A while ago, I went to a seminar on flow-through shares. At first glance, flow-through shares seem like a great way to keep more of your money in your pocket rather than watching the government confiscate it at tax time. Not so.
By offering flow-through shares to the general public, natural resource companies allow their tax deductions to “flow-through” to investors via the Canadian Exploration Expense (CEE). It gets more money into the exploration market without government subsidies, so the Canadian government is fine by extending a tax benefit equivalent to an individual’s marginal tax rate. Flow-through shares can be bought directly from resource companies, but most purchases are made through a mutual-fund-esque entity generally described as a flow-through limited partnership (LPs), ostensibly to “reduce the risk” but in reality so more people can take a cut of your money.
Just like the evasive manner of the Shyster presenting the seminar suggested, there are several things that erode the tax benefit and end up making it a high-risk speculation — i.e. it’s not an investment; it’s a gamble.
Among those fine print items are:
- The resource companies sell the flow-through shares at a premium above market value (up to 25%);
- Commissions on buying FTS average about 6%; and
- Annual Management Expense Ratios (MERs) for the limited partnerships are 1.0 to 1.5%.
The reality is that the share premium plus commission (i.e. fund load) plus MER makes it a break even proposition even if you are in a higher tax bracket. (The lower your tax bracket, the higher the risk.) Also, the typical time horizon is two years to mandatory share redemption, an impossibly short period of time for any company, good or bad, to perform without lottery-esque circumstances and, on the part of the investor, unrealistic expectations.
BOTTOM LINE: Two years is too short time for any investment. Because of flow-through shares’ mandatory redemption period within that time frame, they are highly speculative and therefore risky. Also, assuming the averages outlined above (in share price premiums, commissions and MERs), if the fair market value of the shares stays the same, then you’ll lose about 2.63% on your investment which INCLUDES the tax benefit.
In my opinion, flow-through shares are tax-benefit-hedged mutual funds with fees, commissions and premiums eating up most of the tax benefit — i.e. a product created by resource companies, the government and “financial advisors” for the benefit of resource companies, the government and “financial advisors.”
Vegas would be proud.
Click here to download a spreadsheet demonstrating the calculations.
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