13 April 2000 Internal T.I. 1999-0011917 - CEE; Resource Allowance; Recovery Expense

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1. Whether cost of depreciable property may be CEE
2. Whether resource allowance is reduced by enhanced recovery expenses

Position:

1. No
2. Yes

Reasons:

1. made clear in new retroactive legislation - 66.1(6)(k.1), (l); meaning of "included"
2. "concept of source of production in resource allowance provisions is broader than in legislation where "development" must be distinguished from "production"

			April 13, 2000

Calgary Tax Services Office Resource Industries Section
Denise Dalphy
Attention: Bharat Patel (613) 957-9231
Oil & Gas Specialist
991848
1999-001191

Costs of Tangible Capital Property

This is in reply to you facsimile transmission of July 7, 1999 concerning submissions dated June 2 and 18, 1999 that you received from XXXXXXXXXX.

The submissions address the following issues:

ISSUE 1

Is the interest of a partner in a partnership that owns Canadian resource property "...an interest in any property..." within the meaning of paragraph (g) of the definition of Canadian resource property in subsection 66(15) of the Income Tax Act (the "Act")?

COMMENTS

Our position continues to be as stated in memorandum #982800.

ISSUE 2

Whether the cost of depreciable capital property can qualify as CEE - before and after December 1996.

COMMENTS

We disagree with XXXXXXXXXX position that a taxpayer may deduct the cost of depreciable capital property as a Canadian exploration expense in lieu of claiming capital cost allowance in respect of the property, as well as XXXXXXXXXX view that the above provisions were merely intended to prevent "double counting". In fact, we are not aware that any issue of "double counting" has been raised in respect of this issue with either Revenue Canada or the Department of Finance.

The Department's long-standing position (see E9618289) is that the cost of depreciable capital property cannot be included in CEE. As you are aware, the Department will continue to advance this argument in its appeal of the decision of the Tax Court of Canada in Phénix.

On July 23, 1999, the Department of Finance issued a press release advising that it proposes to amend the definition of CEE in 66.1(6) by adding paragraph (k.1) to make it clear that CEE does not include the cost of post 1987/pre-December 1996 acquisitions of depreciable property. Paragraph 66.1(6)(l) of the definition of CEE, which was enacted to provide greater certainty in determining CEE and applies to taxation years that end after December 6, 1996, provides: "(l) any amount (other than a Canadian renewable and conservation expense) included at any time in the capital cost to the taxpayer of any depreciable property of a prescribed class" [emphasis added].

The crux of the argument raised by XXXXXXXXXX is as follows:

Is an amount included in the capital cost to the taxpayer of any depreciable property of a prescribed class where the taxpayer has not claimed (or does not intend to claim) capital cost allowance?

It is our opinion that an amount is "included" in determining a taxpayer's capital cost of property, irrespective of whether the taxpayer has recorded it as such in his books of account or has claimed any capital cost allowance in respect of the property. The word "included" is quite broad: Webster's Ninth New Collegiate Dictionary defines "include" as "to take in or comprise as a part of a whole", and it is reasonable to state that an amount is included in a taxpayer's capital cost of property if it forms or comprises part of the taxpayer's cost of that property.

This view is consistent with the reasoning in R. v. Kettle River Sawmills Ltd. and Elk Bay Logging Ltd., 94 DTC 6086 (FCA), where the Court found that the timber licences that were acquired before May 6, 1974 and were renewable had a cost and an undepreciated capital cost, notwithstanding that the taxpayers had never claimed capital cost allowance [on the acquisition costs]. It is also consistent with the reasoning of the Exchequer Court of Canada in Sherritt Gordon Mines Ltd. v. MNR, 68 DTC 5180 (where the Court provided the "classic statement of what is cost" and focused on what the asset cost, not how it was accounted for):

"In the absence of any definition in the statute of the expression "capital cost to the taxpayer of property" and in the absence of any authoritative interpretation of those words as used in section 11(1)(a), insofar as they are being considered with reference to the acquisition of capital assets, I am of opinion that they should be interpreted as including outlays of the taxpayer as a business man that were the direct result of the method he adopted to acquire the assets. In the case of the purchase of an asset, this would certainly include the price paid for the asset. It would probably include the legal costs directly related to its acquisition. It might well include, I do not express any opinion on the matter, the cost of moving the asset to the place where it is to be used in the business. When, instead of buying property to be used in the business, the taxpayer has done what is necessary to create it, the capital cost to him of the property clearly includes all monies paid out for the site and to architects, engineers and contractors.

It seems equally clear that it includes the cost to him during the construction period of borrowing the capital required for creating the property, whether the cost is called interest or commitment fee. Such cost is a capital cost that could not be deducted as an operating expense, without special authority. Possibly as good a way as any of testing the matter is to consider the possibility of a third person creating the required assets to the taxpayer's specifications to sell them to him when completed. All their financing costs would enter into the price that the taxpayer would have to pay for the assets and there would be no doubt that the price would be the capital cost of the property to him if he bought it ready to use. If that be so, why should those costs be classified otherwise when he creates the asset himself?" [emphasis added]

Our interpretation that capital cost is, in general terms, the amounts paid to acquire or create the asset is also consistent with the Act. For example, paragraph 20(1)(a) allows a deduction for "such part of the capital cost...". The question as to whether an amount is included in a taxpayer's capital cost before making a cca claim or recording it in accounting records must be answered in the affirmative, for otherwise no claim would ever be possible (no cca unless capital cost, but no capital cost without cca claim, ...). Our interpretation of the legislation is also consistent with our understanding of the intent of the above amendments.

ISSUE 3

Do pre-July 24, 1992 secondary and enhanced recovery expenses reduce resource allowance?

COMMENTS

First it is necessary to determine whether these expenses are CEE. If so, they will not reduce resource allowance. If they are development expenses that are related to an income source that is production and are neither CEE nor CDE, they will reduce resource allowance, provided production has commenced. Simply because a cost may be classified as development expenses does not exclude it from relating to an income source that is production.

A. Classification of Secondary and Enhanced Recovery Costs as CEE

Paragraphs (m) and (n) of the definition of CEE provide, inter alia, that CEE shall not include expenses to assist in the recovery of oil and gas or injections of substances to do so, if production has commenced. These paragraphs apply to taxation years that end after December 5, 1996.

It is possible that certain recovery costs incurred in taxation years ending before December 6, 1996 may qualify as CEE if they satisfied the definition of CEE in either paragraph (a) or (b) therein. With respect to XXXXXXXXXX expenses, it appears that neither paragraph will apply. The facts that are available to us lead to the conclusion that the expenses were not incurred to determine the extent, location, or quantity of the accumulation as is required to fall within paragraph (a). In addition, the expenses would not appear to qualify for inclusion in paragraph (b) because, although it may be possible for the taxpayer to satisfy the purpose test in that paragraph, it appears that these expenses were not incurred before the coming into production in commercial quantities.

B. Resource Profits and Development Expenses

In our view, the decision and rationale of the Court in Mobil Oil Canada Ltd. v. The Queen [1994] 2 CTC 249 (FCA) does not apply in interpreting the resource allowance provisions of the Act.

Facts

XXXXXXXXXX advises that certain costs were incurred:

"XXXXXXXXXX ."

Legislation

During the relevant time for the transactions that are presently under audit, resource allowance was claimed pursuant to section 1210 of the Income Tax Regulations (the "Regulations"), which essentially provided a deduction in the amount of:

"1210 (1) ...

(a) 25% of the amount, if any, by which

(i) his "resource profits" for a year (within the meaning assigned by subsection 1204(1) if that subsection were read without reference to paragraph (a) or subparagraph (b)(iv) thereof) computed as if no amounts were deducted in computing those resource profits

(A) in respect of a rental or royalty....,

(B) in respect of financing, or

(C) under paragraph 20(1)(v.1) of the Act or paragraph 1204(1)(d) or (e) ..."

[emphasis added]

"1204

(1) For the purposes of this Part, "resource profits" of a taxpayer for a taxation year means the amount,
if any, by which the aggregate of
.....

(b) the amount, if any, of the aggregate of his incomes for the year from

(i) the production of petroleum, natural gas or related hydrocarbons from oil or gas wells in Canada operated by him,

.....

exceeds the aggregate of

.....

(e) the amounts deductible or deducted, as the case may be, under 66.1, 66.2 (other than an amount that is in respect of a property described in clause 66(15)(C)(ii)(A) of the Act or 66.4 of the Act for the year; and

(f) such other deductions for the year as may reasonably be regarded as applicable to the sources of income described in paragraph (b) or (b.1), other than ..."

In simple terms, the former legislation detailed above works as follows:

1. ADD all income from the taxpayer's Canadian oil and gas production [1204(1)(b)]

2. SUBTRACT, inter alia,:

the total of (a) the taxpayer's CCEE and CCDE [1204(1)(e)], and

(b) the taxpayer's other production related deductions [1204(1)(f)]

3. ADD the amount in 2(a) above [1210(1)(a)(i)(C)]

The effect of the above is that section 1204 would reduce "resource profits" by CEE and CDE (which was important for calculating earned depletion), but for the rule in section 1210 of the Regulations which provides that exploration and development expenses that are CCEE and CCDE deductions are not to be taken into account in computing the resource allowance.

Analysis

The taxpayer has argued, on the basis of the decision in Mobil Oil Canada Ltd. v. The Queen, that development expense cannot be considered to relate to production for purposes of interpreting the resource allowance provisions. We disagree. There is neither an explicit nor an implicit requirement in the resource allowance legislation that requires a conclusion that an expense cannot be related to production if that expense could be classified as exploration or development or as CEE or CDE. In our view, for the purpose of interpreting the resource allowance provisions, Mobil must be distinguished for the following reasons:

1. Interpretation of Different Legislation with Different Legislative Purposes

In Mobil, the Court was required to interpret the word "development" as this term was used in subparagraph 6(b)(i) of Part XVII of Schedule III of the Excise Tax Act. The Court concluded that the aircraft was purchased for use exclusively in the provision of services directly related to the "development" of natural resources and therefore the taxpayer was entitled to an exemption from federal sales tax.

In Mobil, the Court concluded:

"This test [as to whether an activity is "development"] must in my opinion be understood in the sense of the maximization of the potential of the natural resource. Therefore, development would not include, as the trial judge correctly held, treatment or processing of oil and gas in the field after extraction and before transmission to a refinery occurs. However, the augmentation of the available pool of oil or gas at the bottom of the well bore, through enhanced recovery systems, is not production, but rather quantitatively maximizing the commercial potential of the resource. Development must therefore mean not only the installation of such systems, but also their operation, since the maximization of potential requires both."

Thus development would include whatever precedes the extraction of the oil or gas. Extraction of oil or gas, in however adulterated form, is production, whereas the augmentation of the pool at the bottom of the well bore is development. The two stages are clearly severable in concept, and the results are clearly measurable in fact." [emphasis added]

The resource allowance provisions do not involve an interpretation of the word "development". Instead, the relevant legislation requires an interpretation of the words "deductions ... as may reasonably be regarded as applicable to the source of income [production of petroleum...]".

In discussing an 1985 amendment to subsection 1204(1), the Explanatory Notes to the 1996 Federal Budget provide:

"One of the specified activities is described in existing subparagraph 1204(1)(b)(i) as the "production of petroleum, natural gas or related hydrocarbons from ... petroleum or natural gas extracted by the taxpayer from a natural accumulation thereof in Canada". The existing wording is deficient, as petroleum, natural gas or related hydrocarbons are not "produced" from petroleum or natural gas itself. This subparagraph was meant to accommodate special oil recovery techniques, such as gravity-assisted drainage techniques. As a consequence, clause 1204(1)(b)(i)(b) is amended to describe the activity as the "production of petroleum, natural gas or related hydrocarbons from ... natural accumulations (other than mineral resources) of petroleum or natural gas in Canada operated by the taxpayer". This is a relieving amendment and applies to taxation years that end after March 1985." [emphasis added]

2. The comments of the Court in Mobil re "production" are obiter

The comments of MacGuigan, JA, in Mobil, with respect to "production" are obiter and do not form part of the ratio of the case. In Mobil, the Court was merely required to determine whether certain costs were "development" costs and , while its comments on the meaning of "production" may be persuasive in a case that is on "all fours" with Mobil, XXXXXXXXXX case is not identical and the comments concerning "production" are not binding - they were not a necessary part of the decision-making process in Mobil.

Accordingly, although the analysis in Mobil should be given serious consideration in interpreting the word "production", it is critical to note that the wording in section 1204 of the Regulations is quite different than the words in the Excise Tax Act that were the subject of interpretation Mobil. Section 1204 of the Regulations makes no distinction between concepts of "development" and "production", and as such an analysis of how the two concepts may be different is not relevant in interpreting "production" in the resource allowance context.

3. "Production" is not synonymous with "may reasonably be regarded as applicable to the sources of income [that is production]

In XXXXXXXXXX, the relevant issue is not whether pre-July 24, 1992 secondary and enhanced recovery expenses are "development" costs, or whether they are "production" costs, per se; instead the issue is whether their enhanced and secondary recovery expenses "may reasonably be regarded as applicable to [income from a source that is ... production] ...."[emphasis added]. The latter is a more encompassing concept than production.

4. The Scheme of the Act

As described above, in computing "resource profits" under subsection 1204(1), income from production must be reduced by, among others, CEE, CDE and "such other deductions ... as may reasonably be regarded as applicable" to income source that is production. CEE and CDE are often directly linked to production: for example paragraph (b) in the definition of CEE refers to expenses incurred "for the purpose of bringing" an accumulation "into production" [paragraph (g) has a similar rule with respect to the development of mines]. Expenses that fall within paragraph (b) of the definition of CDE must have been incurred "after the commencement of production".

It is interesting that the definition of "enhanced recovery equipment" in section 1206 of the Regulations looks to the ultimate purpose of this equipment, which is to produce more oil, and not the immediate purpose, to move the oil within the accumulation. The definition describes this equipment as property that "was acquired by the taxpayer...for use in the production of oil...that is incremental to oil that would be recovered using primary recovery techniques alone..." Similarly, the definitions of "secondary recovery method" and "qualified tertiary oil recovery project" focus on the enhanced recovery of oil, not on the fact that the oil is shifted from one location to another.

In conclusion, we are of the view that for the purposes of the resource allowance, there is considerable support for the position that certain development expenses will be production related expenses, within the meaning of 1204(1)(f) of the Regulations.

For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, he can be provided with the LAD version or he may request a copy severed using Privacy Act criteria which does not remove the client's identity. Requests for this latter version should be made by you to Jackie Page at (613) 957-0682. The severed copy will be sent to you for delivery to the client.

If we can be of any further assistance or if you wish to discuss this matter further, please contact the writer.

John Chan, Manager
Resource Industries Section
Resources, Partnerships and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch