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Resource tax shelters can offer high after-tax returns

by Wayne Cheveldayoff, 2004-09-30

Fall is the peak season for resource tax shelters, which have produced sizeable after-tax gains for investors in recent years as resources prices have trended upward.
Several resource tax shelters are already in the process of being marketed to investors and more are probably in the works.
A good example of the way these tax shelters work is the Mavrix Resource Fund 2004-II Limited Partnership, details of which are in a prospectus recently filed at www.sedar.com. (Anyone contemplating an investment in a resource tax shelter should consider them speculative investments and consult a tax specialist and an investment advisor to gauge suitability.)
The Mavrix offering, like the others, takes advantage of the special tax rules governing exploration expenses for oil and gas and mining companies.
Resource companies, particularly the smaller ones which usually have a lot of expenses and can’t take full advantage of the generous tax deductions available for exploration, can flow these tax deductions through to investors via specially created flow-through shares.
The resource limited partnerships buy these flow-through shares with money raised by selling partnership units. The owners of the units – generally high-income investors in high tax brackets – then use these deductions for themselves.
The government, of course, allows this pass-through of deductions so that smaller resource companies, often the ones driven to undertake the risky search for new reserves, can raise sufficient funds for their activities. In short, it benefits the economy.
The Mavrix limited partnership, which will be managed by Mavrix Fund Management Inc. of Toronto, is offering partnership units at $10 per unit (minimum 250 units) and intends to raise between $5 million and $50 million.
The prospectus notes that this is a “blind pool” offering, which means that it is particularly risky since Mavrix doesn’t yet know which securities it will invest in. It will depend to some extent on what flow-through shares are available and what looks good to the manager.
The partnership intends to invest approximately 70 per cent of total funds raised in the flow-through shares of mining explorers and 30 per cent in oil and gas explorers. No more than 5 per cent can be invested in free-trading resource stocks that are not flow-through.
In exchange for purchasing the units, individual investors receive generous tax deductions and the right to receive the net asset value of the units when the partnership is wound up in approximately two years. At that time, the original investors will receive the proceeds of the net asset value, or units in a regular mutual fund managed by Mavrix (a rollover that can occur without triggering a taxable disposition).
The prospectus notes that someone investing $10,000 in the Mavrix partnership units this fall can expect to receive $9,120 in tax deductions that can be applied to the 2004 tax return (calculations assume a full $50 million is raised).
If that person is resident in Ontario and is subject to the highest marginal tax rate of 46.41 per cent, the tax saving will be $4,201 and the net after-tax purchase cost (after certain adjustments) will be $4,851.
Because of the deduction, the adjusted cost base for tax purposes for the individual would essentially be zero. So, if there is any value in the units when the investor exits the partnership (or the subsequent mutual fund units) down the road, the full value will be subject to capital gains taxation.
The prospectus states that in the case of the Ontario taxpayer noted above, the value of the units on dissolution would have to be $6,317 to break even on this transaction ($1,466 in capital gains tax plus the original after-tax $4,851 invested).
For someone in Alberta, where the highest marginal tax rate is 39 per cent, the tax savings for 2004 on $10,000 invested in the partnership units would be $3,530, the net after-tax purchase cost $5,522, and the break even amount $6,860 ($1,338 capital gains tax plus original after-tax $5,522 invested).
As manager of the partnership, Mavrix will benefit from a 2.25-per-cent annual fee calculated on the net asset value of the partnership units. There is also an incentive fee for the manager of 20 per cent of the amount by which the value of the units on dissolution exceeds the original $10-per-unit cost plus 12 per cent per annum. The dozen brokerage houses through which the units are offered also get a selling fee of 7.75 per cent of the amount invested.
How has Mavrix performed in the past with such tax shelters? The Mavrix team advised on the Contrarian Resource Fund 2002 Limited Partnership. When it matured March 31, 2004, the after-tax cumulative return on the after-tax purchase cost was 73 per cent for Ontario residents and 59 per cent for Alberta residents, according to the prospectus.
A second Mavrix-advised partnership created in 2003, the Contrarian Resource Fund 2003 No. 1 Limited Partnership, hasn’t been wound up yet but the calculated after-tax cumulative return on after-tax purchase cost up to June 30, 2004 was 46 per cent for Ontario residents and 34 per cent for Alberta residents.
These are impressive numbers. However, these returns were produced at a time when resource prices and the stocks of resource companies were trending higher.
Risks for the future are many, including a possible slump in resource prices and/or resource company stocks and possibly even a change in tax rules, although since resource tax shelters have been around for so long and working as they should be, it is unlikely the government will tinker with the rules. There is also the disadvantage for investors of having money tied up for at least two years when a lot can change in the world.
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. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff