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Flow-through share scheme a major source of funds for Canadian juniors in challenging market

Flow-through shares can help attract capital back to juniors, and back to grassroots exploration because of the ability for investors to benefit from the Mineral Exploration Tax Credit.

According to tax rates analysed by the PDAC for 2014, the after-tax cost of a $1 000 investment under the ‘super flow-through’ programme varies between a low of $258 in Quebec, to a high of $519 in Alberta.

According to tax rates analysed by the PDAC for 2014, the after-tax cost of a $1 000 investment under the ‘super flow-through’ programme varies between a low of $258 in Quebec, to a high of $519 in Alberta.

PDAC president Rod Thomas

In the last five years, Canadian juniors reached a peak of raising $890-million through flow-through financings in 2011 and in 2014, the amounts fell to $330-million, a 63% drop.

29th May 2015

By: Henry Lazenby

Creamer Media Deputy Editor: North America

  

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The challenging global capital marketplace has seen the junior mining exploration sector struggle to obtain the funds it needs to look for and find the mineral deposits that will become tomorrow’s new major mines.

However, if it were not for Canada’s innovative flow-through share tax incentive, financing volumes for these vulnerable companies that frequently function without stable revenues for years would have been much lower.

With last year having seen share consolidations, mergers and acquisitions, delistings from exchanges, weak share prices and low discovery rates, 2015 is expected to be another challenging year for the exploration industry. While analysts expect that the downturn may have bottomed out, the turnaround will likely not take place until 2016.

According to the flow-through share regime’s biggest proponent, the Prospectors & Developers Association of Canada (PDAC), the total financing activity (including debt and equity) across all exchanges in the mining sector has dropped significantly, falling on average by 13.6% a year since 2007, for a total decline of more than 60% in that period. Much of the decline was due to a drop in equity financing, which fell by 80% during the same period.

Canada’s TSX and TSX-V stock exchanges listed stocks of close to 60% of the world’s publicly traded mining companies, accounting for more than half of the world’s equity financing for mining and mineral exploration. Their share of debt financing came in at 81% (TSX) and 47% (TSX-V) last year. As average prices continue to decline – share prices for mining companies on the TSX-V have declined by 83%, from C$0.62 in 2007 to C$0.11 in 2014 – it is becoming too costly, restrictive and dilutive to issue equities.

“Debt issuance is rarely an attractive alternative for most juniors, as they do not typically have the revenues required,” PDAC president Rod Thomas tells Mining Weekly.

According to PDAC data, yearly financing totals for exploration fell by 91% from 2007 to 2014.

Thomas explains that exploration companies increasingly relied on flow-through shares to raise risk capital, which in certain cases helped several companies to hold onto their claims in Canada.

He notes that flow-through shares played an important counter-cyclical role during the recent downturn. As overall financing levels for exploration fell, the proportion of financings using flow-through shares went up. Flow-through deals accounted for 72% of all financing raised for exploration-stage activities from 2012 to 2014, highlighting its importance as an incentive in attracting capital to the riskiest stage of the mining cycle.

However, the overall volume of flow-through financings is trending negatively. According to data sourced from mining consultancy MECO, Gamah International and PDAC calculations, in the last five years, Canadian juniors reached a peak of raising $890-million through flow-through financings in 2011, and in 2014, the amounts fell to $330-million, a 63% drop.

“The use of flow-through shares as a share of total capital raised specifically for exploration tends to peak during times of financing difficulty. The total amount of financing for exploration purposes from 2007 to 2014, has fallen from $1.3-billion during the fourth quarter of 2007, to a low of $150-million in the fourth quarter of 2014,” PearTree Securities president Norman Brownstein tells Mining Weekly.

“Without an incentive as offered by the flow-through system, financing would have fallen even further,” he stresses.

Thomas also points out that it is important to note that this declining trend for exploration is also being experienced globally and is not limited to Canada.

The global economy is expected to grow by 3.8% in 2015, 4% in 2016 and 4.1% in 2017. Canadian growth is also expected to be positive, albeit at a slower pace and is forecast to grow by 2.4%, 2.4% and 2.2%, respectively. As major economies continue to face uneven growth, metal prices are expected to face similar prospects driven by anaemic demand.

FLOW-THROUGH INCENTIVE
Flow-through shares are a significant source of financing that is targeted specifically at exploration activities in Canada for companies listed on Canadian exchanges. Flow-through shares can help attract capital back to juniors, and back to grassroots exploration because of the ability for investors to benefit from the Mineral Exploration Tax Credit (METC).

“Flow-through shares are essentially common shares of an issuer, which permit the initial purchaser to claim a deduction up to the amount of the share subscription price against any income in respect of resource expenses renounced by a publicly traded issuer,” Thomas says.

Under Canada’s Income Tax Act, there are two types of flow-through share investments – ‘regular,’ which entails a 100% deduction write-off for exploration expenses (net of federal and provincial credits); and ‘super,’ which is similar, but adds an additional 15% federal tax credit for grassroots exploration, as well as provincial and territorial deductions and tax credits.

Canadian rules require that a company renouncing, or flowing through an exploration expense to an investor, must get out in the field and spend those exploration dollars within 24 months, and in certain circumstances in less time, forcing exploration companies to get to work in the quickest timeframe.

Thomas says the PDAC was the first organisation to recommend the government implement a flow-through programme for the exploration sector and has consistently lobbied the federal government to keep the METC in place. The credit was initially implemented in October 2000, for three years, as an interim measure, and extended on a yearly basis.

The programme expired at the end of 2005 but was reinstated, in May 2006, as the METC. Since then, the programme has been extended annually, with federal Finance Minister Joe Oliver announcing the latest METC term in March, at the PDAC convention in Toronto.

Government extended the 15% METC for flow-through share investors for an additional year.

In his speech, Oliver also announced government’s intention to modify the definition of Canadian exploration expenses (CEE) contained in the Income Tax Act, to provide that, effective March 1, the costs associated with undertaking environmental studies and community consultations as a precondition to obtaining a licence or permit to explore, will qualify as tax-deductible CEE.

Income tax benefits to individual investors vary, depending on the taxpayer’s jurisdiction of residence and marginal tax rate for income tax purposes, Brownstein says. At present, Quebec offers the largest potential tax savings for flow-through share investments, followed by the British Columbia, Manitoba and Ontario. The deductions and tax credits apply only to eligible expenditures in the applicable province and territory and are only available to taxpayers residing within the jurisdiction where the exploration is taking place.

While the Ontario tax credits are refundable, the other tax credits are nonrefundable. The Manitoba credit applies even after the federal deadline. Quebec allows a deduction to investors of up to 120% of the cost of certain qualifying exploration expenses in certain locations for provincial tax purposes.

According to tax rates analysed by the PDAC for 2014, the after-tax cost of a $1 000 investment under the ‘super flow-through’ programme varies between a low of $258 in Quebec, to a high of $519 in Alberta.

INVESTOR ENCOURAGEMENT
PearTree’s Brownstein emphasises that exploration is considered high risk, and in a down cycle, such as what is currently the case, the risk is perceived to be even higher. What the benefits associated with flow-through shares effectively do is to reduce the risk associated with these activities, incentivising investors to take on board that increased risk.

From the issuers’ side, flow-through shares often trade at a premium to the common stock, allowing the company to raise more money for reduced dilution. However, he notes, while flow-through shares are a special class of shares, once an investor had bought it, and the tax benefits are conferred, the flow-through share becomes an ordinary tradable share of the issuer, pending certain regulatory conditions and a mandatory holding period.

“It’s a common share with a tax benefit associated with it. Without flow-through shares the investment in mining would be that much lower,” Brownstein says.

Given the melancholy market, there are many companies that really cannot raise any money. “If a company is not financeable, flow-through shares offer little hope of getting investors on board,” he adds.

Brownstein believes that the lower volume of flow-through financings has little to do with exploration projects becoming scarcer, but rather more to do with negative market sentiment and the fact that investors and companies are not being rewarded for good exploration results.

“The stock rallies one saw in the bull market, where a company publishes good results and the stock rallies 20% to 30%, are just not happening. Now, where companies are already trading at depressed prices, the stock just does not budge.”

EXPORTING THE REGIME
Canada’s system is a good system and would be a boon to any minerals-rich country wishing to spur exploration investment.

South Africa’s Davis Committee on Tax is due to put out a draft report soon and some South Africans are calling for Canada’s quirky tax innovation, or something like it, to be introduced in the country. Australia is also mulling emulating similar tax legislation, albeit a somewhat more complex form than the tried and tested Canadian system.

“We’re are at a stage in the cycle where sentiment is quite weak, making flow-through shares a major, major tool for the mining sector, and specifically the junior miners, to get capital. Canada is a leader in this and could be an example for other countries such as South Africa and Australia to emulate, to increase exploration investment on own soil,” Brownstein says.

He explains that the reality is that the flow-through regime is very efficient. For every dollar deduction, the company has to spend that dollar on exploration, possibly in some remote part of the country, were another person would receive the dollar and pay tax on that.

“So in effect [governments] are giving with one hand but taking with the other, making it a very efficient mechanism for getting exploration and economic activity,” Brownstein says.

Partner in the Vancouver office of Canadian law firm Blake, Cassels & Graydon LLP Kevin Zimka agrees, telling Mining Weekly that he is surprised that more countries have not embraced the flow-through share programme to raise funds for their own junior mining industries.

However, the analysts noted that there is room for improvement.

Zimka observes that there are certain rules in the regulations to the Income Tax Act that can cause one to be ‘offside’ of the flow-through regime. He says these rules can be somewhat convoluted and there is not a lot of either court or administrative guidance in their application.

“So there is great uncertainty in some cases, prompting people to administer the flow-through share regime rather strictly, which is a good thing. But, I think one of the teething problems was that Canada has not provided enough guidance on the prescribed share rules. I think any other jurisdiction that does it, may want to look to define what puts you in the flow-through share packet and what puts you outside of it,” he says.

Zimka says for example, that if a person has an obligation to provide assistance (tax credits) with respect to the share, maybe considered in repayment or return by the issuing corporation of some of a person’s money, that can send an investor offside. “A much-clearer description would eliminate such uncertainty,” he argues.

He advocates for the incentive to be made permanent.

Brownstein concurs, saying PearTree always hoped that the federal government would make the flow-through share programme permanent, in which case it would create a lot more stability in the market.

“Even multiterm periods would also be better – the longer the term, the greater the stability in the market. We’ve seen many issuers rushing private placements through near to the end of each annual term, despite it not being the best time to do this, just in case the incentive is not extended for another term,” he says.

Edited by Martin Zhuwakinyu
Creamer Media Senior Deputy Editor

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