Risk outweighs the reward of these tax shelters

Investors continue to look for ways to profit from rising commodity prices. Some are considering a unique kind of tax shelter: flow-through funds.

Flow-through funds mainly invest in flow-through shares issued by junior mining and oil companies. The companies spend the money they receive for these shares on mineral exploration and development, which carries certain tax benefits, in the form of tax credits and tax deferral.

These tax benefits “flow through” to investors in the fund. To take advantage of them, investors need to hang on to the funds for a fixed time, usually 18 months to two years. At the end of that period, flow-through funds convert into standard mutual funds. These tax shelters developed out of a Canadian government plan to encourage natural resource exploration and development.

Tax shelters: A typical flow-through fund by the numbers

For example, an investor in the 50% tax bracket buying $10,000 of a flow-through fund would save $5,000 on income taxes over two years.

That would make the effective cost of the investment $5,000. If the investor later sold the units for $6,200, they would pay capital gains tax of $1,550 ($6,200 times the 50% capital gains inclusion rate, times the 50% tax rate). That would leave a net gain of $5,000. That, plus the $5,000 in tax savings, would be a break-even amount of $10,000.

In other words, the tax shelter could drop 38% and you’d still break even. However, you’d have nothing to show for your investment.

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If the investment sold for more than $6,200 (having originally invested $10,000 in the flow-through fund) then that would be profit (less capital gains taxes).

There is the added benefit that you get the tax reduction in the current year, and you only pay the capital gains taxes in the year you sell the fund.

Flow-through tax shelters are riskier than many investors realize

The problem with tax shelters like these is that the government only provides the tax benefits to persuade you to make a risky investment that you wouldn’t otherwise make. However, some of the benefits go to pay the fund’s organizers and the brokers. What’s left over may not be enough to pay you for taking on the extra risk.

(Instead of flow-through funds, we think you would be better off investing in one of the resource funds we recommend in our new special report, “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds.” Click here for further details.)

Oil and mining stocks have moved up with a recovering global economy. However, flow-through investments may be less rewarding in the next year or two. If resource prices level off or fall, the market in junior-resource stocks could slump deeply, wiping out all the benefits for flow-through investors. You could wind up losing on the deal, even with the tax advantages.

As well, keep in mind that most flow-through issuers are junior companies that are short on financing, or that don’t have enough income to make full use of the tax benefits associated with their exploration. That’s why they sell these shares to investors.

RRSPs, TFSAs the best tax shelters for most Canadian investors

The federal government has eliminated many tax shelters over the years. But there are still a number of highly effective ways for Canadians to cut their tax bills, such as RRSPs, Tax-Free Savings Accounts (TFSAs), and Individual Pension Plans (IPPs).

Another highly effective way to cut your tax bill is to buy high-quality stocks on margin. That’s because you’ll be able to write off your margin interest in full against ordinary income in the current year. However, you’ll pay less than ordinary income-tax rates on dividends from Canadian stocks, thanks to the dividend tax credit. In addition, you only pay capital gains tax on a stock when you sell, or “realize” the increase in the value of the stock over and above what you paid for it.