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.
Principal Issues: Whether subsection 75(2) would apply to attribute royalty income from an oil and gas property to the settlor of a discretionary trust and to the gain resulting from the disposition of the right to receive that income.
Position: Yes, 75(2) would apply.
Reasons: 75(2) will apply provided the income generated by the NPI is property income.
February 7, 2003
Re: Attribution of "net profit interest" royalty income.
This is in reply to your letter of February 26, 2002, in which you ask whether subsection 75(2) of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended (the "Act") would apply to attribute royalty income from an oil and gas property to the settlor of a discretionary trust. You also query whether that subsection would apply to the gain resulting from the disposition of the right to receive that income. We apologize for the delay in providing our response.
In the scenario described in your letter, you specify that the beneficiaries of the trust are the settlor and his family members. The trust uses the settlement proceeds to buy a "net profits interest" in a particular oil and gas property which entitles it to a percentage of the profits arising from an oil and gas property. The trust will have no involvement in the operation or management of that property and its acquisition is not incidental to or pertain to an active business carried on by the trust. You specify in your letter that the amounts received by the trust are royalty payments that constitute "Canadian resource property" according to paragraph (e) of that definition in ss. 66(15) of the Act.
In Income Tax Technical News No. 10, dated July 11, 1997, it is stated that:
Revenue Canada has traditionally taken the view that a net profits interest (NPI) would constitute a CRP where it entitled the holder to share in the net proceeds from the production and sale by the grantor of the NPI of oil or gas (footnote 1), or the output from a mineral resource in Canada.
the Department will accept that in situations similar to the above, an NPI can qualify as a CRP where the conditions of the NPI provide that 90% or more of the total payments for each particular year under the NPI will directly relate to the amount or value of the NPI grantor's production during that year from:
i) an oil or gas well in Canada;
ii) a natural accumulation of petroleum or natural gas in Canada; or
iii) a mineral resource in Canada
from which the NPI was granted and, in addition, the remaining payments will be connected to the operation of the above resource property from which the NPI was granted (the "90% test").
We will assume that those conditions are met and that the NPI is a Canadian resource property according to paragraph (e) of that definition in ss. 66(15) of the Act.
Paragraph 5 of Interpretation Bulletin IT-369R specifies that "the subsection does not apply to attribute business income or losses even if the business operates with some or all of the property received from the particular taxpayer". All the other conditions of ss. 75(2) of the Act seem to be met in the above scenario as the settlor transferred property to the trust and that property may revert to him because he is a beneficiary of that trust. Therefore, the question boils down to the determination of whether the amounts paid under the net profits interest are within the ambit of ss. 75(2) of the Act.
An NPI is a right to income. It is an industry term that is not defined in the Income Tax Act.
Williams and Meyers, Manual of Oil and Gas Terms, 11th edition:
A share of gross production from a property, measured by net profits from operation of the property. It is carved out of the working interest.
Miller's, Oil and Gas, Federal Income Taxation:
A net profit agreement is a contract providing that the beneficiary thereof shall receive a stated percentage of the net profits from the operation of the oil and gas property to which the contract refers. As a part of the contract, an accounting arrangement is described in detail which informs the reader of those expenditures deemed expenses for purposes of subtraction from production revenue to arrive at "net profit".
According to Fryers, in an article entitled "Net Serve! One to Come!" (The Net Profits Interest in the Oil and Gas Industry - An In-Depth Analysis), Canadian Petroleum Tax Journal, Vol. 1, 1988:
An NPI can arise in essentially two ways: one party conveys away or disposes of a 'Canadian resource property' and takes back the NPI as consideration therefor or, alternately, carves-out the NPI from an interest he continues to hold and conveys it to another, perhaps for geological services or even simply for a cash payment. In either case, once created, an NPI can be transferred to a third party for consideration.
The terms of the document creating the NPI have to be taken into account in determining what was the intention of the parties and what is the exact nature of the income derived on the NPI. As discussed in a former technical interpretation (9203097), we are prepared to assist in making a determination on a case-by-case basis where all relevant documentation is submitted for our review. In the absence of the relevant documentation, we can only offer the following general comments.
In Miller, Pyrcz and Roberts Ltd. v. MNR, 59 DTC 67 (TAB), the Court made the following obiter dicta about the nature of the amounts received by the owners of net royalty units: "there is no doubt that such receipts would be income in the hands of the holders of certificates, just as dividends or interest on bonds would be, and that the balance remaining after payment of the royalties would similarly be income liable to tax in the hands of the appellant".
In Pachal v. MNR, 55 DTC 112 (TAB) and 55 DTC 115 (TAB), the Court had to determine whether the forerunner of ss. 74.1, s. 21 of the Income Tax Act, 1948, was applicable to attribute the royalty income received by a trust according to the terms of a lease of land. The appellant was the owner of land which was leased to Imperial Oil Limited and he was to receive 12.5% of all production of crude oil and natural gas. A trust agreement was thereafter signed, assigning a percentage of whatever might be produced from the leased lands to the taxpayer's wife and children and all those interests were assigned to the trustee to be held accordingly in trust. The relevant provision read as follows:
21. (1) Where a person has, on or after the first day of August, 1917, transferred property, either directly or indirectly, by means of a trust or by any other means whatsoever, to his spouse, or to a person who has since become his spouse, the income for a taxation year from the property or from property substituted therefore shall be deemed to be income of the transferor and not of the transferee.
The Court concluded that the provision applied to attribute to the taxpayer amounts paid to his wife.
We therefore conclude that a NPI transferred to a trust as described in the above mentioned scenario would be subject to the application of ss. 75(2) of the Act.
When the NPI is sold, ss. 59(3.2) of the Act might apply to include a fraction of the proceeds in income. That provision is in subdivision d - other sources of income, but not specifically prescribed to be from a source that is business. In our opinion, ss. 75(2) of the Act would be applicable to the amount included in income under ss. 59(3.2) of the Act.
This opinion is provided in accordance with the comments in paragraph 22 of Information Circular 70-6R5.
We trust our comments will be of assistance.
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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