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moneysense.ca, 18/03/09
Avoid Flow-Through Limited Partnerships
In an earlier post, I explained why I avoided flow-through limited partnerships, which provide tax breaks for investing in resource exploration companies. When I wrote that post, flow-through funds had posted double-digit, after-tax returns in the recent past. Not anymore, notes Fabrice Taylor in The Globe and Mail:
Flow through isn’t flowing. It’s plugged up. First-quarter offerings were down almost 70 per cent in terms of number of deals and even more in terms of aggregate size. That’s obviously partly because there’s less appetite for tax shelters since everyone’s net worth has been atomized.
But it’s largely because of performance. They’re just not a good deal. Flow-through funds have all cratered. Yes, you can blame the drop in commodity prices to a degree. But there’s more blame to spread around.
Does anyone know how badly these funds have performed? I checked the resource funds from the Middlefield Group, some of which seem to be down 40%, which wouldn’t be too bad in this market.
moneysense.ca, 18/03/09
I can’t understand from your post whether you mean to say that you don’t like flow-through partnerships as a structure, or do you mean that you don’t like to invest in resource companies? If you meant that you don’t like to invest in junior exploration companies, then I completely agree with you whole-heartedly. But if you’re referring to the flow-through limited partnership tax structure, then I completely disagree. I think that tax structure is a great way for an entrepreneur to raise cash, allowing the investor to have some downside protection (due to the tax deductions) while having the upside potential. No bank would ever lend money to junior exploration companies because it’s really like gambling… And that brings me back to my first point why I agree that we shouldn’t invest in junior explorers.
I like the US master limited partnerships, which provide inflation indexes utility like stability in earnings and dividends. Few of them could be had in a tax deferred account however..
Phil S: Flow-through funds typically invest in junior mining companies; typically they are very speculative. My understanding is the tax code provides a way for these companies to pass on the exploration tax credits to individual investors. So, say I want to invest $5,000 in a flow-through fund. I get a $5,000 tax deduction for the current year but the ACB of the investment becomes zero. When I sell these funds in two years (typically, these funds are illiquid for two years), the entire proceeds become liable for capital gains tax.
I utilized a flow through when I left my employer and had a tax issue. My intent was to double up the tax benefits by donating the shares to a charity on the first date that I could do so without impacting my tax credit. Unfortunately, the units dropped 70% and my $10k is currently worth less than $3k. Having said that, I will still follow through on my plan, the charity donation will be a few years later than expected and slightly smaller I imagine. Even if the shares are down 50%, I will have the initial tax credit, the charity credit, and a good feeling that my donation will help somebody.
In short, it is a tax scenario NOT an investment scenario. Anytime you invest in a tax scenario always assume you are throwing the initial investment away. If it was a quality investment grade security it would not be a flow-though to begin with.
CC. Yes, I know what they are… But in my opinion, as a tax structure, I think it’s a good thing. Are you saying that you don’t like the tax entity?
Or, are you saying that it’s a bad idea to invest in junior resource companies, regardless of the tax structure? If that’s the case, then I agree, I don’t like to invest in junior resources.
It wasn’t clear from your post whether you’re saying that the structure is bad, or that investing in junior resource companies are bad.
Phil & CC
I think flow through’s cause confusion because they are often sold as an investment vehicle with tax benefits. They do not really stand on their own as an investment strategy.
If they are sold as a tax strategy and the risk fully explained, then they do have a place and a role in certain portfolios. If I read the comments right, Phil is pointing to the tax strategy which has a potential to add value and CC is pointing out the investment strategy which seems to have little value on its own..
I was hoping for another post about Derek Foster. Whats going on here ?
mike, Phil: I’m doubtful even the tax strategy has merits because the tax savings seem to be eaten up by frictional costs. For one thing, there is a 6% commission to buy these funds. On top of it there is a 2-and-20 fee structure. The flow-through shares are issued at a premium to market value. Taken together, these costs wipe out the 20% tax advantage we start out with.
And of course, the investment itself is very speculative.
mfd: As it turns out, I’m getting “Money for Nothing” out from the library. I’ll be reviewing it but it will be the last post on DF for a while.
This makes me think of Labour Sponsored Funds, which offer an up-front tax benefit, but poor liquidity and high-risk investments. They tend to perform quite poorly, and in Manitoba, the Crocus Fund went bust.
Historically, and intuitively it makes sense, the best time to invest in flow through’s is after a year or two of bad returns (i.e. commodity prices). However, the most offerings, and demand, is after strong returns. This may be a good time look at them (or possibly next year). Also, with any tax enhanced investment, certainly look at the investment merits first and the tax savings second, IMHO.