Flow-Through Shares for Healthcare Part 1 of 3: What Are Flow-Through Shares?
March 24, 2011
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The extension of flow-through tax incentives to development stage biotech and healthcare companies has been discussed for many years, including twice previously on this blog (here and here). One of the most recent articles supporting this change was written by David Allan, a former investment banker who is a founder and current Chairman of YM Biosciences (Biotechnology Focus, March 2011). In order to properly assess what impact this action might have on our industry, we need to first understand how flow-through shares work. Please note that any companies mentioned in this assessment were chosen strictly at random and are used only to illustrate the use of flow-through shares.
The provisions of the Income Tax Act (Canada) relating to flow-through shares permit a natural resource company to renounce expenses that the corporation would otherwise treat as Canadian exploration expense (CEE) or Canadian development expense (CDE) to purchasers of flow-through shares so that the purchasers can claim the relevant deductions instead of the corporation. I am not a tax accounting expert and would appreciate such experts correcting me if there are any errors in this simple example.
- Assume that an individual purchases 10,000 flow-through shares in a company at $1.00 per flow-through share
- The $10,000 purchase price can be deducted from income in the current tax year assuming that the company has sufficient CEE and CDE expenses
- If the individual’s overall income tax rate is 45%, there is an immediate tax saving of $4,500, leaving $5,500 at risk in the shares
- The flow-through shares convert to common shares
- Assume that the individual is able to sell the common shares for $1.00 per share, or $10,000 in total (excludes any selling costs)
- The cost-base for the shares is $0 and, if the individual’s capital gains tax rate is 20% (applied to half of the capital gain of $10,000), the capital gains tax is $1,000
- From an initial investment of $10,000, the individual would have received $13,500
- The break-even selling price, assuming no cost-of-capital or selling costs, is about $0.61 per share
An example of a completed flow-through share offering is one by Silver Quest Resources (TSXV: SQI) (see their August 27, 2010 Material Change Report for details). This offering was a private placement so all shares were subject to a four-month hold; but a prospectus-based offering can also be used, such as that completed by Quest Rare Minerals (TSXV: QRM) for which (see their October 7, 2010 final prospectus). Both of these regulatory filings contain a description of some of the legal and tax matters associated with flow-through shares. The structures of these financings will be discussed in Part 2 of this series.
A number of fund managers structure Limited Partnerships (LPs) that invest in a diversified portfolio of flow-through common shares of companies involved primarily in Canadian oil and gas or mining exploration, development and production. One example is Middlefield Group which offers its Middlefield Resource LP. Their web site has links to the financial reports and prospectuses of these LPs, which have descriptions of the tax implications and potential returns from flow-through share investments. These LPs are generally intended to be dissolved after a short period and the net asset value converted into another asset class. These LPs generally invest in public companies since they need to invest, sell and roll-over any unsold assets within the short lifetime of the LP. For example, the Middlefield Resource LPs are scheduled to be dissolved about two years after their formation — investors in the 2009 LP received shares of the Middlefield Canadian Growth Class Mutual Fund.
In Part 2, we will look more closely at the structure of flow-through financings and how much financing they provide to Canadian natural resource companies.