Section 66(1) of the Income Tax Act allows principal business corporations (certain corporations in the mining, oil and gas, and renewable energy and energy conservation sectors) to fully deduct exploration and pre-development expenses incurred in Canada from its income in the year the expenses were incurred.
Many corporations with exploration and development expenses, however, are in a non-taxable position in a given tax year and are unable to deduct these expenses. Whilst unused exploration and pre-development expenses can be carried forward indefinitely, qualifying corporations can also choose to transfer these deductions to flow-through-share (FTS) investors.
FTSs are attractive to corporations that have difficulty raising capital to finance exploration and pre-development activities, notably junior resource corporations, which have little prospect of generating revenue in the foreseeable future, and which will go out of businesses and not be able to use the deductions without FTS investments. They are also attractive to investors as they are permitted to fully deduct the cost of their FTSs from their income: the deduction is worth more to an individual than to a corporation since personal income tax rates are notably higher than corporate tax rates.
While FTSs are not a recent addition to the Canadian tax regime, the super flow-through-share (SFTS) is. In the 2000 Economic Statement and Budget Update (Finance Canada 2000), the Government of Canada announced the non-refundable Investment Tax Credit for Exploration (ITCE). It was intended to be temporary (expiring at the end of 2003) 15% investment tax credit for investors in flow-through shares of mineral exploration companies. The impetus for the SFTS was the low price of metals that occurred throughout the 1990s and which caused a significant contraction in mineral exploration. While metal prices rebounded to historical highs by the mid 2000s, the tax credit was renewed for additional one year periods. It was re-instated in 2006 as the Mineral Exploration Tax Credit (METC) which was set to expire March 31, 2009 but subsequent budgets have extended the credit for one year periods and is currently set to expire March 31, 2014. Many provinces also have comparable programs.
It is useful to provide an example of how FTSs in general and the tax credit specifically benefit the investor. Mary is an investor located in BC who earns $150,000 a year and is taxed at the highest rate both federally (29%) and the second highest provincially (14.7%).
She decides to invest $10,000 in a mining exploration company though the purchase of FTS. In the tax year in which she makes the purchase, she is able to deduct the $10,000 from her income. Had she not made the purchase, she would have paid $2,900 in federal taxes and $1,470 in provincial taxes on the $10,000. As a result of the deduction, Mary saved $4,370 in income taxes making the cost of the investment to Mary only $5,630.
Since Mary invested in a mining exploration company, she is also eligible for provincial and federal tax credits. The value of the BC tax credit is 20% or $2,000. The federal METC is 15% but is calculated on the value of the investment minus any provincial tax credit. In Mary’s case it is calculated on $8,000 for a federal tax credit worth $1,200. Because the tax credits are in effect a grant, the value of the federal and provincial tax credit is subject to income tax, resulting in Mary incurring a tax liability of $1,390. In total, Mary garners a tax benefit of $6,180. Of the $10,000 initial investment, Mary shoulders $3,820 (38.2%) of the cost while taxpayers bear $6,180 (61.8%) of the cost of the investment.
In order for Mary to break even (ignoring inflation and other time costs of money), she only needs to sell the $10,000 investment for $4,888.03 (the adjusted cost basis of the shares is zero). If she sells for this amount, she will only pay $1,068.03 in capital gains taxes, leaving Mary with the initial after-tax cost of the investment ($3,820). In this scenario, the taxpayer is left with a $5,111.97 deficit. Because Mary sold at a value less than her original investment, this implies that the company’s stock price decreased and it can be assumed that they did not find any mineral deposits of value implying no additional corporate taxes to make up the difference.
In fact, in order for the taxpayer to break even (assuming no additional corporate taxes), Mary would have to sell the shares for $28,283.75 which represents an unlikely 182% return on her (and the taxpayers) investment. Clearly, the tax regime for FTS is preferential even without the METC and one has to wonder how much additional influence the tax credit has had on investment in mining FTS.
There is evidence to indicate that the investments in mining FTS is predominately done for tax planning reasons as demand for these products increases at the end of the calendar year. They are also actively marketed to investors who are looking for last-minute tax deductions. An unintended cost of the SFTS regime is that it is likely shifting investment dollars away from other, less risky, and unsubsidized investments.
The Prospectors & Developers Association of Canada credits the METC as contributing significantly to mineral exploration activity and new mineral discoveries in Canada. In particular: increasing exploration expenditures from approximately $300 million in the late 1990s to an estimated $3.9 billion in2012, well in excess of the lows seen in the late 1990s. If one examines exploration expenditures along with the Metal Price Index (MPI) one see a high correlation between expenditures and metal prices and it is likely that the true driving force behind the expansion was the increase in metal prices.
In terms of the value of the deposits found, the value has increased, however, most of this increase is due solely to the rise in prices. This indicates that the increase in exploration is not paying off in terms of an increase in the value of located deposits.
There is little evidence that the METC and their related provincial counterparts induces increased exploration activity over that stimulated by commodity prices. On the investor side, the METC subsidizes high risk investments and appears to be predominately used for tax planning purposes by high income taxpayers rather than for calculated investment purposes. On the administration side, the FTS regime is associated with high administrative and compliance costs and most of the benefits accrue to tax lawyers and accountants.
Many low and middle income tax payers are themselves unable to benefit from deductions yet there is no corresponding ability for them to flow through their deductions to other.It is time to end these tax credits that benefit only wealthy investors and restore fairness to our tax system.