Written by Matthew Peters and Greg Johnson
On December 16, 2020, the Department of Finance released draft legislation aimed at providing relief to resource companies that had issued (or will issue prior to the end of 2020) "flow-through shares" (FTS) by extending the statutory time period by which such companies may incur qualifying expenditures. This legislation, which is consistent with the government's original announcement of such measures in July 2020, has been eagerly anticipated by an industry dependent on flow-through share financing but hampered this past year with shut-down or similar operational issues as a result of the COVID-19 pandemic.
FTS financing is extremely popular in Canada as a way for junior resource companies to raise capital at a premium to market prices in order to fund exploration and development activities. A FTS generally sells for a premium because the initial subscriber of the FTS is entitled to claim federal tax deductions up to the amount of the subscription price and may also be entitled to claim provincial tax deductions and federal/provincial tax credits. Accordingly, the personal tax benefits of a FTS can be very attractive to investors seeking to create tax attributes to shelter other sources of personal income from federal/provincial tax. However, in order for the subscriber to claim these benefits, the company issuing the FTS must incur exploration/development expenditures equal to the subscription price within a certain statutory period (which varies depending on the precise nature of the exploration/development activities to be undertaken) in order for it to "renounce" the expenditure to the initial subscriber.
The general timing rule under current law is that the qualifying expenditures must be incurred in the period that begins on the day on which the FTS agreement is entered into and ends 24 months after the end of the month that includes that day (colloquially referred to as the "general rule"). Such expenditures are renounced to the subscriber as they are incurred.
However, there is a different timing rule (colloquially referred to as the "look-back rule") applicable to a more limited subset of qualifying exploration and development expenditures. Under the look-back rule, the issuer of the FTS is entitled to renounce all of the expenditures to the subscriber in the year that the FTS agreement is entered into even though the company may not yet have incurred such expenditures. However, under current law, the company must ensure that all of the expenditures are, in fact, incurred no later than December 31 of the next calendar year. Subscribers therefore get the benefit of claiming all federal/provincial deductions/credits up front and will typically pay an additional premium for FTS that qualify for such look-back treatment. The issuer of FTS under the look-back rule is further liable to pay something akin to a monthly "toll charge" (Part XII.6 tax) in exchange for the right to renounce expenditures before they are incurred.
A potential pitfall of the look-back rule is that, if the company fails to incur all of the expenditures before December 31 of the following calendar year, the company will have "over-renounced" to the subscriber in the year the FTS agreement was entered into. This means that the subscribers will have claimed excessive deductions and credits in their personal tax returns for that year and will be subject to reassessment for taxes, interest and penalties. The company typically agrees to indemnify a subscriber for any taxes arising from a breach of the company's obligation to properly incur and renounce expenditures.
Practical Difficulties with the Current Law
Companies that issued FTS as far back as 2018 under the general rule may still potentially have had unfulfilled expenditure obligations into 2020. Companies that issued FTS under the look-back rule as far back as 2019 would potentially have had expenditure obligations in 2020. An issuer of FTS under either rule in 2020 would likely have expenditure obligations into 2021 unless they were able to fully incur all expenditures in 2020.
All seemed fine, and then the pandemic hit. Exploration and development activities in certain provinces and territories may have been formally shut down or have been otherwise limited. Health and safety concerns, including the implementation of continually-evolving and non-universal social distancing guidelines, may have created significant challenges for a company to satisfy its expenditure obligations that could not have been anticipated at the time it issued the FTS. As with many areas of the economy, significant uncertainty abounded as to what business could actually be carried out in 2020 (and potentially beyond).
In the absence of the government extending the statutory periods for being able to incur expenditures, there would have been a material risk that we would witness a significant curtailing in the ability of junior resource companies to raise FTS financing in 2020 and thus jeopardize their ability to remain operational. Moreover, the prospect of many junior resource companies having to incur significant cash costs in order to satisfy future indemnification obligations to subscribers was looming.
The Legislative Proposals
The draft legislation is pretty much as anticipated.
For FTS agreements based on the general rule, the 24-month time period is to be extended to 36 months. This is applicable for FTS agreements entered into after February 2018 and before 2021.
For FTS agreements based on the look-back rule, the company that issued the FTS will have an additional 12 months to incur the expenditures. For FTS agreements entered into in 2019, this means that the company will have until the end of 2021 to incur the expenditures (contrary to the December 31, 2020, deadline under current law). For FTS agreements entered into in 2020, this means that the company will have until the end of 2022 to incur the expenditures (contrary to the December 31, 2021, deadline under current law).
Note that these proposed extensions do not apply to FTS agreements entered into after 2020. If the pandemic continues to disrupt the economy and the activities of resource companies into 2021, another round of similar legislative amendments may be desirable.
The proposed legislation has certain corresponding changes extending particular filing deadlines as well as changes that defer the company-level "toll charge", mentioned above.
If your business or organization has any questions about flow-through shares please contact the authors of this blog or a member of the Bennett Jones Tax group.