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 CCRA.

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

2002 Oil and Gas Steering Committee Meeting
Halifax, Nova Scotia
September 9-11, 2002

Re: Crown Surface Rights Rentals and Charges
Prepared by Peter Lee
Income Tax Rulings Directorate
September 9, 2002 (#2002-012203)

Introduction

Further to our memorandum to Special Audit Division dated March 26, 1991 (#7-902877) in respect of a study on surface rights rentals, we have been recently asked by an auditor of Calgary TSO to confirm whether payments to the Crown on surface rights rentals and charges should be disallowed as deductions pursuant to paragraph 18(1)(m) of the Income Tax Act (the "Act").

Legislation

Pursuant to paragraph 18(1)(m) of the Act,

"... in computing the income of a taxpayer from a business or property no deduction shall be made in respect of... any amount (other than a prescribed amount) paid or payable by virtue of an obligation imposed by statute or a contractual obligation substituted for an obligation imposed by statute to

(i) Her Majesty in right of Canada or a province,
(ii) an agent of Her Majesty in right of Canada or a province, or
(iii) a corporation, commission or association that is controlled by Her Majesty in right of Canada or a province or by an agent of Her Majesty in right of Canada or a province

as a royalty, tax (other than a tax or portion of a tax that can reasonably be considered to be a municipal or school tax), lease rental or bonus or as an amount, however described, that can reasonably be regarded as being in lieu of any such amount, or in respect of the late payment or non-payment of any such amount, and that can reasonably be regarded as being in relation to

(iv) the acquisition, development or ownership of a Canadian resource property, or
(v) the production in Canada
(A) of petroleum, natural gas or related hydrocarbons from a natural accumulation of petroleum or natural gas... (B) of sulphur from a natural accumulation of petroleum or natural gas... (E) to any stage that is not beyond the crude oil stage or its equivalent, of petroleum or related hydrocarbons from tar sands... "

Background

1. With respect to the enactment of new paragraph 18(1)(m) of the Act, the Minister of Finance commented in the November 18, 1974 Budget Speech as follows:

"... I proposed that royalties, taxes and other like payments to governments should no longer be recognized as a deduction in computing income for tax purposes... I am satisfied that this is necessary step in order to avoid the erosion of the federal tax base... it is evident that a royalty is no longer a royalty in the traditional meaning of the word. There have emerged various provincial charges which are thinly disguised income taxes... provincial charges take many forms... In fact, there are so many kinds of provincial charges and claims that it would be virtually impossible to draft workable legislation which could distinguish between bona fide royalties, traditionally deductible, and other taxes and charges. That being so, we have chosen to disallow the deduction of all these levies and to make room for the provinces by giving additional tax abatement. In this way, the provincial taxes and charges and the federal taxes will each be discrete and visible decisions, which each can take in the light of what they know the other is doing, giving full recognition to the needs of the industries."

2. In 1977, the term "rental" used in paragraph 18(1)(m) of the Act was cancelled and replaced by the term "lease rental" effective after May 25, 1976 (i.e., amended by 1976-77, c.4, subsection 4(1)).

3. With respect to the amendment to paragraph 18(1)(m) of the Act in 1978 effective after May 6, 1974 (i.e., amended by 1977-78, c.1, subsection 11(1)), it was stated in the 1977 De Boo Budget Day Comment as follows:

"It is proposed that the provisions of paragraphs 12(1)(o) and 18(1)(m) be attenuated retroactively to May 6, 1974 to require the inclusion in income, or disallow the deduction of, royalties paid to governments or government bodies only where those royalties are payable pursuant to a statutory obligation. The apparent purpose behind this amendment is to exclude from those provisions royalties which are the subject of commercial arrangements and to restrict their operation to statutory royalties that in the words of the Minister of Finance in introducing the November 1974 budget, are "thinly disguised income taxes".

4. Pursuant to subsection 12(1) of the Surface Rights Act (Alberta), RSA 2000, Chapter S-24, (the "SR Act") no operator (i.e., a person who has the right to a mineral (including oil and gas) or the right to work it, or a person who is empowered to acquire an interest in land for the purpose of the pipeline, power transmission line or telephone line) has a right of entry of the surface of any land in Alberta until the operator has obtained the consent of the owner and the occupant of the surface of the land or has become entitled to right of entry by reason of an order of the Surface Rights Board (the "Board") pursuant to the SR Act. Where a right-of-entry order is issued by the Board, it would also determine the amount of compensation for such a right based upon the various factors set out in subsection 25(1) of the SR Act (i.e., the so-called global approach) to the extent that those factors are within the knowledge of or reasonably available to the operator. In the other situations, the amount of compensation in respect of the right of entry to the surface of land would be negotiated between the operator and the land surface owner or its occupant in the normal commercial terms. It is our understanding that the provinces of British Columbia and Saskatchewan have similar legislations in respect of surface rights. These surface rights rentals and charges can be differentiated from the payments to the Crown in respect of road allowances under the Road Allowances Crown Oil Act (Saskatchewan), RSS 1978, Chapter R-23 (the "Road Act"), in that such payments were made in order to satisfy a taxpayer's obligation under section 4 of the Road Act to pay an amount equal to 1% of the total value of the taxpayer's oil production in the province of Saskatchewan. In the case of Mobil Oil Canada Limited, 2001 DTC 5668 (FCA), the Court concluded that such payments were royalties in respect of Mobil's oil production for the purpose of paragraph 18(1)(m) of the Act and therefore should be disallowed as deductions in computing Mobil's income. We note that the Road Act was repealed on June 21, 2000.

5. Mr. Zul Ladak, the oil and gas specialist, has informed us that the annual estimate of Crown surface lease rentals and charges paid to the province of Alberta would amount to approximately $25 to 30 million. Mr. Ladak has also informed us that the province of Alberta has a separate royalty regime for oil sands and it would not be difficult to move the royalty burden to surface rights rentals under such regime.

Our Comments

6. Given the broad scope of paragraph 18(1)(m) of the Act as intended and described in 1 above, given that the term "lease rental" could arguably include "surface lease rental", and given that a surface rights rental or charge may reasonably be regarded as being in relation to the development and production in Canada of petroleum, natural gas or related hydrocarbons because such surface rights must be obtained before such development and production can be made, it is arguable that this provision would apply to all of the Crown charges except the amounts prescribed in section 1211 of the Income Tax Regulations (the "Regulations"), including those Crown surface rights rentals and charges.

7. As discussed in 4 above, the amount of compensation in respect of the right of entry to the surface of land would generally be negotiated between the operator and the land surface owner or its occupant in the normal commercial terms. Given the intent of the amendment to paragraph 18(1)(m) of the Act as described in 3 above, it is our view that this amount is not considered as "paid or payable by virtue of an obligation imposed by the statute or a contractual obligation substituted for an obligation imposed by the statute" for the purpose of paragraph 18(1)(m) of the Act.

8. Given the term "rental" has been amended to "lease rental" as described in 2 above, given the term "lease" is defined in the Manual of Oil and Gas Terms (8th ed.) as "the conveyance of a non-freehold interest in land; the instrument by which a leasehold or working interest is created in minerals", and given that a mineral rights rental is generally referred to as "lease rental", "oil and gas lease rental" or "mineral lease rental" by the oil and gas and mining industries, by analogy to the cases of Will-Kare Paving & Contracting Limited, 2000 DTC 6467 (SCC), and Citibank Canada, 2002 DTC 6876 (FCA), it is our view that the legal and industry (oil and gas and mining industries) meaning of "lease rental" should be used. This would exclude any surface rights rental or charge which applies not merely to the oil and gas and mining industries, but, also applies to the pipeline, power transmission and telecommunication industries.

9. Based upon our above-noted discussions, the better view of the matter is that paragraph 18(1)(m) of the Act should not apply to the Crown surface rights rentals and charges. As a result, these rentals and charges should not be disallowed from deductions in computing a taxpayer's income.