Go with the flow - how the Australian critical minerals sector can benefit from Canada's flow-through shares regime
The utility of flow-through shares
Australia is a key exploration and development focus for junior to mid-market ASX listed companies operating in the critical minerals sector. However, as the sector becomes increasingly dominated by established market participants (driven in part by transaction activity - see recently for example, Albemarle’s efforts to engage with Liontown Resources, Wyloo’s bid for Mincor Resources and the potential contest for Essential Metals) and those with downstream processing capability, Australian exploration companies are looking overseas for project opportunities. One of those jurisdictions is Canada, where the combination of its critical minerals exploration and resource potential and rule of law presents an attractive alternative project destination for Australian companies.
In addition to Canada’s exploration and development potential, its tax regime offers mining sector participants a tax-based capital raising incentive not available in Australia. This is via the issue of flow-through shares. Where a company issues flow-through shares, that company renounces its Canadian exploration and development expenditures to Canadian taxpayers (who in turn can utilise those tax deductions for their own income tax purposes). The value attached to a company’s ability to renounce this expenditure in the hands of Canadian taxpayers means that certain Australian companies with exploration and development projects in Canada have been able to utilise flow-through shares to raise capital at a premium to the prevailing market price for their securities (in turn minimising the dilutive impact of the raising). This presents an attractive regime for eligible Australian critical minerals companies that have incurred exploration and development expenditure and have “capital hungry” Canadian projects.
We explain further below how Australian companies with projects in Canada can utilise the flow-through share regime.
Who can issue flow-through shares?
There are two threshold matters to consider in determining eligibility to carry out a flow-through share issue:
- First, at the entity level, under Canadian tax laws, the entity has to be a “principal business corporation”, which refers to a corporation whose principal business consists of one or more specified activities. In relation to mineral exploration, the specified activities include: (i) mining or exploring for minerals; (ii) processing mineral ores to recover metals or minerals from the ores; (iii) processing or marketing metals or minerals that were recovered from mineral ores; and (iv) fabricating metals. While the entity must be a corporation, it does not need to be a Canadian corporation (either incorporated or headquartered or with mind and management in Canada).
- Second, at the asset level, the key requirement under Canadian tax laws is that the exploration property in question must be a “mineral resource” property located in Canada. The term “mineral resource” is defined to include base or precious metal deposits as well as certain industrial mineral deposits (in some cases, certification must be obtained to qualify the mineral deposit as a mineral resource). Very recently, the Canadian government has proposed to include lithium from brines as a “mineral resource”.
Accordingly, subject to satisfying this eligibility criteria, Australian incorporated ASX listed companies with Canadian critical minerals assets can issue shares under Canada’s flow-through share regime.
How are flow-through shares issued?
“Flow-through shares” are an Income Tax Act (Canada) concept but are not a special class of shares. The rights (for the purchaser) and obligations (for the company) associated with the renunciation of tax-deductible mining expenditures are created via contract subject to the Income Tax Act (Canada). Specifically, flow-through shares are created when the purchaser enters into a subscription and renunciation agreement with the company to acquire ordinary shares, under which the company agrees to (i) incur ”Canadian exploration expenses” for an amount not less than the subscription amount within two years; and (ii) renounce such expenses to the subscriber before a certain date (generally, on or before 31 December of the year in which the shares are issued, but in any case before 1 March of the first calendar year ending after the last year in which Canadian exploration expenses are to be incurred). This written contract creates the flow-through shares.
How it works
In practice, an issue of flow-through shares by an Australian company works in a similar way to an ordinary share placement, including the requirement to ensure it has sufficient ASX Listing Rule placement capacity (unless it seeks shareholder approval due to insufficient placement capacity). However, there are a few additional steps involved for the issue of flow-through shares by ASX listed companies. A typical process is carried out on the following basis:
- The company engages a Canadian flow-through share dealer and enters into a subscription and renunciation agreement with that dealer (as described above). Under that agreement, the company agrees to issue, and the dealer agrees to subscribe for the flow-through shares as agent for certain Canadian resident investors (the Initial Purchasers) at a premium to the market price for the company’s shares. The company agrees to incur “Canadian exploration expenses” equal to the subscription amount and renounce such expenses to those Initial Purchasers by 31 December 31 of the year in which the shares are issued.
- For flow-through share offerings by Australian companies, the Initial Purchasers generally do not ultimately hold the flow-through shares issued by the company; however, as the Initial Purchasers of the flow-through shares, they are able to benefit from the tax deduction in respect of the “Canadian exploration expenses” renounced by the company. The company makes the renunciation by filing certain prescribed Canadian federal and/or provincial forms.
Initial Purchasers that are individuals (other than trusts) may also claim an additional 15% tax credit for flow-through mining expenditures or, where the mining and exploration activities relate to critical minerals, a 30% tax credit. In the context of Canadian tax law, the term “critical minerals” refers to copper, nickel, lithium (with proposed amendments to include lithium from brines), cobalt, graphite, a rare earth element, scandium, titanium, gallium, vanadium, tellurium, magnesium, zinc, a platinum group metal, or uranium.
On top of the federal flow-through tax incentives described above, certain Canadian provinces also offer flow-through tax credits or enhanced deductions for mining and exploration activities relating to mineral resource properties located within the province.
- In addition to engaging the Canadian flow-through share dealer, the company engages a lead manager (or more than one lead manager) for the purposes of managing the placement and sourcing sophisticated and professional investors to acquire shares (the Placement Investors).
- The Canadian flow-through share dealer enters into a block trade agreement with the lead manager to facilitate the secondary sale of the flow-through shares to the Placement Investors. The shares sold under the block trade to Placement Investors are priced at a discount to the market price of the company’s shares prior to announcement. The Placement Investors are the final holders of the flow-through shares under the placement and are not entitled to renunciations for flow-through expenses or to any tax credits.
- To facilitate the secondary sale of the flow-through shares (and any other securities issued under the capital raising), the placement is cleansed at or around the time the flow-through shares are issued. There appears to be a market practice in Australia to prepare a transaction specific prospectus to cleanse the secondary sale of shares in flow-through share offerings. However, as a matter of securities law, flow-through shares do not form a separate or distinct class of shares in the company (as described above). In other words, flow-through shares are simply ordinary shares, and, in our view, the secondary sale of those shares can be cleansed in the same way as an issue of ordinary shares under a conventional share placement (for example, by a cleansing notice rather than a prospectus, assuming the company is eligible to issue a cleansing notice).
Hard vs soft dollars
A key planning and structuring consideration for any flow-through share offering is to consider the role of “hard” versus “soft” dollars in the corporation’s financial planning and budgeting process. In this context, a “soft” dollar refers to the fact that funds raised through a flow-through capital raising may only be used for those purposes outlined under Canadian tax laws as eligible for flow-through treatment. The most common form of permitted expenses are “grassroots” Canadian exploration expenses - meaning expenses incurred to determine the existence, location, extent, or quality of a mineral resource in Canada. This includes expenses for environmental studies, community consultations, and expenses incurred during (i) prospecting, (ii) carrying out geological, geophysical, or geochemical surveys, (iii) drilling by rotary, diamond, percussion, or other methods, or (iv) trenching, digging test pits and preliminary sampling.
This means that there are several other budgetary and operational items which a mining exploration company may need to source funding for (which may be solely through financing activities if it is an exploration company with no significant project revenue). Examples include executive salaries, general and administrative and head office expenses. When equity capital raisings are a company’s main or sole source of funding, then these matters must be funded by the issue of non-flow-through shares to raise “hard” dollars (i.e., where the use of funds is not restricted by Canadian tax legislation).
As a result, placements of flow-through shares are often structured as a component of a larger equity raising undertaken by the ASX listed company, with the balance of the raising structured as a conventional share placement, entitlement offer or a share purchase plan (or combination of those). Because of the comparative attractiveness of flow-through-shares to Canadian purchasers, multi-component offerings typically price the flow-through shares at a premium, while the non-flow-through share offering is priced at a discount to market.
As noted above, companies generally have issued a prospectus to cleanse the on-sale of shares issued in connection with a flow-through share raising. We don’t consider a cleansing prospectus is necessarily required for these purposes (assuming a company is eligible to issue a cleansing notice under the Corporations Act). If a company elects to (or is otherwise required to) to prepare a prospectus for the flow-through shares, it will need to ensure it allows itself sufficient time in advance of announcing the offering to establish an appropriate system of due diligence and satisfy the content requirements for transaction specific prospectuses under the Corporations Act.