A tax dodge for the brave

The last great tax shelter.

by

From the May 2008 issue of the magazine.

Still smarting from your last tax bill? Then flow-through shares may suddenly look very attractive. These deals allow you to write off 100% of the money you put into them.

Yes, you read that right. Flow-throughs are one of the last legal tax shelters out there, and they have been red hot. Last year, Canadians put a staggering $1.7 billion into flow-throughs — almost six times as much as they did just six years before.

Unfortunately, there’s a catch. While flow-throughs can cut your tax bill and have produced sizzling results in recent years, they are also far riskier than most people think.

Flow-throughs are usually sold through advisers, who put your money into a limited partnership. The partnership, in turn, puts your cash into small Canadian companies that explore for minerals, oil or gas.

These small companies get big tax breaks thanks to the Canadian Exploration Expense program, but they don’t have earnings to pay tax on, so they don’t need the credits. What these companies do need are investors, so the firms are allowed to flow the tax breaks through to you — hence the flow-through label.

As a result of the tax breaks, you don’t pay tax on the money you put into the limited partnership. If you’re in the top tax bracket, you get a tax credit equivalent to about 40% or 50% of the money you invest. In other words, you appear to be getting a $10,000 investment for only $5,000 to $6,000 of your own money.

So far, so good. But there’s some fine print, and the more of it you read, the less attractive flow-throughs look.

First of all, your money is typically locked into the partnership for up to two years, so you can’t get out of your investment if the market drops. Then, when you’re allowed to take your money out, you have to pay tax on your capital gains — but those gains are calculated as if your investment had cost you nothing.

This means that if your original $10,000 investment hasn’t budged and it’s still worth $10,000 when it comes time to cash out, you pay tax on $10,000 in capital gains. So what’s the advantage of using flow-throughs? It comes down to a difference in tax rates. Capital gains are taxed at about half the rate as normal income. So flow-throughs will reduce your tax bill — but the savings aren’t as big as they initially look.

Then there are the fees. You’re often charged a sales commission of about 5% of your investment. Some funds charge about 2% a year for management and take up to 50% of any returns you get above a pre-set benchmark. On top of that, flow-through shares are usually issued at a premium to regular shares. All of this means that a $10,000 investment in flow-through shares may get you investments that are worth only about $7,000 or $8,000 on the open market.

Still, as many advisers point out, even if the underlying investment loses 20%, you can still come out ahead if you’re in the top tax bracket. And if one of your exploration companies literally strikes gold, you could do amazingly well.

The problem is that many of the underlying investments lose money — and it’s hard to tell the good bets from the bad ones. Adrian Mastracci, president and portfolio manager at KCM Wealth Management in Vancouver, thinks most people should steer clear of flow-throughs. “If I strip away all of the tax stuff, would I still invest in these things?” he asks. For him, the answer is no. With or without tax credits, flow-through shares are a bet on higher-risk illiquid investments.

Earl Phillips, an investment adviser at Wellington West Capital in Winnipeg, says he uses flow-throughs when a client collapses his or her pension plan and takes the lump sum in cash. Since the client might otherwise have to pay up to 50% of the lump sum in tax, any way to shelter the income is worth considering. But Phillips says he would never put more than 8% of a portfolio in flow-through shares.

Phillips says he’s never lost money on flow-throughs after taxes, but he has lost money before tax. He adds that most limited partnerships are blind pools, so you don’t know what you’re investing in. In essence, he says, a bet on flow-throughs is a bet on how well the whole resource sector will do over the next two years.

A few years ago, that would have been a smart bet to make. But there’s no guarantee that resource investments will continue to do well. If you’re not confident in your ability to predict where resource markets are going, you may want to just pay your taxes and invest in something safer. You’ll take on a lot less risk, and you could still come out ahead.

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