20 June 2014 External T.I. 2014-0532221E5 - Disposition of Canadian resource property

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: What is the tax treatment of future Royalty payments received by an estate?

Position: The Royalty Payments are included in income under section 9 or paragraph 12(1)(g).

Reasons: Text of the legislation.

XXXXXXXXXX
2014-053222
Boriana Christov
(613) 946-5350

June 20, 2014

Dear XXXXXXXXXX:

Re: Petroleum and Natural Gas Lease

We are writing in response to your request of May 13, 2014 wherein you enquired as to the tax consequences of certain amounts received by your client in respect of a petroleum and natural gas lease (the "Lease"). You provided us with the following facts:

1. Mr. A owned certain subsurface rights (the "Property") which allowed Mr. A the right to explore for, drill for or take petroleum.
2. Several years ago, Mr. A entered into the Lease with an oil company whereunder the Property was leased to the oil company for the purpose of drilling petroleum in consideration for an upfront bonus payment and a right to receive royalty payments based on the value of future production from the well (the "Royalty").
3. Mr. A received monthly royalty payments (the "Royalty Payments") pursuant to the Royalty.
4. Mr. A died in XXXXXXXXXX.
5. Immediately before the death of Mr. A, the Property was valued at approximately $XXXXXXXXXX. The valuation was based on the fair market value of the future Royalty Payments.
6. The estate of Mr. A (the "Estate") is continuing to receive the Royalty Payments.

You enquire as to the tax consequences that result from the above-described situation.

OUR COMMENTS

Written confirmation of the income tax implications inherent in particular transactions is given by this directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request as described in Information Circular 70-6R5 dated May 17, 2002 issued by the Canada Revenue Agency ("CRA"). A fee is charged for this service. Although we are unable to provide any comments with respect to a particular fact situation otherwise than in the form of an advance income tax ruling, the following general comments may be of assistance.

The term "Canadian resource property" ("CRP") is defined under subsection 66(15) of the Income Tax Act (footnote 1) as including any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada. Generally, when a taxpayer enters into such a lease with an oil company, he disposes of the right to drill for petroleum and receives consideration that includes the fair market value of the Royalty and the upfront bonus. Provided that the Property qualified as CRP, the consideration received by Mr. A for entering into the Lease represented proceeds of disposition of a CRP. Since the CRP consisted of oil and gas rights, these proceeds would have been deducted from Mr. A's "cumulative Canadian oil and gas property expense" ("CCOGPE") balance as defined in subsection 66.4(5) of the Act pursuant to element F of that definition.

Under paragraph (d) of the definition of CRP, a right to royalty computed by reference to the value of production from an oil well in Canada may qualify as CRP provided that the payor has an interest in the well and 90% or more of the royalty is payable from the production from the well. Provided that the Royalty qualified as CRP, Mr. A would have added the fair market value of the Royalty to the CCOGPE balance.

If the CCOGPE balance was negative as a result of these adjustments and there was no balance in the "cumulative Canadian development expense" pool (as defined under subsection 66.2(5) of the Act), the negative amount would be included in Mr. A's income for that taxation year.

Upon the death of Mr. A, paragraph 70(5.2)(a) of the Act would apply such that Mr. A would be deemed to have disposed, immediately before his death, of any CRP owned by him and to have received proceeds of disposition equal to the fair market value of the CRP at that time. Accordingly, the CCOGPE balance would be reduced by the fair market value of the Royalty immediately before the death of Mr. A. As discussed above, where the CCOGPE balance was negative as a result of this adjustment and there was no balance in the "cumulative Canadian development expense" pool, the negative balance would be included in Mr. A's income.

Under paragraph 70(5.2)(b) of the Act, the Estate is deemed to have acquired the Royalty at its fair market value immediately before death of Mr. A and this amount should be added to its CCOGPE balance. The Estate would be entitled to deduct any amount not exceeding 10% of the balance in the CCOGPE pool at the end of a taxation year pursuant to subsection 66.4(2) of the Act. The Royalty Payments will be included in the income of the Estate under section 9 or paragraph 12(1)(g) of the Act.

We hope that these comments will be of assistance.

Yours truly,

Fiona Harrison, CPA, CA
Manager,
Resources Section
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy & Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 R.S.C. 1985, c. 1 (5th suppl.) as amended; hereinafter (the "Act").