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Canada Tax Changes Add to Tough Mining Environment

Life remains hard for junior resource companies...

LIFE is difficult for junior resource companies. Not only are stocks and commodity prices moving sideways, but tax changes in Canada may signal less friendly treatment for exploration investment. But not all is grim, according to Arie Papernick, the head of equity capital markets at Secutor Capital Management Corp. in Toronto. In this interview with The Metals Report, Papernick says investors can still make money if they focus on companies that are producing or near production with an attractive capital structure and strong balance sheets. He reveals that the next big opportunity may be coming in the energy metals space.

The Metals Report: Arie, the Canadian government recently introduced a new budget that contains changes to the tax code that are expected to affect mining companies with producing mines. John Gravelle, a mining expert for PricewaterhouseCoopers, recently called this legislation "a form of stealth resource nationalism." What's your view?

Arie Papernick: The budget proposes reductions to some of the tax benefits that can be passed to flow-through shareholders. The major impact is that some traditional pre-production expenses, also called Canadian exploration expenses (CEE), which previously could be 100% written off in the year incurred, will be phased out over the next few years. Starting in 2018, only 30% of these expenses can be deducted on a declining basis as Canadian development expenses (CDE). This will potentially hurt resource companies' ability to raise capital through flow-through shares as the flow-through investor community generally insists on receiving only CEE deductions.

The changes will also be troublesome for junior companies that are developing new mines, because they will have to start paying taxes much sooner if CEE can no longer be used to reduce taxable income on a 100% deduction basis.

TMR: Do the budget changes suggest Canada is becoming a less viable place to start a mine?

Arie Papernick: Not at all. Of course, any time you mess around with tax benefits or the deduction rates on capital equipment, it affects cash flows and makes capital investment less attractive. But at the same time, Canada is a pretty safe jurisdiction. And flow-through shares are a terrific way of raising capital that is unique to Canada. On the positive side, the budget extended the investment tax credit for flow-through shares in respect of certain grassroots mining expenses. The combination of federal and provincial tax credits provides powerful incentives. It's unfortunate that Canada is proposing tweaks in this budget that may make flow-through investment a bit less attractive.

TMR: How would Arie Papernick fix what is happening? Could this be done by legislation?

Arie Papernick: I think maintaining the benefits of flow-through investment for the Canadian resource market is key. If anything, the government should be going the other way. In certain areas that are more remote, there should be additional tax benefits for investing in these projects. Experts believe the proposed budget changes are trying to align the mining industry with the oil and gas industry, but there are significant differences between the two, and, if anything, the mining space needs more tax incentives to motivate investment.

TMR: Funding for exploration is very difficult right now. What fallout do you see in the market if this dearth of financing persists?

Arie Papernick: I see a future with a lot fewer mining companies. We'll see more mergers and acquisitions (M&A) as well as property acquisitions due to interest from Asian and South American companies. You're also going to see a lot of a junior exploration companies looking for opportunistic property acquisitions. I'm getting a lot of calls from clients on that. Smaller companies that have good balance sheets are looking for opportunities. You're going to see a lot of combinations of smaller companies to create a new company with more assets. Combining companies is a good reason to restructure and make companies more attractive as investments. In the current market, the capital structure of many junior miners won't attract institutional investment capital and that has to be fixed.

TMR: What commodities are you most bullish on right now?

Arie Papernick: The action seems to be focused on uranium. We're seeing a few successes in that space. Uranium exploration around the southwest of the Athabasca basin seems to be where the interest is building. There have also been a lot of acquisitions and land deals in the area and the price of uranium has been going in the right direction.

TMR: What's your outlook for the junior mining equity space over the rest of the year?

Arie Papernick: It's still going to be tough. The main problem stems from a few years ago when the major miners overspent on acquisitions and subsequently wrote them off. In the past, the majors were always viewed as the exit strategy for the juniors, and so those exit dreams are being questioned. The other major reason for our weak market is basically flow of funds. Major indices are hitting all-time highs, so a lot of portfolio managers are moving money out of the juniors and into large-cap plays. They've been able to chase returns on much bigger non-resource names.

For these reasons, the problems in the resource space are likely to continue for some time. Moreover, resource issuers are highly dependent on financings and the amount of money available is much less than the number of people looking for it. It's going to take some time and a couple of things will need to happen. A lot of experts believe there are too many public resource companies. A lot of them won't be able to continue. This will help the survivors get access to the limited available funds.

We've seen over the last few months numerous very small financings, sub-$500,000, some even less than $100,000. You can't further exploration on that kind of a shoestring budget. As such, a lot of resource companies just won't make it. As I mentioned, there will be a lot of consolidation with a lot of juniors pairing together, people in similar jurisdictions trying to work together to increase their asset base in order to survive.

TMR: Do you have one last piece of advice for investors in this space?

Arie Papernick: Companies need to have the ability to finance themselves, but if successful, they then need to be able to use the money as wisely as possible and continue to be active and create news. Many of the companies that have cash are so worried about the market that they tend to hoard the cash. Cutting back dramatically on their programs leads to less news, and when there is less news, there's no reason to buy the stock. That keeps the downward pressure on the share price, and that can put companies into a lousy position when eventually they will need to finance again. 

Operating a junior resource company is not easy; it is a constant battle. Most do not produce any revenue, so they are just spending. They constantly need sources of funding, and as soon as they get money, they are in a race to produce results to keep the share price attractive, so that further financings don't totally dilute existing investors. I don't envy the position of junior resource executive.

TMR: Thank you for your insights, Arie.

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