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The ABCs of resource tax shelters: flow-through tax benefits but tricky fine print

by Wayne Cheveldayoff, 2003-12-07

Investors who routinely contribute the maximum to their RRSPs would be wise to consider resource tax shelters for additional tax-deferred investing opportunities.

Given the recent share-price gains for junior resource companies, such tax shelters have yielded substantial after-tax returns for participants. With the strong markets for oil and gas and metals expected to continue, investors have a good chance at similar returns in the future.

Resource tax shelters have been around for a long time. Governments provide special tax deductions for oil and gas and other mineral exploration and development because they want to encourage activity and job creation in this sector.

The tax credits and deductions effectively permit investors in specially designed flow-through limited partnerships to claim a deduction against other income of between 85 and 100 per cent of the amount invested.

While this type of tax shelter can get quite complicated, here is a simplified example.

For someone with a 46 per cent marginal income tax rate, a $10,000 investment in a partnership that offers a 100 per cent tax deduction would effectively cost $5,400 after tax (because the $10,000 deduction would save $4,600 in income taxes).

When it comes time to sell the investment, any return over zero would be taxed as a capital gain. (This is because the adjusted cost base of the investment is reduced by the amount of the tax deduction.)

Several resource limited partnerships are offered each year by different managers. Examples this year include the NCE Flow-Through (2003) Limited Partnership offered by Sentry Select Capital Corporation (www.nceresource.com) and the Augen Limited Partnership 2003 offered by Augen Capital Corporation (www.augencc.com).

These limited partnerships usually invest in flow-through shares issued by a variety of junior oil and gas and metal explorers.

It is possible to invest directly in such flow-through shares from oil and gas and mining companies if they become available through your stockbroker. But investing in a limited partnership provides important diversification and reduction of risk.

Investors now have the option of investing in the first wind power flow-through fund. Creststreet Asset Management Limited (www.creststreet.com) recently announced a limited partnership that would invest in wind energy projects to generate electricity for sale to provincial utilities. Known as the Creststreet Power & Income Fund, the partnership is offering tax deductions of up to 85 per cent of the amount invested in the 2003 taxation year.

While the flow-through tax deductions are attractive, investors need to pay attention to the fine print of these deals.

For instance, each limited partnership should have a registration number from the Canada Customs and Revenue Agency (CCRA). Without a registration number, investors will not be allowed to claim the deduction on their tax returns.

The number doesn’t guarantee that CCRA will eventually approve the flow-through element of the partnership but in the resource area, where limited partnerships have been around a long time, the managers and their lawyers usually know what it takes to satisfy CCRA.

Another thing to watch for is whether the partnership will be borrowing money. Those offering deductions of more than 100 per cent usually can do so because investors are effectively taking on some debt. While this type of leverage can work very well when the exploration is successful, there is also the risk of “dry holes” and that investors could end up with a big bank loan to pay with nothing else to show for it.

A third important detail investors should consider is how and when they will be able to cash in their investment. The money that goes into a limited partnership is usually tied up for 18 months or more, after which most partnership units convert into mutual fund units that can be sold.

The new wind power partnership offered by Creststreet is somewhat different. It is designed to eventually turn itself into an income fund that will pay distributions.

While reviewing the details of each deal is time consuming, the rewards from investing in a limited partnership could be substantial. Augen Capital reported in early November that investors in its 2002 limited partnership had enjoyed a 36 per cent pre-tax return.

Creststreet noted in the prospectus for its 2003 deal that up to mid-October, the after-tax total returns were 57 per cent for its 2000 partnership, 55 and 71 per cent for its first and second 2001 partnerships, and 37 per cent for its 2002 partnership.

It is important to remember that there are both tax and investment elements to consider. Before investing in a limited partnership, investors should consult their investment advisor on the outlook for the companies or sectors being invested in as well as their accountant for the tax implications.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff