Besides, it’s never too early to be talking about taxes! To be honest, after spending hours of research on how to use flow-through shares to invest, I came to the conclusion that the average Canadian investor is way better sticking to something simple like a robo-advisor, or a discount brokerage like Questrade, where they can invest in a basic couch potato portfolio of vanilla index ETFs. If you are fortunate enough to have maxed out both your TFSA and RRSP, then you might consider flow-through shares simply because the tax advantages would then start to become a little more pertinent.
So your big question might be, “What the heck are flow-through shares? How do they “flow-through”? … and who gave them that name anyways?”
I can’t answer who came up with the name flow-through shares, but I’ll try and answer the former two questions.
Flow-through shares
- Basically, an investment that has intense tax advantages (which means you get a big refund come tax refund time)
- Primarily involves investments in the Oil and Gas Industry, the Mining Industry, and the Wind Power Industry
- The investment is 100% tax-deductible against your income
- After a certain period (usually 1-2 years) your shares will roll over into a mutual fund which you can sell at any time
- It turns fully taxable income into future tax-advantaged capital gains
- You have to look at the Marginal Tax Bracket you’re in to see how much money you will get back come refund time
- The higher your pay (the more taxes you pay), the more you’ll get out of this
Here’s how it works:
Let’s pretend you bought $10K worth of flow-through shares. Let’s pretend you make the big bucks, and your Marginal Tax Bracket is 43.7%.
When you get your tax refund- if you work as an employee, you will get $4370 back, meaning you will have tax savings of $4370.
This works by multiplying $10,000 x 43.7%= $4370.
(It’s just like an RRSP- whatever you contribute, you get a tax savings of your marginal tax bracket)
However, there’s a catch.
When you sell your flow-through shares- let’s assume for simplicity’s sake that you neither make nor lose money on the $10,000 you invested, the adjusted cost base is $0- so the capital gain is considered $10,000.
So the tax you would have to pay when you sell is:
$10,000/2=$5000x 43.7%=$2185.
So you got $4370 back from the government, but when you sell, you have to pay a capital gains tax of $2185. Therefore, the net income advantage is $2185.
Pros and cons
Again, since I haven’t done a PROS and CONS list in a long time, I’ll do one now:
Pros
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It’s a nice tax shelter from the government (as we know, there are few tax shelters!)
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If you’re in a high tax bracket, it’s one way to not have to be gauged in paying taxes
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You help stimulate the Canadian economy, eh?
Cons
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When you sell, the adjusted cost base is $0, so whatever you have is considered a capital gain
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They can be super risky
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They are often sold at a premium
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It would be supportive of the oil and gas industry, mining.. I guess that’s what Canada is all about, but if you have issues with it in terms of the environmental consequences of supporting exploration companies, then it might not be for you
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Doing the taxes for flow through shares is complicated. You’ll probably need to get an accountant involved (which might incur extra costs)
My own experience:
Check out my post on my “other” investments. As you know, initially in my personal finance journey, I was tax savings hungry and all I cared about was getting a nice fat tax refund. One shouldn’t just jump into an investment for the tax refund (as I have now learned, lol). I had bought $5000 worth of flow-through shares in 2005. I received approximately $1500 in a tax refund which I later reinvested into something else. However, the current value of my flow-through shares is $1800 (note that I had invested $3500 initially). So if I were to sell it (which I plan to do soon), I would have to pay about $270 in capital gains tax. So I had actually received $1,230 in a tax refund, were I to sell it at its current pricing. So I am down a net of $1930.
So as you can see, flow-through shares have not been good to me (hey that rhymed!). I’ve had much better results using basic index funds and recently switching over to a “hands-off” index investing service called Wealthsimple.
Tips on buying flow-through shares:
- It is recommended that Flow Through shares are not to exceed 5-10% of your portfolio since they’re so risky
- They can be bought buy your local financial adviser (mine kind of pushed them on me)
- They are usually sold at certain times of the year (“offerings”) and are often sold at a premium
- Try and time your flow through shares purchase well
- Make sure you understand that your money won’t be accessible for at least a year or two- so don’t buy it if you’re planning to save up for a large purchase
- Don’t be like me and just get it for the tax advantages (though very tempting, I know)
I hope that helps clarify the confusion! Any readers out there have flow-through shares in their portfolio?
