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Mining for cash: Financing incentives for Canadian mineral companies

Evaluating a mineral project and bringing it into production is a long, capital-intensive process. Given the current economic climate where exploration ...

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|Jul 10|magazine28 min read

Evaluating a mineral project and bringing it into production is a long, capital-intensive process. Given the current economic climate where exploration and development funding can be scarce, mineral companies need to stretch every dollar. The Canadian Government has a number of generous incentive programs designed to encourage mineral companies to develop Canadian projects in order to retain the economic benefit of those projects. As with most government programs, it’s important to engage in the process carefully so as to fully realize the advantages while minimizing exposure to unnecessary liabilities.

Mining exploration tax credit programs

Many Canadian provinces and territories have mining exploration tax credit (METC) programs or a variation thereof. Those offered by British Columbia and Quebec are the more generous of the available programs with the highest available being 38.75 percent of qualifying exploration expenditures. Generally, these programs may provide a company with a refundable tax credit as a percentage of qualifying expenditures claimed.

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Qualifying expenditures include those incurred on “grass roots” exploration activity with a higher tax credit rate if incurred within certain geographical areas within the province or territory as a means to encourage such activity and further the economic benefit from the mining industry to that province or territory.

Qualifying criteria

When considering such programs in an exploration budget, it is important to understand whether such activity will qualify for the relevant program and the amount that can be expected to be received. To qualify for any METC program, the company claiming the credit must be a corporation with a permanent establishment in the relevant province and must not to be tax-exempt.

Refund limitations

Assuming the company’s claim qualifies, the amount of credit to be received varies within jurisdictions, with additional amounts available for expenditures for activity in certain geographical areas, such as in Quebec. It is key to understand the specifics of the applicable METC program early on in order to avoid shortfalls against budgeted tax credits.

Preparing for CRA scrutiny

The Canada Revenue Agency (CRA) is vigilant in its administration of the Income Tax Act. Part of such activity includes audits of significant claims through METC and other such programs that they administer. It’s a reasonable expectation that a significant claim through a METC program will be subject to CRA audit and, as such, it is prudent to ensure any METC claim is thoroughly and accurately prepared, with detailed documentation maintained to defend the claim in the event of an audit. Depending on a company’s internal resources and capabilities, the engagement of an experienced tax professional in the preparation of a METC claim may serve to reduce the likelihood of a CRA challenge of all or a portion of a claim and otherwise reduce any delay in refund of the credit in the event of a CRA audit.

Flow-through share program

Flow-through shares are a common tax incentive program used by mineral exploration companies as they can be a good option for companies with projects in the “grass roots” exploration stage.

A flow-through share is a non-prescribed, “plain vanilla” common share that allows the company to “transfer” the qualifying expenditures to the shareholder for a deduction on the shareholder’s tax return. Certain provinces, such as Quebec, have enhanced tax benefits to the flow-through shareholder for funding spent on mineral exploration performed in certain strategic regions, such as the far north in Quebec. This tax deduction would be of limited value to the company given that the utilization of the ensuing non-capital losses is uncertain or far off in the future. However, this tax benefit is attractive to investors with significant taxable income to shelter, effectively providing a discount on the flow-through share for the purchaser.

Qualifying criteria

In general, flow-through funds must be spent on “grass roots” exploration activities incurred for the purpose of determining the:

• Existence;

• Location; and

• Extent or quality of a mineral resource in Canada, including but not limited to the following activities:

• Prospecting;

• Carrying out geological, geophysical or geochemical surveys;

• Drilling by rotary, diamond, percussion or other methods;

• Trenching, digging test pits and preliminary sampling; or

• Certain pre-production activities.

The look-back rule

The timing of the “transfer”, or renunciation, of the qualifying expenditure to the shareholder can occur either before or after the funds from the issuance of flow-through shares are spent by the company. The former option is referred to as the “look-back rule” and carries with it certain drawbacks. When the look-back rule is applied, the CRA encourages expedient spending by levying Part XII.6 tax penalties, which are deductible by the company, on unspent funds shortly after renunciation. Once in effect, these penalties are calculated monthly at the CRA’s prescribed rate (1 percent yearly as of the date of this publication) with an additional 10 percent penalty applied at the end of the first calendar year following the year of renunciation if the funds are unspent.

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Should funds remain unspent within 24 months after the month of the signing of flow-through share agreements, the CRA will reverse the shareholder’s tax benefit which can result in the shareholder repaying the associated tax refunds and may force the company to reimburse the amount of the lost tax benefit if the shareholder agreement contains an indemnity clause. The existence of a limited indemnity for tax losses will not affect the shares’ eligibility for renunciation under the flow-through share program. Outlays for non-qualifying expenditures will be rejected by the CRA, which may result in penalties and interest should there be insufficient qualifying expenditures to cover the full amount of the flow-through funds raised within the necessary time period.

These types of unpleasant scenarios can be avoided by applying the look-back rule only to funds to be spent before the trigger date for penalties: February 28 of the calendar year following the year in which the funds were raised. In many cases, shareholders hungry for an immediate tax benefit will pressure the company to apply the look-back rule on more funding than it can effectively spend prior to incurring penalties. Should this scenario be anticipated, the resulting penalties should be considered in the cost of the financing and, if possible, the company should avoid the inclusion of an indemnity clause in the shareholder agreement.

Scientific Research and Experimental Development tax credit program

The single largest indirect funding program in Canada is the Scientific Research and Experimental Development (SR&ED) tax credit program, which allows companies to receive tax credits or generous refunds for qualifying expenditures. Companies developing new technology including new products, new processes or other new technological knowledge can generate significant qualifying expenditures related to labor costs, materials consumed or transformed, Canadian contractors and other overhead costs directly related to qualifying activities. The most generous refundable SR&ED tax credits can be available to small and medium-sized private Canadian corporations. Large private Canadian, all public and all non-Canadian corporations benefit through the less generous, non-refundable SR&ED tax credits. There is no defined budget for the program, meaning that any company incurring qualifying expenditures is eligible; however, claims must be filed within 18 months of the end of the company’s tax year.

Qualifying criteria

The key requirement to receive the refundable federal credits is that the entity must be a Canadian-controlled private company (CCPC) meaning that it is a Canadian corporation that is not publicly listed or controlled by non-residents. For this reason, the SR&ED program is rarely utilized by early stage mineral exploration companies as these are often public companies and thus qualify only for a tax credit, which is of little use to a loss-making exploration stage entity. However, mining companies with profitable projects where technological advances are made during the construction and ongoing operation of a revenue producing project can take advantage of this program with such tax credits reducing their ongoing tax expense.

Most provinces also have their own SR&ED credit and some of them may be refundable even if the entity is not structured as a CCPC. Despite the planning efforts of any initial company structure, it is important to note that small changes within the R&D entity’s structure could prevent the company from participating in the refundable SR&ED tax credits. Further to this, the ultimate determination of eligibility can be made only by the CRA.

It’s important that any company claiming SR&ED tax credits follow the scientific method and track all potentially related activities and the associated costs contemporaneously. We find that a periodic review of candidate SR&ED activities by an experienced SR&ED consultant can be beneficial to maximize the claim. Many companies are surprised to find out what actually qualifies.

This post was written in collaboration with Daryl Maduke, International Tax Partner at BDO Canada and David Spicer, SR&ED Partner at BDO Canada, both of whom have been valuable resources and trusted colleagues for many years.

Bryndon Kydd is the head of BDO’s Natural Resources practice in Vancouver, Canada. He can be reached at via [email protected] on LinkedIn.

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