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Tax manoeuvre tempts, but 'boy, you can just take a bath'

A truck is loaded with iron ore at a Rio Tinto mine in Western Australia.


Investors are flocking to flow-through shares because of the boom in prices for commodities such as gold, silver and copper. But experts warn there are considerable risks to what right now appears to be a sure bet.

"When you hit a home run on these things, if you get into the right company, you can make a mint," says Larry Moser, regional sales manager at Bank of Montreal. "There have been some great stories of good, aggressive exploration companies who know what they're doing, have a good board of directors, have an idea what they're looking for, and they hit it.

"All of a sudden it's like winning the lottery," he says.

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But Mr. Moser and other financial advisers add that flow-through shares are not for the faint-of-heart. Indeed, some experts tell their clients not to go anywhere near them.

"There are risks that investors should be aware of if they get into that realm, one being that flow-through shares are often sold at a premium, with high commissions," says Shona Stone, head of investment products and services for UBS's Canadian wealth management business.

Here's how it works: The investor will buy units in a limited partnership that invests in the flow-through shares of junior mining or oil companies that are still on the hunt for their big find (although an alternative is to invest directly in flow-through shares issued by one of these companies). While the government offers tax breaks to these exploration firms, they are unable to take full advantage of them because they aren't making money. Flow-through shares are designed to pass those tax breaks along to investors. Most flow-through shares require the original investor to hold them for a minimum period, often two years.

"Our view on flow-through shares is that most people offer them based on the tax rationale, and our philosophy has always been that the tax tail shouldn't wag the investment dog," says Sam Sivarajan, UBS's head of private wealth management in Canada.

It's invariably true that a good tax shelter that is a bad investment equals a bad tax shelter. But that shouldn't rule out all investments in flow-through shares, says Prashant Patel, vice-president of high net worth initiatives at RBC Wealth Management Services.

"There are a number of companies that have been offering flow-through shares and limited partnerships for the past five, 10 years that have had a fairly good track record factoring the tax deductions," he says.

For those considering flow-through shares, the first thing to know is that investors in the highest tax bracket will get the biggest bang for their buck.

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"Let's say you are paying 46 per cent [income]tax. If you put $10,000 in a flow-through share, you immediately get a $4,600 tax break," says Mr. Moser. "You can't ask for anything better than that in regards to a tax break."

But, he adds, your effective "cost base" is zero. That means whatever price you later sell the investment at becomes a taxable capital gain.

Some investors might be able to avoid the capital gains tax by donating their flow-through shares in-kind to charity down the road.

For instance, if that $10,000 investment was still worth $10,000 when they donated it two years later, that investor would receive a further $4,600 tax savings as a result of the donation tax receipt, and there would be no capital gain, explains Mr. Patel. That's a total of $9,200 of tax benefits, meaning the investment - whose face value neither rose nor fell - cost $800.

It is possible that investors holding flow-through shares in their portfolios will receive taxable distributions, which is another thing to bear in mind.

But the main thing to be aware of is that, as Mr. Moser puts it, they're "tremendously risky" investments.

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"Some of these things are just fly by night companies," he says. "I've bought them before because once in a while you need a tax break, but boy, you can just take a bath."

Flow-through shares are definitely more volatile than a blue chip investment or a GIC and should not be a core part of an investor's portfolio, adds Mr. Patel. "It's for where someone is willing to add to or diversify their portfolio, and is willing to take a bit of risk - so has a high risk tolerance - and in most cases is prepared to hold the investment for at least two years."

Some clients are willing to assume the risks because there is a measure of downside protection in flow-through shares, he says. That's because, with the tax break, it's possible for the value of the investments to fall a bit and for the investor to still break even.

Any investor who does decide to proceed with this gamble should be sure to work with a good accountant, since there will be more tax reporting.

Another tip from Mr. Moser is to look for flow-through shares early in the year. "You want to start looking at them in February, March and April, as opposed to November and December when everybody's going 'Hey, flow-through shares, I need a tax break.' The quality really dissipates by the end of the year."

For investors who decide against flow-throughs, Ms. Stone suggests taking a look at regular stocks. "Given that we think the energy sector is likely to post a good performance in 2011, I would say it's probably best to look as an alternative at just buying the equities directly," she says.

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