Flow-through shares investing

Written by Caroline Cakebread

High-income entrepreneurs love the thought of opportunity and tax breaks. Flow-through shares can give you both. They’re unique equity investments in Canadian companies ۉ‚¬ typically, resource firms ۉ‚¬ that need cash for exploration and development. The Income Tax Act allows the company’s tax deductions to “flow through” to the investor.

Here’s an example: an investor with a marginal tax rate of 46% buys $10,000 in flow-through shares. Because the investment is tax-deductible, the net cost of the shares is only $5,400. When the shares are sold, net proceeds are taxed as a capital gain (in this case, the rate is 23%). Although you cannot use the flow-through deduction to nullify your year-end tax bill, there is otherwise no limit to the size of your deduction.

The results are highly attractive. If the issuer’s exploration efforts are successful, then you could be sitting on an investment gold mine that’s leveraged by your tax savings. If the stock tanks, then your original discount mitigates your losses.

The catch: There can be liquidity issues. Flow-though shares typically have a holding period of 12 to 18 months, and some issuers are not publicly traded. Moreover, many mining and energy concerns that offer flow-through shares are highly speculative.

Turbo tip: Hedge your bets by holding at least four companies in your flow-through portfolio, advises Laurie Glans, vice-president of Phillips, Hager & North Investment Management in Calgary. “The whole idea,” says Glans, “is to build some diversification and not simply to ride one company.” In fact, flow-though share mutual funds exist to make this kind of high-risk, high-yield investing easier. One example: the Middlefield Resource Fund 1995 has generated a cumulative after-tax return of 101% since inception (assuming a 46% marginal rate). Toronto-based Middlefield’s worst fund still generated net returns of 14% since 1998.

© 2004 Caroline Cakebread

Originally appeared on PROFITguide.com