(Corrects name in final two paragraphs)
* Flow-throughs are risky but can effectively shelter tax
* Their popularity is also driven by high commodity prices
* Loophole on big gifting benefit may be closed soon
By John McCrank
TORONTO, March 25 (Reuters) - Flow-through shares are a distinctly Canadian investment vehicle that enables the wealthy to save on tax bills while playing the red-hot resource sector.
Even though changes in Canadian law may soon strip them of some of their most generous tax benefits, flow-throughs are still an attractive option for high-net-wealth investors that financial advisers should consider recommending to their clients.
The Conservative government included a measure in its budget aimed at saving Ottawa C$185 million ($181 million) over five years by blocking a loophole that basically made it possible for rich people to give money away without it costing them anything.
The government on Friday lost a no-confidence motion, triggering an election later this spring and putting the flow-through measure in hiatus for now. But analysts say changes to the tax treatment for flow-throughs are only a matter of time.
"Flow-through charitable donations were in the government's mind too generous because they gave such an incredible tax break," said Larry Short, a senior investment adviser at DundeeWealth in St. John's, Newfoundland.
"They still are popular, because a lot of people are very interested in investing in commodities because basically, China is trying to buy every rock and tree that we have," he said.
Flow-through shares were introduced more than two decades ago to encourage investment in junior resource companies, which are often high-risk ventures that don't generate revenue and don't have the capital for start up, exploration, and development costs.
To make buying into these companies more palatable, the government allows them to flow through the tax deductions they receive to investors. So the full amount paid for the shares is deductible against the income of the investor.
When the shares are sold, at a preset time of up to two years, the adjusted cost base of the investment is deemed zero, so the full amount is taxed as capital gains, which can be beneficial to those in high tax brackets.
Mining companies using flow-through shares to attract investment have had some major discoveries, including one of the world's largest nickel finds, Voisey's Bay in Labrador.
Short said junior resource companies are especially popular among high-net-worth clients right now due to the recent run-up in the prices of commodities like copper, gold and oil. The flow-through tax shelter is an added bonus.
Short, whose average client is 62 years old and has around C$700,000 in assets, gave an example of how a client in a high tax bracket could use flow-through shares.
The client has just received a severance pay of C$10,000, on which he is going to get taxed at 46 percent, or C$4,600. The client takes the C$10,000 and invests in flow-through shares, and the amount is deducted against his income.
Two years later the shares are still worth C$10,000, with an adjusted cost base of zero. The client sells them and the C$10,000 is taxed as capital gains causing about C$2,200 in taxes to be paid, for a tax savings of C$2,400.
"It's kind of like converting regular income into capital gains income," said Allison Marshall, a financial advisory consultant at Royal Bank of Canada's wealth management arm.
Marshall, who cautioned that junior resource stocks can be very volatile and that losses can outweigh the tax benefit of the investment, said flow-through shares have also been a popular vehicle for people to donate to registered charities.
"It was something that quite a number of our high-net-worth clients were looking at as a strategy," she said.
In 2006, Ottawa eliminated capital gains on the donation of publicly traded shares to registered charities. That made donating flow-through shares especially attractive.
By donating the C$10,000 in shares to a registered charity rather than selling them, the investor would get a tax receipt for the whole amount, and would not have to pay the C$2,200 in capital gains taxes. The C$10,000 donation cost him C$800.
However, the Conservatives included in their budget earlier this week a measure that would make the capital gains exemption on donations of flow-through shares only count to the extent that the capital gain exceeds the amount paid for the shares, ignoring the deemed zero-adjusted cost base.
Jamie Golembek, managing director of tax and estate planning at CIBC Private Wealth Management (CM.TO), said that under the new measure, after donating C$10,000 in flow-through shares, the capital gains tax, at a rate of 50 percent, would be C$2,300 - making the cost of the donation C$3,100.
The measure would have applied to all flow-through shares bought after March 22.
While the Conservatives lost the confidence of Parliament, pushing the country into an election before the budget was passed, both Short and Marshall said that doesn't mean the measure won't get enacted in the future.
"It's best to assume that the rules are going to be place as of March 22 for planning purposes," Short said. "If it comes out that it's better, then so be it."
(Editing by Frank McGurty)