Flow-through limited partnerships offer big tax breaks but may not be the best things for your portfolio

Flow-through limited partnerships developed out of a Canadian government plan to encourage the exploration and development of Canada’s natural resources. Under the plan, companies involved in oil and gas, mining and base metals and other natural resource industries are permitted to fully deduct specific exploration expenses, known as the Canadian Exploration Expense (CEE). They can pass these deductions on to investors, through flow through shares.

Investors buy units of a limited partnership, which in turn invests in flow-through shares of public resource companies. Most of these companies trade on the Toronto Exchange or the TSX Venture exchange. In turn, the partnership passes the Canadian Exploration Expenses through to its unitholders.

Typically, initial investors buying flow-through limited partnerships are able to deduct 100% or more of their investment against income by the end of the second year. This leaves the investor with an adjusted cost base on the units of zero. When you subsequently redeem or sell the limited partnership units, you pay capital gains on the entire balance of the sale.

Usually at the end of 18 months or 24 months, flow-through limited partnerships convert into mutual funds, or in some cases into limited partnerships trading on a stock exchange. Investors then have the option of continuing to hold their units on a tax-deferred basis, or of redeeming their mutual fund shares at their net asset value per share, or selling them on the stock exchange.

For example, an investor in the 50% tax bracket buying $10,000 of a flow-through limited partnership would save $5,000 on income taxes over two years.

That would make the effective cost of the investment $5,000. If the investor later sold the investment for $6,200, he or she would pay capital gains tax of $1,550 ($6,200 times the 50% capital gains inclusion rate, times the 50% tax rate). That would leave a net gain of $5,000. That, plus the $5,000 in tax savings, would be a breakeven amount of $10,000.

In other words, the flow-through investment could drop 38% and you’d still break even. However, you’d have nothing to show for your investment.

If the investment sold for more than $6,200 (having originally invested $10,000 in the flow-through limited partnership) then that would be profit (less capital gains taxes). 

There is the added benefit that you get the tax reduction in the current year, and you only pay the capital gains taxes in the year when you sell the fund.

One big drawback in flow-through limited partnerships is that many of the flow-through mining and energy stocks they invest in are highly speculative. The partnerships are also usually in a hurry to invest their money to pass the tax deductions on to their investors as quickly as possible. That can lead to some hasty stock selections. 

Another drawback with flow-through partnerships is their lack of liquidity. In most cases you can’t get your money out until the partnerships convert into mutual funds, or limited partnership trading on a stock exchange, after 18 months to 24 months.

Like all new issues, flow-through partnerships have upfront fees. These could be agent fees, offering fees and even annual management fees. Managers can often be paid an incentive bonus which is a percentage of how much the asset has appreciated over the two years.

Despite their tax benefits, investments in illiquid flow-through partnerships are risky. That’s even true right now, with prices of junior oil and gas stocks trading at multi-year lows on the basis of currently low oil and gas prices.

We don’t recommend investing in flow-through limited partnerships.

Have you invested in flow-through limited partnerships? Was it a profitable experience? Let us know in the comments.