investors’ returns by an average of 33 percentage points over the pre-tax result. Differences in the impact of flow-through share tax benefits on returns may be attributed to a variety of factors, including assumptions relating to marginal tax rates. In relative terms, the 1994 evaluation found that an investment in a flow-through share limited partnership “typically fares worse than an investment in the corresponding average share for that industry.”

Tax Expenditures

This section presents federal tax expenditure estimates for flow-through shares from 2007 to 2013 and analyzes the degree to which tax benefits are shared between corporations, intermediaries and investors.

Table 11 presents federal tax expenditures related to flow-through shares from 2007 to 2013.

Table 11
Flow-Through Shares: Federal Tax Expenditures
millions of dollars
  2007 2008 2009 2010 2011 2012 2013
Individuals              
Flow-through share deductions 435 235 190 285 340 210 205
Reclassification of expenses under flow-through shares -4 -11 -12 S -7 -10 -7
Mineral Exploration Tax Credit for flow-through share investors 150 45 65 110 100 45 40
Corporations              
Flow-through share deductions 120 74 69 69 81 54 51
Reclassification of expenses under flow-through shares -3 -4 -3 S S S S
Note: An “S” indicates that the absolute value of the tax expenditure is less than $2.5 million.

Table 12 estimates, in respect of an illustrative flow-through share, the proportion of flow-through share tax benefits that accrues respectively to the investor, intermediaries and the issuing corporation:

  • The investor’s share is equal to the value of the tax benefits to the investor less the amount the investor paid to acquire those benefits (i.e., the flow-through share premium).
  • The share of the tax benefits attributed to intermediaries (i.e., transactions costs) is a function of the commission rate. For the purpose of this analysis, the commission rate is assumed to be 6%, that is, the median rate observed for flow-through shares issuers listing on the TSX/V.14
  • The issuing corporation’s share is a function of the premium received, net of commissions.

The analysis assumes that the investor is an Ontario resident with a 42% marginal tax rate and that the mining flow-through shares are eligible for the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit. It does not consider the extent to which the particular share may represent an “incremental” share that the corporation could not have issued but for the flow-through share benefits.

The analysis shows that, on average, between 19% and 53% of the tax benefit related to flow-through shares accrues to flow-through share investors as opposed to the corporations that issue them. It also shows that, in the oil and gas sector, a much higher proportion of the tax benefit goes to issuing corporations (between 69% and 77%) than is the case in the mining sector (45%). 

Table 12
Sharing of Flow-Through Share Tax Benefits
$ except when otherwise noted
Oil and Gas Senior Oil and Gas Junior Mining
(Eligible for Tax Credits)
Common share price 100.00 100.00 100.00
Average flow-through share premium 26% 22% 20%
Flow-through share price 126.00 122.00 120.00

Value of tax benefits1 31.90 30.20 42.80
Investor’s share  
Tax benefits accruing to investor 31.90 30.20 42.80
Less: amount of premium 26.00 22.00 20.00
 
Net tax benefits to investor 5.90 8.20 22.80

Investor’s share of tax benefits 18.5% 27.2% 53.3%
Intermediaries’ share  
Amount of premium 26.00 22.00 20.00
Multiplied by: commission rate 6.0% 6.0% 6.0%
 
Commission on premium 1.60 1.30 1.20

Intermediaries’ share of tax benefits 5.0% 4.3% 2.8%
Issuer’s share  
Premium received from investors 26.00 22.00 20.00
Less: commission on premium 1.60 1.30 1.20
 
Net premium to issuer 24.40 20.70 18.80

Issuer’s share of tax benefits 76.5% 68.5% 44.9%
Note: These estimates assume that the investor is an Ontario resident with a 42% marginal tax rate and that the mining flow-through shares are eligible for the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit.
1 The value of the tax benefits is equal to the value of the tax deductions, plus the net value of any available investment tax credits, less incremental capital gains tax on disposition. These calculations are carried out, for example, in Table 7.

Summary

This paper uses stock market data from 2007 to 2012, as well as tax data, to update certain key statistics presented in the evaluation of flow-through shares published by the Department of Finance Canada in 1994. The data show that:

  • During the sample period, flow-through shares played a significant role in equity financing for both the oil and gas and mining sectors. From 2007 to 2012, approximately $1.4 billion per year in public equity for the oil and gas, mining and clean energy sectors was raised via flow-through shares. Based on available stock market data, flow-through shares accounted on average for more than one-quarter of the number of equity issues and between 5% and 13% of the total value of equity raised by mining and oil and gas corporations. Tax data indicate that approximately 21% of total CEE are financed via flow-through shares.
  • A survey of 60 flow-through share offers indicates that underwriters’ commissions on flow-through share issues generally range between 5% and 6%. Commission rates are comparable across sectors, but junior companies generally pay a higher percentage fee. In addition to commissions, there are fixed costs to issuing that do not seem to be correlated with offer size. These costs ranged between $200,000 and $400,000 in the offers surveyed.
  • Flow-through share investors are typically high-income individuals. The majority of these individuals invest in flow-through shares via limited partnership structures that allow them to pool their funds with other investors and diversify their risk by investing in multiple flow-through share issues.
  • The distribution of flow-through share investors across provinces and territories is in general consistent with Canada’s population distribution, but for a relatively high take-up in Alberta and a relatively low take-up in Quebec. The location of flow-through share issuers’ head offices is spread across all provinces, with higher proportions in British Columbia, Alberta and Ontario.
  • Premiums received by corporations for their flow-through shares are fairly consistent across years, exchanges and sectors—generally on the order of 21%.  
  • Tax deductions associated with flow-through shares improve returns on flow-through shares by an average of 21 percentage points when compared to the pre-tax rate of return. When investment tax credits are available (e.g., the federal 15% Mineral Exploration Tax Credit and the 5% Ontario Focused Flow-Through Share Tax Credit), returns for the average flow-through share investor improve by an additional 11 percentage points, for a total after-tax return that is 32 percentage points above the pre-tax return.
  • Flow-through shares are a significant federal tax expenditure. The resulting tax benefits are allocated between investors, issuers and intermediaries. Stylized assumptions in illustrative examples suggest that tax benefits related to flow-through shares are shared as follows:
    • Between 19% and 53% go to flow-through share investors;
    • Between 3% and 5% go to intermediaries; and
    • Between 45% and 77% go to flow-through share issuers.

Annex—A Brief History of Flow-Through Shares

Various forms of the “expenses-for-shares” financing model for exploration and development activities have been allowed by the Income Tax Act (ITA) since the 1950s. The current flow-through share regime was formally introduced in the ITA in 1986, when a measure was implemented that allowed companies to incur eligible expenses and then renounce them to flow-through share investors. Previously, the tax rules had required flow-through share investors to incur the expenses directly on behalf of the company in exchange for the shares. The 1986 federal budget stated that the goal of the measure was to support investment in mining and oil and gas exploration by making “the existing flow-through share provisions for the mining sector and the oil and gas sector simpler and more effective.”

Table 13 provides a brief overview of the history of flow-through shares since 1972.

Table 13
Brief History of Flow-Through Share Rules

Pre-1972
Only corporations engaged in mining or oil and gas activities (“principal business corporations” or PBCs) may invest in flow-through shares. Flow-through share investors must incur exploration and development costs directly. Flow-through shares are held as inventory (i.e., proceeds of disposition are taxed as income).
1972
Flow-through shares are expanded to allow investment by non-PBCs, including individuals. Non-PBCs are allowed to deduct flow-through share expenses at 20% per year on a declining-balance basis.
1976
The deduction rate for non-PBC investors is increased to 100% for CEE to match the deduction rate for PBCs.
1981
Flow-through shares are held as capital—proceeds from the disposition of flow-through shares are now taxed as capital gains rather than income.
1985
The look-back rule is introduced, allowing flow-through share investors to deduct CEE incurred in the first 60 days of the calendar year from taxable income in the immediately preceding calendar year.
1986
Flow-through share investors are no longer required to incur exploration and development costs directly, eliminating liability concerns for flow-through share investors.
1992
Small oil and gas companies may reclassify up to $2 million of CDE (30% deduction rate) renounced to flow-through share investors as CEE (100% deduction rate).
1996
The 60-day limit for the look-back rule is extended to one year. Flow-through shares are extended to allow companies to renounce CRCE to investors. The $2 million limit on the CDE reclassification is reduced to $1 million. Canadian Oil and Gas Property Expenses (deductible at a 10% annual declining-balance rate) are no longer eligible for flow-through shares.
2000
The temporary 15% Mineral Exploration Tax Credit for individual investors in certain mining flow-through shares is introduced. This measure has been extended regularly and is currently scheduled to expire on March 31, 2014.

1   Previously, flow-through share investors had been required to incur eligible exploration and development expenses directly. See the annex for a brief history of the flow-through share regime.

2   Eligible exploration expenses for the Mineral Exploration Tax Credit are limited to above-ground greenfield exploration (i.e., expenditures for exploration in the vicinity of an operating mine, or formerly operating mine, are not generally eligible) and do not include expenses relating to exploration for oil and gas, coal, oil sands or oil shale.

3   Investment tax credits for mining flow-through shares are available in Ontario (5%), Manitoba (30%), Saskatchewan (10%) and British Columbia (20%). In addition, Quebec allows a 150% deduction for Canadian Exploration Expenses renounced by qualifying companies.

4   Small oil and gas corporations may “reclassify” up to $1 million of CDE renounced to flow-through share investors as CEE.

5   Junior mining companies are typically defined as companies that are primarily engaged in mineral exploration activities and not mineral production.

6   The tax data reflect all flow-through share investors and issuers. As flow-through shares may be either publicly listed shares or private common shares of corporations, the statistics presented using TSX and TSX/V data are only representative of a subset of total flow-through shares issued. A comparison of TSX and TSX/V data on flow-through shares to available tax data suggests that approximately 70% of flow-through shares issued are publicly listed on one of these two exchanges.

7   The values in Table 1 and Table 2 cannot be directly compared. Table 1 presents the six-year sum from 2007 to 2012. Conversely, Table 2 presents annual averages. Annual averages are presented in Table 2 to allow comparison between the exchanges, since different date ranges are available for each.

8   Source: TSX and TSX/V sector presentations.

9   Source: TSX sector profiles, as at December 31, 2012.

10 Source: Statistics Canada, Cansim Table 378-0121, National Balance Sheet Accounts. This measure does not include public, private and mutual fund shares held by non-residents. Government claims and foreign investments are also not included.

11 The federal general corporate income tax rate is 15%. By contrast, individuals face marginal federal income tax rates up to 29%, depending on taxable income.

12 Source: Statistics Canada, Cansim Table 111-0037.

13 Tax deductions may be of value to a business even in situations where it is not taxable. For example, unused tax deductions may be a consideration when an investor (the “successor”) is considering the potential takeover of another corporation (the “predecessor”). The ability of a successor to make use of a predecessor’s resource expense pools (e.g., CEE) may be limited by the “successor rules”, which for example limit the ability of the successor to make use of the predecessor’s expense pools except against income generated by assets acquired from the predecessor. These rules may reduce the value of unused deductions in net-present-value terms.

14 This analysis assumes that the observed 6% median commission for flow-through shares is generally the same as commissions for non-flow-through shares.

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