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The new allure of global commodities markets: flow-through limited partnerships offer an intriguing investment option for high-income earners.

Global trends require us to update our portfolio investments on a regular basis. But even the most dedicated retail investors occasionally overlook valuable options in the rapidly changing investment field. Flow-through limited partnerships (FTLPs), for instance, are often overlooked by retail investors but can be useful tools for managing the portfolios of high-income individuals or corporations.

FTLPs are tax-advantaged vehicles designed for investment in a portfolio of flow-through shares, which are usually issued by companies in the oil, gas and mining sectors. By taking a look at the current economic picture, the potential value of such an investment appears fairly clear.

The macroeconomic picture

In a recent analysis of global financial markets, Don Coxe, chairman and chief strategist for Harris Investment Management Inc., and chairman of Jones Heward Investments, suggested that future historians will view the early years of the new millennium as, "the time when world economic leadership shifted from the Atlantic to the Pacific world." (1)

The driving force in that shift in leadership is the reemergence of China as a major engine of global economic growth. Beginning in the last two decades of the 20th Century, Chinese manufacturing growth accelerated to the point that it's now the factory to the world. Today, China is in the early stages of its transformation from an export-driven economy to a consumer-driven economy: the sleeping giant will soon fully awaken.

Demand in China has steadily driven commodity prices higher. China has changed from a net exporter to a net importer of oil in the course of a few years. A periodic check on a Bloomberg terminal shows a steady stream of tankers headed from the Persian Gulf to Asian ports. Chinese demand and a weak U.S. dollar has many analysts contending that oil will trade in, and OPEC will target, a new trading band that is substantially higher than in the past.

The pace of urbanization--China builds the infrastructure equivalent of the city of Houston every year--shows no sign of abating and creates a steady demand for precious and base metals. Growing consumption among the Chinese (and Indian) middle class provides more stimulus for commodities. Despite the cooling of its growth rate in the first two months of 2004, it's difficult to foresee anything but steady, and at times spectacular, growth for China for the remainder of the decade.

As a resource exporting country, Canada is well positioned to benefit from strong macroeconomic prospects for commodities. We profit from both surging global demand and the apparently insatiable appetite of American consumers. The greatest threat to a sustained world recovery is the spectre of a U.S. dollar crisis, a possibility that can't be discounted. Holding gold would be a hedge against that possibility. Overweighting base metals and gold positions an investor to benefit from a sustained Asian boom while providing some downside protection.

FTLP structures

FTLPs, as investments primarily in the oil, gas and minerals sectors, seem likely vehicles to benefit from global trends. Flow-through shares are a special type of common equity share issued by a resource company to fund exploration and development expenditures. The issuing company renounces the tax shelter created by these expenditures, which is then "flowed through" to the investors who purchased the shares at a premium to the value of the common shares.

FTLPs were created to allow professional managers to build portfolios of flow-through shares for investors and still allow for the tax benefits (i.e. the renounced tax write-offs) to pass to the limited partnership investors. In a typical structure, the general partner has authority to manage, and has unlimited liability for, the operations and affairs of the partnership. Investors are limited partners and therefore have their liability limited to the amount of their initial investment. The general partner may also hire a portfolio manager to assist in the selection of the partnership's investments. It is crucial to carefully consider the track record, managerial ability, experience and resources available to the general and portfolio managers of any FTLP you might consider.

FTLPs can be offered at any time but often raise funds early in the year to have time to deploy the funds and, not surprisingly, to coincide with individual tax return deadlines. In instances where the manager is able to deploy capital rapidly, additional limited partnerships may be offered. One of the key issues faced by the portfolio manager during the investment process is the acquisition of the flow-through shares. Due to the tax benefits that accompany those shares, issuers usually command a premium issue price relative to ordinary common shares. Premiums can range from 0-30% depending on the demand for the issue and the attractiveness of the company. To ensure adequate portfolio performance, portfolio managers generally try to pay premiums of 10% or less when acquiring flow-through shares. One cautionary note regarding flow-through shares is the total size of the market for them. If too much money is chasing too few deals, the premium paid for the flow-through shares will eventually reach a point that effectively negates the tax benefits.

Tax benefits of FTLPs

Investors in FTLPs usually find the amounts invested to be fully or almost fully deductible against other taxable income in the year the investment is made. The deduction is found on line 224 of the T-1 Canadian income tax return. For individuals at the highest marginal rate, tax savings could amount to nearly half of the original investment. Most FTLPs have a life span of less than two years--enough time to allocate most of the tax deductions to investors. Investors then remain partners in a portfolio of smaller Canadian resource companies, and their adjusted cost base will usually be low or nil. At that point, many partnerships elect to exchange their partnership interests for an open-ended mutual fund with no immediate tax consequences. Taxation is deferred until the investor redeems the mutual fund shares, at which point he/she realizes a capital gain.

Tax planning strategies

Investing in a FTLP can be an important tax planning tool. There are three common uses for these vehicles: to reduce taxable income, to take advantage of capital loss carry-forwards, and by corporations. To illustrate, assume that the flow-through investment is 100% deductible in the year of investment (in practice, it is typically 90-100% deductible with the balance deducted in future years and attributable to organization costs). Furthermore, assume the value of the investment at maturity is the same as its original purchase price, whereas in practice the value of the investment in the FTLP will rise or fall. Finally, our notional investor is a single Ontario resident taxed at the top marginal rate of 46.41%.

If our investor earns $200,000 in 2004, he will pay approximately $77,137 in taxes. If he invests $50,000 in a FTLP, his income tax will be reduced to about $53,937, resulting in an immediate saving of $23,200. When he redeems the investment after its conversion to a mutual fund, there will be a $50,000 capital gain, of which $25,000 is taxable, and tax payable of approximately $11,600, leaving him a net tax saving of about $11,600. Many investors use a two-year "ladder" of FTLPs and roll over the redeemed amount into a new partnership each year. If our investor had capital loss carry-forwards from the previous three years, he could use them to reduce the capital gains realized upon redemption of the mutual fund shares. In all cases, investors should consult their tax adviser to be sure they don't trigger the application of the Alternative Minimum Tax.

Corporations can also own FTLPs. While it's generally tax inefficient to realize capital gains in a corporation, it might make sense to use FTLPs when a corporation has capital loss carry-forwards. Assume our notional taxpayer invests $100,000 in a FTLP and receives a tax saving of $46,400 in the first year. After receiving the initial tax benefit, he transfers the FTLP or the mutual fund shares into his company and elects under subsection 85(1) of the Income Tax Act to transfer the investment at his adjusted cost base of approximately zero. The transfer should trigger no income tax. Finally, the corporation then sells or redeems the investment, either while it's still an FTLP or when it has "matured" into a mutual fund. There will be a $100,000 capital gain, $50,000 of which is taxable, but the gain is sheltered by the corporation's capital losses. The non-taxable portion of the capital losses and the $50,000 non-taxable portion of the capital gain would be included in the company's capital dividend account. The positive balance, if any, of the capital dividend account could be paid as a tax-free dividend to our taxpayer.

This article summarized the basic features of FTLPs and some of the ways they may be incorporated into investment portfolios and tax planning strategies. The strategies briefly described here are hardly exhaustive. FTLPs certainly have a place in the portfolios of high-income individuals who wish to have exposure to resource exploration. To reiterate, the quality of the individual limited partnership must be carefully considered before making an investment. Nevertheless, the macroeconomic picture appears to be favourable at this time for oil, gas, and mining--the sectors most identified with the flow-through market.

1 Basic Points: The Great Symbiosis, February 27, 2004.

Andrew Hood (andrew.hood@nbpcd.com), Ph.D., is an Investment Advisor with BMO Nesbitt Burns Inc. Opinions are those of the author and may not reflect those of BMO Nesbitt Burns. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. BMO Nesbitt Burns is a member of CIFP. The comments included in the publication are not intended to be a definitive analysis of tax law: The comments contained herein are general in nature and professional advice regarding an individual's particular tax position should be attained in respect of any person's specific circumstances.
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Title Annotation:Money Management
Author:Hood, Andrew
Publication:CMA Management
Geographic Code:1CANA
Date:Jun 1, 2004
Words:1670
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