Removing the Insult from Injury
Adam Aptowitzer, February 01, 2007
I have recently started to field many questions about the donation of flow through shares to charity. It appears that since the budget announcements in May 2006, word has slowly been spreading about the effect of donating flow-through shares to a charitable organization or public foundation (colloquially called a public charity).
Flow-through shares are defined in extremely technical language in the Income Tax Act but are fairly easy to understand. A flow-through share is a special type of share of a mining company which allows the shareholder to use certain exploration expenses as a deduction against their personal income. Different types of expenses are treated in different ways. Some expenses incurred by the corporation are 100% deductible by the shareholder whereas some are limited to 30%. Under many circumstances the shareholder would get to deduct 100% of the purchase price of the share in the year it was bought.
The catch though is that for income tax purposes the cost of the share is deemed to be zero. So even if the buyer buys the share at $10.00 and sells it at $8.00 the shareholder is still taxed on an $8.00 capital gain. Of course, when compared to the fact that the shareholder may have already deducted the purchase price of the share from his or her income and capital gains are only taxed at half the amount of other income the incentive still exists to buy the share.
However, from a cash flow perspective the shareholder will be selling the share well after the deduction is taken, and given that there is an automatic capital gain on the shares (unless they fall to zero) the shareholder will by definition be paying tax on the sale.
In a situation where a taxpayer bought publicly traded shares for $5,000 and they are now worth $4,000 he can either sell them for $4,000 or donate them to a charity for $4,000. If he sells them there will be a taxable capital gain of $2,000 and at the highest marginal rates a tax liability of $920. So the taxpayer has not only lost $1,000 of value (absent the deduction) but to add insult to injury he must pay an additional $920 to the government.
On the other hand, if the shares are donated to charity, the taxpayer will receive a $4,000 donation tax credit, which will offset approximately $1,840 of taxes. Thus, the difference between selling the shares and donating them to charity is only $1,240, this represents the true cost of the donation in the circumstances, and assuming the shareholder has taken advantage of the deductions allowed by flow through shares the cost of the donation in this example could easily be reduced to zero.
Of course, the deduction is an important element of the decision to purchase the shares in the first place and one cannot calculate the true value of the share without accounting for it. In fact, at least psychologically, it may help convince people to make the donation. If, as in the above example, the true cost of a donation is $1,240 and one has already taken advantage of a $5,000 deduction when the expenses were flowed out to the shareholder, one may be convinced to donate the share on the assumption that the real cost of the share (after the donation) is close to (or perhaps below) zero. It is still not as good as keeping the share for yourself but at least it makes the donor feel that much better about donating.