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: (a) Whether the losses incurred by A Co. from its oil and natural gas price hedging transactions under certain contracts could be considered as losses from speculation for investment purposes and not losses from A Co.'s oil and natural gas production business. (b) Whether these losses could be excluded from the resource profit calculation under section 1204 of the Regulations.
Position: (a) No (b) No
Reasons: (a) Given the jurisprudence and XXXXXXXXXX given that it appears the contracts were entered into in the normal course and as an integral part of A Co.'s oil and natural gas production business even though the contracts might not bear the normal characteristics of its other hedging instruments, we opine that the losses resulting from the contracts would be considered as losses from A Co.'s oil and natural gas production business and not from its speculation for investment purposes. (b) Based on the above-noted conclusion, these losses should be included in the resource profit calculation pursuant to subsection 1204(1) of the Regulations. For certainty, even if subsection 1204(1) of the Regulations did not apply to these losses, given that they relate to the "resource activity" of A Co. within the meaning of the expression in subsection 1206(1) of the Regulations, it is our view that these losses would reduce resource profits under paragraph 1204(1.1)(a) of the Regulations.
2000-002748
XXXXXXXXXX Peter Lee
(613) 957-8977
Attention: XXXXXXXXXX
September 15, 2000
Dear Sir:
Re: XXXXXXXXXX
Speculative vs. Non-Speculative Contracts
Further to our meeting of May 9, 2000 (Lee/XXXXXXXXXX), this is in reply to your letter of May 16, 2000, wherein you have requested our views on whether certain contracts entered into by XXXXXXXXXX could be considered as speculative contracts and hence the losses therefrom would not have to be included in the calculation of "gross resource profits" and "resource profits" of XXXXXXXXXX within the meaning of the expressions in section 1204 of the Income Tax Regulations (the "Regulations").
Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request. Where the particular transactions are completed as in this case, your inquiry should be addressed to the relevant tax services office. However, we are prepared to offer the following general comments which may be of assistance.
Hypothetical Situation
1. A Co. carries on the business of exploration, development and production of oil and natural gas. Due to the volatility of the market price of oil and natural gas, it is not unusual that many companies in this industry enter into various hedging instruments, such as forward sales contracts, call options and commodity price swaps. A Co. has at least two long standing master commodity price swap agreements (the "Master Agreements") under which A Co. could enter into various hedging instrument transactions in respect of its oil and natural gas production business. XXXXXXXXXX Certain designated officials of A Co. have been specifically authorized by its Board of Directors to utilize financial market hedging instruments relating to only up to XXXXXXXXXX of the oil and natural gas volumes produced by A Co. At all relevant times, this oil and natural gas volume limit was not exceeded. A Co. generally enters into hedging instrument contracts with certain common characteristics: (a) the term is normally not more than six months; and (b) commodity volume is normally between XXXXXXXXXX barrels per contract.
2. Several hedging instrument contracts (the "Contracts") were entered into by a designated official on behalf of A Co. pursuant to the Master Agreements at the time the oil and natural gas market prices were very low. The fixed prices under the Contracts were approximately XXXXXXXXXX higher than the current market prices at the time of entering into the Contracts. However, the term of the Contracts was more than six months, the commodity volume was more than XXXXXXXXXX barrels per contract, and in one case, both the oil and natural gas prices and not just oil price were hedged. Thereafter, the oil and natural gas prices rose more than the prices fixed in the Contracts. As a result, A Co. incurred substantial losses from these hedging transactions under the Contracts.
Issues
3. The issues are: (a) whether the losses from these hedging transactions under the Contracts could be considered as losses from speculation for investment purposes and not losses from its oil and natural gas production business; and (b) whether these losses could be excluded from the resource profit calculation under section 1204 of the Regulations.
4. In the case of Gulf Canada Limited, 92 DTC 6123 (FCA), Hugessen, J.A. commented for the Court as follows:
It is true that the mere physical act of taking minerals or oil or gas from the ground does not and cannot produce income; when Parliament has described "production" as being a "source", as it clearly has in sections 124.1 and 124.2 [the predecessor provisions to subsection 1204(1)], it must be understood as the business of production.
5. In the case of Gulf Canada Resources Limited, 96 DTC 6065 (FCA), Pratte, J. commented for the majority of the Court as follows:
In the first Gulf Oil case relating to its 1974 income tax, it was held that the word "production" in a provision similar to section 1204 was used in the narrow sense of extraction from the ground and that, as a consequence, the only incomes and deductions referred to in that provision were those that were directly related to the actual production of petroleum.
6. In concluding that the forward sales contracts were an integral aspect of the company's business of producing silver and hence the profits therefrom could properly be characterized as "resource profits" in the case of Echo Bay Mines Ltd., 92 DTC 6437 (FCTD), MacKay, J. commented as follows:
Exact matching was not feasible from a practical point of view, nor is it required in order to constitute hedging. In respect of this final conclusion, I rely on the reasons of Locke, J. in Atlantic Sugar Refineries Limited, 49 DTC 602 (SCC)...
Production activities yield no income without sales. Activities reasonably interconnected with marketing the product, undertaken to assure its sale at a satisfactory price, to yield income, and hopefully a profit, are, in my view, activities that form an integral part of production which is to yield income, and resource profits, within Regulation 1204(1)...
I conclude that the price received by the plaintiff for the silver it produced was the sum of receipts from delivery of actual production and from settlement of forward sales contracts. The business of the plaintiff was silver production. In these circumstances where the plaintiff participated in forward sales contracts and settlement, however, as a hedge against price fluctuations in silver, and in which the commodity traded was silver futures, I do not conclude that the plaintiff was involved in futures speculation for investment purposes. There was a clear business purpose in its sales and settlement of silver futures contracts, a purpose integrated with its sales of product to yield income; the plaintiff was trying to obtain an assured price for the sale of the silver it produced...
Here the forward sales transactions were in respect of the same commodity as the plaintiff's production; both were, in my view, integral aspects of the plaintiff's business of producing silver, and returns from these activities were income from production of metals within Regulation 1204(1).
7. Given the above-noted jurisprudence and given that XXXXXXXXXX and given that it appears the Contracts were entered into in the normal course and as an integral part of A Co.'s oil and natural gas production business even though the Contracts might not bear the normal characteristics of its other hedging instruments, we opine that the losses resulting from the Contracts would be considered as losses from A Co.'s oil and natural gas production business and not from its speculation for investment purposes. As a result, these losses should be included in the resource profit calculation pursuant to subsection 1204(1) of the Regulations.
8. Even if these losses from the Contract were not included in the resource profit calculation by virtue of subsection 1204(1) of the Regulations, given that these losses and the Contracts relate to the "resource activity" of A Co. within the meaning of the expression in subsection 1206(1) of the Regulations, it is our view that these losses would reduce resource profits under paragraph 1204(1.1)(a) of the Regulations.
We hope that our comments are helpful to you. These are only our general views on the matter and do not constitute an advance income tax ruling and accordingly they are not binding on the Canada Customs and Revenue Agency in accordance with paragraph 22 of Information Circular 70-6R3 as amended.
Yours truly,
John Chan, CA
Manager
Resource Industries Section
Resources, Partnerships and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch
??
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2000
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2000
Email this Content