Go with the flow

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A gold ingot is poured at the San Gold operation in Bissett. (PHIL.HOSSACK / WINNIPEG FREE PRESS ARCHIVES)

TO the layperson, a sparkling speck in a piece of ore the size of a hockey puck is tiny enough to miss at first glance; it hardly looks worth mentioning.

But to an exploration firm, it's a glaring indi­cation the company could be sitting on a poten­tial gold mine -- literally.

It's certainly what the people behind Wildcat Exploration, a Manitoba­based resource exploration firm, hope they've found.

The company discovered the gold sample while drilling in the Rice Lake Greenstone Belt, a region with a history of gold prospecting and mining in Manitoba.

San Gold Corp. already has an operating gold mine nearby, increasing its ore resources and reserves from 500,000 ounces of gold in 2004 to 1.6 million in 2006.

And if Wildcat can find enough high-grade samples on its 240 square kilometres of prop­erty on the eastern border of Manitoba, the company and its shareholders could soon find themselves in the driver's seat, says John Know­les, president of the company.

"If we make a discovery that is sufficiently attractive, mine operators will approach us to acquire either the property or the company," he says. "We hope that our shareholders will reap rewards from our successes by ultimately our share price going up."

Mineral exploration, however, is a risky enterprise.

"The number of projects that are not success­ful exceeds the number of projects that are suc­cessful by a long shot," says Knowles, a former chief financial officer with HudBay Minerals Inc., which owns mines in Manitoba and across North America.

With those odds, it's hard to understand why anyone would invest in these companies.

But the federal and provincial governments have been sweetening the pot for more than two decades by allowing companies to sell flow­through shares, which can offer some investors substantial tax savings.

Here's how they work.

Normally, an exploration company can deduct 100 per cent of its costs associated with ex­ploration from its revenue, Knowles says. The problem is most firms do not have any revenue, so Canada Revenue Agency allows them to pass on those tax savings to investors in the form of flow-through share offerings.

"You can deduct 100 per cent of the amount invested from any source of income at your marginal tax rate," says Daniel Solomon, an investment funds analyst with BMO Nesbitt Burns.

Investors who buy $1,000 worth of flow­through shares, for instance, can then deduct $1,000 from their gross income -- similar to an RRSP deduction.

Unlike an RRSP, when you sell the stock you would only have to pay a capital gain tax, which is 50 per cent of your marginal tax rate. An RRSP would be taxed as income at the marginal rate, Solomon says.

Besides the tax deduction, the federal and provincial governments also offer non-refund­able tax credits on flow-through shares. The federal credit is 15 per cent on certain flow­through share expenses. In Manitoba, the Manitoba Mineral Explora­tion Tax Credit (MMETC) provides investors an additional 20-per-cent savings.

What this regime of incentives does for Manitobans is reduce the risk associated with investing in exploration and junior mining com­panies, says Sheldon Stier of Hatch Alternative Investments.

"This would mean that a $10,000 investment reduces your reportable income," says Stier, whose company is offering its clients the oppor­tunity to purchase Wildcat flow-through shares. "At the highest marginal rate, this would equal $6,350 in savings to an investor."

From a tax perspective, flow-through shares do look like a sweetened deal for investors who want the high risk/return exposure to venture resources companies.

BUT they should carefully consider whether flow-through shares suit their needs. For one, flow-through shares are not liquid over the short term. For a set period of time, often six to 24 months, investors cannot sell them on the stock market like they would com­mon shares.

Also, investors shouldn't buy more than they can realistically afford to lose, Stier says. Typ­ically, flow-through investments would be part of an investor's high-risk, non-registered por­tion of a portfolio, which can account for about five to 20 per cent of the entire portfolio.

Many proponents of flow-through deals say that because of the tax savings, investors do not need to make a profit on the shares themselves to realize a return. But flow-through shares often are priced at a premium com­pared to common-share prices, usually 10 to 30 per cent above the common-share price.

"If you paid a 10-per­cent premium and made a 25-per-cent tax gain, then you are 15 per cent ahead," Solomon says. "But if you paid a 30-per-cent premium, even if you save 25 per cent on the taxes, you are probably still behind."

Because of the risks involved with investing in just one junior resource company, Solomon says many people invest in limited partnerships, which mostly offer access to flow-through shares of several companies, similar to a mutual fund.

"Usually, the way these work is somewhere between six to 18 months after they're issued they transfer into a normal mutual fund," Solo­mon says.

And just like mutual funds, management has a cost.

Many charge a two-per-cent annual manage­ment fee and take 20 per cent of the profits, but the structures do vary, he says.

Tax savings can also be lessened in limited partnerships. They often invest in companies across Canada and, as a result, may not fully qualify for the provincial tax credit that only applies to companies operating in the province, Stier says.

Other investors are only interested in one company because they know a lot about the sec­tor and the firm, and they figure the potential return outweighs the risks.

But without the flow-through tax incentives, these investors might back away from the deal because they regard these companies as too small and way too risky. In fact, many of Canada's biggest success stories in the mining sector wouldn't be where they are today without the investment capital that the flow-through structure provides, Knowles says.

"It's the way the small companies grow into large ones," he says. "All the large companies that are so well-known in Canada -- Noranda, Vale-Inco, Falconbridge, Teck, Barrick -- start­ed off as little-known explorers."

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To buy, or not to buy

Flow-through shares tax incentives:

Cost of investment is 100-per-cent deductible against income Federal government provides 15-per-cent non-refundable tax credit on most of the cost of flow-through purchase. (Non-refundable credits can only reduce taxes if you are paying taxes.) Provincial government provides a 20-per-cent non-refundable tax credit on cost of flow-through purchase so long as the company is using the capital raised for exploration in Manitoba. (The credit will increase in 2010 to 30 per cent.) They are ineligible for registered savings, but the tax savings resulting from flow-through shares can be reinvested in an RRSP for addi­tional tax savings.

Who should be interested in flow-through shares?

Anyone with high income, looking to reduce tax costs.

Any investor interested in purchasing stock in junior resource firms and wanting to reduce the amount of money at risk in the investment.

Anyone wanting to make a charitable donation can purchase flow-through shares, receive the tax savings and donate the shares to a regis­tered charity. In addition to the flow-through tax savings, the donated amount also receives a tax credit of 15 to 29 per cent.

How to purchase flow-through shares

An investor looking to invest in a company offering flow-through shares can contact the company directly, but chartered financial ana­lyst Daniel Solomon with BMO Nesbitt-Burns cautions that only sophisticated investors who have good financial knowledge or advice about the company should choose this route. The other option for many investors is purchas­ing units in a limited partnership, which more often than not invests in several junior resource firms offering flow-through shares. Mackenzie Investments, for instance, manages a resource limited partnership on a yearly basis.

Other firms, like Hatch Alternative Invest­ments, provide the opportunity to purchase flow-through shares using an offering memo­randum. Only investors who meet certain criteria can invest, such as having an annual income of $75,000 or more, or owning more than $400,000 in assets. Anyone, however, can invest up to $10,000 in a deal as long as there is an offering memorandum.

How do flow-through shares perform?

The results may vary for specific compan­ies, but generally, flow-through-share limited partnerships do well in bull markets, when demand for commodities is very high, as in 2006 and 2007, Solomon says. In bear markets, like last year, they often do much worse than more established companies because investors shy away from businesses that do not have revenue.

There's gold in those hills

It's often been said that the Golden Boy points toward Bissett, where gold mines have oper­ated on and off for almost 100 years, says John Knowles, president of Wildcat Exploration. San Gold Corp. operates two gold mines in the Rice Lake region and has three more potentially viable discoveries in the works. Wildcat owns a large portion of the land surrounding San Gold, including the former Jeep Mine site, reputed to be Manitoba's highest average gold producer.

But gold production in that region has been a start-and-stop enterprise, and many compan­ies have successfully mined gold for periods of time only to fall on bad market conditions or plain bad luck, says Wayne Stebbe, Wildcat's vice-president of investor relations. Even San Gold Corp., despite being hailed as a Manitoba success story, has yet to show positive returns after paying its expenses.

When does a gold discovery become viable?

If you can see the gold in the rock, then you know you're onto something, says Knowles, but you don't have to be able to see the sparkle to be sitting on a viable mining operation. De­pending on where the deposit is located and its size, a gold discovery may or may not lead to a mining development. Exploration companies measure gold discoveries in grams of gold per ton of ore, and gold at even two grams per ton may be viable if it's easily accessible. Lower­grade gold deposits close to the surface, near infrastructure like roads and in politically stable regions can make for a profitable gold mine. At higher concentrations, like the samples Wildcat discovered on the Jeep property at 109 grams per ton, the profitability of the gold outweighs the extraction cost although it's deeper under­ground. The price of gold is a key profitability factor, Stebbe says, adding the Jeep gold mine closed down under a previous owner in the late '60s when gold still backed the U.S. dollar at $35 per ounce. Today, gold is trading at more than US$1,100 an ounce.