‘Double-dip’ tax strategy for high-net-worth Canadians in jeopardy for flow-through mining financings

Terry Lynch last week launched a $20-million flow-through deal for his junior mining exploration company Power Nickel Inc. This wasn’t the ideal time to do the financing, but his hand was forced by an impending change in the capital-gains tax, which will very soon make these transactions significantly harder to pull off.

On June 25, the inclusion rate is set to increase to two-thirds for capital gains of more than $250,000 from 50 per cent. Owing to a quirk in the way flow-through shares sales are taxed, the capital-gains tweak is expected to hit the market in a big way.

Even ahead of the changes, Mr. Lynch is feeling the pinch. The premium on new Power Nickel shares this time around was 1.9 times the market price, or about 10-per-cent lower than when he went to market a few months ago.

“The cost is $2-million just straight out,” said Mr. Lynch, chief executive of Power Nickel.

“And it’s going to get worse.”

Eighty-eight per cent of newly issued flow-through shares in Canada are sold to high-net-worth “front-end” investors, who immediately donate them to a registered charity. This strategy generates two tax breaks, a straight deduction in income for the entire amount paid for the shares, and a charitable tax credit, what many in the flow-through world call the “double dip.”

The only snag for investors is the way flow-through shares are taxed when they are sold. The Canada Revenue Agency designates the cost base on the securities as $0, meaning that even those sold at a significant loss are taxed as a gain. Since charities don’t pay tax, it is the front-end investor that is on the hook.

Like the front-end investors, charities have no interest in holding flow-through shares, so they are flipped to a “back-end” investor at a steep discount in order to generate cash.

‘Double-dip’ tax strategy in jeopardy

Power Nickel issues $20-million in

flow-through units

Front-end investor buys units at $1.25

(fully tax deductible)

Front-end investor immediately donates units to charity (charitable tax credit receipt issued)

Charity sells units to back-end investor for $0.66

Front-end investor pays capital-gains tax on $0.66

NIALL McGEE AND JOHN SOPINSKI/the globe and mail

‘Double-dip’ tax strategy in jeopardy

Power Nickel issues $20-million in flow-

through units

Front-end investor buys units at $1.25

(fully tax deductible)

Front-end investor immediately donates units to charity (charitable tax credit receipt issued)

Charity sells units to back-end investor for $0.66

Front-end investor pays capital-gains tax on $0.66

NIALL McGEE AND JOHN SOPINSKI/the globe and mail

‘Double-dip’ tax strategy in jeopardy

Power Nickel issues $20-million

in flow-through units

Front-end investor buys units at $1.25 (fully tax deductible)

Front-end investor immediately donates units to charity (charitable tax credit receipt issued)

Charity sells units to back-end

investor for $0.66

Front-end investor pays capital-gains tax on $0.66

NIALL McGEE AND JOHN SOPINSKI/the globe and mail

Up to now, the tax incentives for the front-end investors have been sufficiently attractive to make flow-through shares work. But the mining sector is concerned that the increase in the capital-gains tax that is to take effect next week will scare them off.

“People are losing their minds about the inclusion rate going up,” said Peter Clausi, CEO of mining exploration company CBLT Inc. “Because for people who are investing a million dollars in a flow-through and then donating it, the hit to them is very real.”

In addition, the rollout of the new alternative minimum tax (AMT) means the high-net-worth crowd are already facing a separate burn. The AMT will curb the ability of high-income investors to use tax deductions.

The changes in both the AMT and the capital-gains inclusion rate will hurt the ability of junior miners to raise money, curb charitable giving in Canada, and discourage back-end investors from taking a big swing on investments that have long odds.

The prospect of a key capital tool drying up comes amid a multiyear TSX Venture Exchange collapse. While Canada’s “big board” S&P/TSX Composite Index is trading near an all-time high, the S&P/TSX Venture Composite Index is trading more than 80 per cent below its high reached in 2007.

The financial services industry is also set to take a hit. Several companies, including PearTree Securities Inc, Wealth Creation Preservation & Donation Inc. (”WCPD”) and Oberon Capital Corp. connect high-net-worth investors to charities and facilitate the front-end trade on flow-through deals. That business model is now threatened.

“It’s become extremely hard for the firms that are in the business of assembling these deals on behalf of the exploration industry, like PearTree in Toronto, or WCPD here in Ottawa,” said Pierre Gratton, president of the Mining Association of Canada.

“They’re estimating that about 70 per cent of flow-through funding will disappear because of the increase in the capital gains and the increase in the minimum tax.”

The Canadian mining industry is hoping that Ottawa will carve out an exception for the sector around coming changes to the capital-gains tax that it hopes will pre-empt a large drop in financings.

“From the people I talked to in the federal government, they didn’t expect the blowback that they got from the mining industry, so they’re scrambling to find a way to make it palatable,” Mr. Clausi said.

When Finance Minister Chrystia Freeland tabled a notice of ways and means motion for the capital-gains tax changes earlier this month, she said the federal government intends to provide “clarifications” to ensure Canada’s mining exploration companies can thrive.

Among the tweaks that would help the mining industry would be raising the cost base for flow-through share sales and/or changing the capital-gains inclusion rate for investors who donate their stock to charities.

Flow-through shares have been around since the 1950s. They can be issued only by junior resource companies and the proceeds must be used for exploration. Flow-through shares became mainstream in the late 1980s with the introduction of the charitable tax credit. They gained in popularity after 2006 when Stephen Harper’s government eliminated capital gains payable for shares that were donated. Finance minister Jim Flaherty in 2011, however, reinstated capital gains for flow-through shares that were donated to charities, as their tax breaks were judged to be excessive. While the securities fell in popularity somewhat in the aftermath of Mr. Flaherty’s changes, they have remained a key part of the financing market for junior resource companies in Canada. Just more than $1-billion was raised in Canada in 2022 from flow-through shares, according to the Prospectors and Developers Association of Canada. In 2021, $1.5-billion was raised.

Flow-through shares have also enabled a class of maverick investors like Robert McEwen, who pick up shares at a discount on the back end. In the Power Nickel transaction, Mr. McEwen was able to buy shares and half a warrant at 66 cents, far below both the flow-through issue price of $1.25, and below the market price of $0.68 leading into the deal.

“They’re getting it cheaper than they would normally,” said Power Nickel’s Mr. Lynch. “In a quantity that they probably couldn’t get in the market without driving the price up.”

And because the company is issuing new shares, it has more capital to work with, “which ultimately helps them de-risk their investment.”

Alongside Power Nickel, several other resource companies have moved their financings forward ahead of the changes, including Patriot Battery Metals Inc., which last month raised $75-million in a flow-through share offering.