Federal Tax Traps for the Unwary Flow-Through Share Issuer

Overview

Generally, flow-through share issuers (“Issuers”) finance their exploration expenditures through the issuance of flow-through shares to investors. Issuers are then able to incur certain eligible expenditures and renounce them in favour of the investors. Once renounced, these expenditures become deductible in the hands of the investors. Issuers may incur and renounce expenditures using either the “general rule” or the “look-back rule.”

The “general rule” allows Issuers to incur eligible expenditures during the period that begins on the day the flow-through share agreement is entered into and ends 24-months after the end of the month in which such agreement was reached. It is only after the expenditures have been incurred that the Issuer can renounce them to the investors.

In order to make investments more attractive to investors, many Issuers use the “look-back rule” to accelerate the availability of deductions for their investors. The “look-back rule” allows Issuers to renounce eligible expenditures effective December 31 of the year in which the flow-through share agreement is entered into, even if the Issuer has yet to incur the expenditures.

The trouble for Issuers is that once the “look-back rule” is used, the spending clock is on, and it ticks fast. Any expenditures renounced under this rule need to be incurred by December 31 of the calendar year following the year in which the flow-through share agreement was entered into (the “Expenditure Deadline”). This means that Issuers using the “look-back rule” may have as little as 12 months to incur such expenditures.

The Tax Traps

To compensate the Federal Government for the accelerated deduction taken by investors, Issuers may be subject to tax under Part XII.6 of the Income Tax Act (Canada) (“Part XII.6 Tax”) for each month (other than January) of the year following the year in which the flow-through share agreement was entered. Akin to an interest charge, this tax is based on the eligible expenditures renounced by the Issuers but yet to be incurred by the end of that month. In simple terms, the monthly Part XII.6 Tax is equal to the amount of renounced expenditures that have yet to be incurred before the end of the month, multiplied by 1/12 of the annual prescribed interest rate. Of important note is that the prescribed interest rate applicable in calculating Part XII.6 Tax for the first quarter of 2023 is 4%, which is 3% higher than it was a year ago.

In addition, if at the end of the Expenditure Deadline the Issuer has failed to incur all the expenditures renounced to the investors under the “look-back rule,” an additional 10% penalty tax (the “Penalty Tax”) is payable by the Issuer on the unspent expenditures. To make matters worse, where an Issuer fails to fully incur the amount of expenditures renounced to the investors, the investors can face retroactive adjustments to their tax payable. Issuers may also be required to indemnify investors for failing to incur the full amount of the eligible expenditures by the Expenditure Deadline pursuant to the terms of the flow-through subscription agreements.

What Does This Mean for Issuers?

Issuers will be required to calculate their Part XII.6 Tax payable and file a return before March of the year following the Expenditure Deadline year. Any taxes owing under Part XII.6 must also be paid by such time.

While Part XII.6 Tax is deductible to the Issuer, some Issuers may not be able to utilize such deduction immediately if they are in the early stages of exploration and development phases of their projects and are not generating any taxable income. It is also important to note that Issuers will not be able to use the subscription proceeds received from the issuance of flow-through shares to pay this tax (as such funds must be used for eligible expenditures) and will need to source such funds by alternative means. Issuers need to carefully consider and weigh the tax implications and associated costs of utilizing the “look-back rule” against the desire to be seen as attractive to investors.

If you have any questions with respect to the matters discussed above, please contact Marija Tasevska ([email protected]) or any other member of our Tax Practice Group.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.