I went to a seminar on flow-through shares. Then I went home, did the math, and confirmed what I suspected: although pitched as investments, flow-through shares favor the sellers (resource companies and stock brokers), not the buyers.
What are 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 allows extending these tax benefits 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, this is to “reduce the risk”, but in reality it allows more people to take a cut of your money.
Why are they bad?
Several things erode the tax benefit from flow-through shares 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 up to 25% above market value;
- Commissions on buying flow-through shares average about 6%; and
- Annual Management Expense Ratios (MERs) for the limited partnerships are 1.0 to 1.5%.
So, a $100 flow-through share will cost you $131 when you buy it and $1 to $1.50 per year that you own it.
The ugly reality is that the share premium (25%), plus commission (6%, also called a “fund load”), plus MER (1.5%) make it a break even proposition even if you are in a higher tax bracket. (And therefore, 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 most companies, good or bad, to outperform your $31 cost above the share price. Buy a lottery ticket instead.
But don’t you get a tax credit to offset this?
Yes, you get a tax credit, but no, it doesn’t offset the premiums and fees. (Or rather, it almost equals them, which is a funny coincidence, don’t you think?) For example, if you buy $10,000 in flow-through shares:
- You receive a tax credit of $4,000 if your marginal tax rate is 40%. If you are not in a high tax bracket, then your tax credit is proportionally less (making the following calculations less in your favor).
- The market value of the flow-through shares is $8,000 (You paid $10,000, because the resource company charged you a 25% premium to buy them);
- Then 6% of your $10,000 investment gets sent to the brokers as a commission, leaving you with $7,400 in the flow-through limited partnership fund.
* $8,000 – ($10,000 * 6%) = $7,400 - At the end of the first year, you pay the fund a management fee (aka. MER) of 1.5%, leaving $7,289.
* $7,400 – ($7,400 * 1.5%) = $7,289 - At the end of the second year, you pay the fund a management fee (aka. MER) of 1.5%, leaving $7,179.67.
* $7,289 – ($7,289 * 1.5%) = $7,179.67 - When you redeem the flow-through shares (mandatory after two years), the government considers the whole amount a capital gain (presumably because they gave you a tax credit when you bought them). 50% of capital gains are taxed at your marginal rate (40% in this example). That leaves you with proceeds from the flow-through shares of $5,743.73.
* $7,179.67 – ($7,179.67 * 50% * 40%) = $5,743.73 - If you add the initial tax credit of $4,000 to the proceeds of your share sale, then you can tell if flow-through shares were a good investment or not. In this case, you invested $10,000 and you’re left with a total benefit — i.e. tax credit plus sale proceeds — of $9,743.73; a loss of 2.63%. Here’s a spreadsheet of the calculations.
- But it’s not over. In the two years that your money has been tied up in the flow-through limited partnership, inflation has eaten away at it at an average of 3% per year. So in 2010, that $9,743.73 is worth $9,167.88 in 2008 dollars, creating an overall loss on this investment of 8.3%.
What’s the verdict?
Two years is too short a time for any investment. Because of flow-through shares’ mandatory redemption period within that time frame, they are highly speculative and very high-risk. Also, assuming the averages outlined above (in share price premiums, commissions and MERs), if the fair market value of the shares stays the same over the two-year period, then you’ll lose about 8.3% on your investment which includes the tax benefit and the negative effects of inflation.
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.
