4 July 2003 Internal T.I. 2002-0173367 - Timber Royalty

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 amounts arising in respect of timber harvesting performed by third parties on non-commercial woodlots owned by non-residents of Canada would constitute "a timber royalty in respect of...a timber limit in Canada" for purposes of paragraph 212(1)(e).

Position: Whether or not the provisions of paragraph 212(1)(e) will apply is a question to be determined having regard to all the facts relevant to a particular situation.

Reasons: Review of the relevant provisions of the Act and Regulations as well as relevant jurisprudence.

July 4, 2003

International Tax Directorate Resource Industries Section
Policies & Publications Unit A.A. Cameron
Louise Green (613) 347-1361
A/Manager

Attention: France Marengere
2002-017336

Timber Royalties and Part XIII Tax

We are writing further to your memorandum, dated November 12, 2002, wherein you have requested our views with regard to the appropriate treatment under the Income Tax Act (the "Act") of amounts received in respect of timber harvesting performed by third parties on non-commercial woodlots owned by persons not resident in Canada for purposes of the Act (each a "non-resident"). In particular, you have asked whether such amounts received by a non-resident would be subject to tax under Part XIII of the Act pursuant to paragraph 212(1)(e) thereof.

It is our understanding that the situations with which your memorandum is concerned are those where the non-resident would not be "carrying on business in Canada" (taking into consideration the extended meaning of the above phrase as provided in section 253 of the Act) but would own land with standing timber (i.e., a timber limit) in Canada which is held as capital property and would provide to a third party (that is resident in Canada for purposes of the Act) a right to cut or remove timber from that land on a non-recurring basis, i.e., in a one-time transaction for cutting or removing timber within a limited period of time in a specific area.

Our Comments

The provisions of the Act that may be applicable to amounts derived from Canada by a non-resident will vary depending upon all the facts and circumstances of a particular situation. Of course, once a basis for taxation under the Act has been established the provisions of any relevant income tax convention must be considered to determine if Canada's ability to tax the amounts in question is altered thereby.

The above arrangements or transactions would involve a disposition of property by the non-resident. The nature of the property disposed of in these situations may be either a profit à prendre (i.e., an interest in land) or a right that is not an interest in real property.

Our detailed comments are contained in the attached appendix, however, in our view:

1. The consideration received by the non-resident in the above situations would not constitute a "royalty" or a "timber royalty", within the ordinary meaning of such terms, in respect of the timber limit for purposes of subparagraph 212(1)(d)(v) and paragraph 212(1)(e) of the Act.

2. In situations of the type described above, if an amount of consideration received by a non-resident for a right to cut or take timber is "dependent on, or computed by reference to, the amount of timber cut or taken", it is arguable that such consideration would be considered a timber royalty which may be subject to tax under paragraph 212(1)(e) of the Act due to the extended meaning which that phrase gives to the term "timber royalty".

The fact that the property (i.e., the right to cut or take timber) was disposed of by the non-resident in a transaction otherwise on account of capital does not preclude the application of the provisions of paragraph 212(1)(e) of the Act to the proceeds of disposition.

3. Whether or not the consideration so received by the non-resident is "dependent on, or computed by reference to, the amount of timber cut or taken" within the meaning of paragraph 212(1)(e) of the Act, it is arguable that the property disposed of by the non-resident was a "taxable Canadian property", i.e., an interest in real property, such that the disposition may be subject to tax under Part I of the Act.

This argument would be consistent with the finding of the Federal Court of Appeal in the Jens Larsen case (99 DTC 5757).

4. Of course, notwithstanding that pursuant to the provisions of paragraph 212(1)(e) of the Act a "timber royalty" is subject to taxation under Part XIII thereof, the non-resident may choose to be taxed under Part I of the Act in the manner provided in section 216 thereof.

5. Where it is concluded that paragraph 212(1)(e) is the appropriate basis for taxation under the Act of consideration received by a non-resident for a right to cut or remove timber from a timber limit in Canada, such taxation would be in accordance with the provisions of Article VI of the Canada-U.S. Income Tax Convention (1980).

Where it is concluded that subsection 2(3) is the appropriate basis for taxation under the Act of consideration arising to a non-resident for a right to cut or remove timber from a timber limit in Canada, i.e., the transaction is taxed as a disposition of taxable Canadian property, such taxation would be in accordance with the provisions of Article XIII of the above convention. However, the provisions of Article XIII of such convention may alter the amount of the gain subject to tax in Canada.

6. The facts of a particular situation may be such that a non-resident could be taxed under either Part XIII of the Act (pursuant to paragraph 212(1)(e) as a "timber royalty") or Part I thereof (pursuant to subsection 2(3) as a disposition of "taxable Canadian property").

In our view, there is nothing in the Act or Income Tax Regulations that mandates how the non-resident must be taxed in such a situation. In this case, the non-resident may be taxed under Part I or Part XIII of the Act, subject to our comments in 4 above.

If we can be of further assistance, please contact the writer.

Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch

Appendix - Timber Royalties and Part XIII Tax

Part XIII of the Act

Pursuant to paragraph 212(1)(e) of the Act, a non-resident is required to pay income tax under Part XIII thereof "on every amount that a person resident in Canada pays or credits, or is deemed by Part I to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of":

a timber royalty in respect of a timber resource property or a timber limit in Canada (which, for the purposes of this Part, includes any consideration for a right under or pursuant to which a right to cut or take timber from a timber resource property or a timber limit in Canada is obtained or derived, to the extent that the consideration is dependent on, or computed by reference to, the amount of timber cut or taken)

Land with standing merchantable timber in Canada would constitute a "timber limit in Canada". Therefore, where a person resident in Canada gives consideration for a right to cut or remove timber from such a limit owned by a non-resident, that consideration will be expressly subject to income tax under Part XIII of the Act pursuant to paragraph 212(1)(e) thereof to the extent that it "is dependent on, or computed by reference to, the amount of timber cut or taken".

Where other consideration received by the non-resident is not determined in the manner specified in the previous paragraph, it would be a question to be determined from all of the facts and circumstances relevant to a particular situation whether that consideration related to a "timber royalty", within the ordinary meaning of the term, for purposes of paragraph 212(1)(e) of the Act.

Neither the term "timber royalty" (except for the express inclusion discussed above) nor the word "royalty" is defined in the Act. With regard to the ordinary meaning of the word "royalty", it was indicated in the decision from the Federal Court - Trial Division in the Vauban Productions case (75 DTC 5371 at page 5372) that:

The term "royalties" normally refers to a share in the profits or a share or percentage of a profit based on user or on the number of units, copies or articles sold, rented or used. When referring to a right, the amount of the royalty is related in some way to the degree of use of that right. This is evident from the various dictionary definitions of the word "royalty" when used in connection with a sum payable. Royalties, which are akin to rental payments, have invariably been considered as income since they are either based on the degree of use of the right or on the duration of the use, while a lump sum payment for the absolute transfer of a right, without regard to the use to be made of it, is of its nature considered a capital payment, although it may of course be taxable as income in the hands of the recipient if it is part of that taxpayer's regular business. ...

							[Emphasis added.]

Where consideration is received by a non-resident "for a right under or pursuant to which a right to cut or take timber from a timber resource property or a timber limit in Canada is obtained or derived", the question then becomes the extent, if any, that such consideration is "dependent on, or computed by reference to, the amount of timber cut or taken". It should be noted that this test contained in paragraph 212(1)(e) of the Act differs from the test contained in paragraph 12(1)(g), or subparagraph 212(1)(d)(v), thereof that refers only to amounts that are "dependent on the use of or production from property". It also differs in that it specifically refers to a" right to cut or take timber", which may or may not be a "royalty", within the ordinary meaning of that word.

That the provisions of paragraph 212(1)(e) of the Act are intended to apply to amounts not encompassed by the predecessor to subparagraph 212(1)(d)(v) thereof may be seen from materials released with the federal budget of April 5, 1955 when the predecessor to paragraph 212(1)(e) was introduced. At page 15 of the budget speech it is indicated that:

Commencing tomorrow, payments for timber cut in Canada made to non-resident persons will be subject to our regular [then] 15 per cent tax. This will close a gap in the existing law.

                                                        [Emphasis added.]

In addition, the corresponding budget "resolution" (number 12) indicated:

That payments made after April 5, 1955, to a non-resident, computed by reference to the amount of timber cut or taken from a limit in Canada be subject to the [then] 15 per cent tax on income from Canada of non-residents.

To our knowledge, the interpretation of the provisions of paragraph 212(1)(e) of the Act has not been specifically addressed in existing jurisprudence. As such, it is uncertain as to how the Courts would interpret those provisions. On the other hand, the above "dependent on the use of or production from property" has been considered by the Courts on several occasions in the context of paragraph 12(1)(g) [or it's predecessor, paragraph 6(1)(j)] of the Act.

In the decision of the Tax Appeal Board in the Thomas William Mouat case (58 DTC 694; where a sale of all the merchantable timber standing on part of a taxpayer's acreage at a fixed price per thousand feet was found to yield a capital gain) it is indicated at page 698:

If we examine carefully the wording of paragraph (j) of section 6 of the Income Tax Act, we find that the legislator used the words "dependent upon use of or production from property". In my opinion, the legislator intended to tax, not the fructus naturales, but the fructus industriales such as a crop, minerals, timber, which produce a periodical return as a result of yearly exploitation. The first is a natural produce of the soil, while the second represent the fruits of industry. Minerals are produce of the soil, but to derive income therefrom operations are required before the ore can be extracted from the soil and turned to account. Then what makes a mine fall within the ambit of section 6(j) is not so much the presence of the mineral but the mining operation itself. As said before, timber, which is fructus naturales, may become fructus industriales if it is exploited in such a way as to provide a return, year after year, from cutting and lumbering.

							[Emphasis added.]

Similarly, in the subsequent decision of the Tax Appeal Board in the Israel Hoffman case (65 DTC 617; where a sale of all marketable standing timber to a lumber company separate from the sale of a taxpayer's farm was found to be a capital realization of part of the farm), it is indicated, at page 623, that:

From the legal background to the phrase profit à prendre, quoted above, it is clear that the expression should be reserved to cover such typical situations as the granting of a continuing license or right to fish and to take away the catch, to hunt and to take away the bag, to dig and to take away the gravel, to cut and to remove the timber, and so on. In all of those examples, it is readily discernable that the licence or right, known as a profit à prendre, is used to cover some continuing activity which can be described in no better way than in the pertinent language of section 6(1)(j) of the Act which reads as follows: a profit dependent upon use of or production from property. Thus, the interpretation of that statutory language by my colleague Mr. Boisvert in the Mouat case (supra) would appear to be, as already mentioned, peculiarly relevant to this appeal.

							[Emphasis added.]

On the other hand, in the decision of the Federal Court Trial - Division in the George E. Lackie case (78 DTC 6128, as affirmed by the Federal Court of Appeal at 79 DTC 5309), the provisions of former paragraph 6(1)(j) were found to apply where an exclusive right to remove gravel from a farm property over five years was granted at a price of $20 dollars per ton of gravel removed with minimum payments of $10,000 to be received yearly. In particular, after referring to earlier jurisprudence, including the Mouat and Hoffman cases mentioned above, it was indicated at page 6132 of the decision that:

Several useful guidelines emerge from the decisions above referred to. Where property is sold for a set sum to be paid in fixed instalments, those payments are not income. If it is sold for a share of the profits, the payments then bear the character of income, and so would annuities and royalties. If property is sold for a sum certain, plus annual sums dependent on the volume of business, those annual sums would be income. But, if what is sold relates to the use of land, including excavation for gravel, that is a profit à prendre, thus taxable income, whether or not the sale is considered to be a "business" (under the provisions of the old paragraph 139(1)(e) or the new subsection 248(1)). Profit à prendre implies a continuing licence, or continuous right to use land; a single final transaction transferring all the property (i.e. gravel) would not be a profit à prendre.

I should think that if plaintiff's spouse had sold all the gravel, whether the amount agreed upon had been paid in one lump sum, or by instalments, that would be described as a transaction in the nature of capital (It is common ground that she was not in the business of selling gravel). But we are faced here with the sale of some gravel over a continuous period, the use of land and a profit à prendre over more than five years. The agreement does provide a minimum of $50,000, but no maximum. Neither can it really be said that the agreement and the benefits derived therefrom are not dependent upon the volume of business: to recall the words of Rowlatt, J.: in Jones v. Commissioners of Inland Revenue (supra), the vendor "took something which rose or fell with the chances of the business". True, the amounts could not fall below a certain floor, but above that, they could rise and fall, and in fact did rise and fall during the first part of the schedule.

							[Emphasis added.]

In the Mel-Bar Ranches Ltd. case (89 DTC 5189), the Federal Court - Trial Division was faced with a situation regarding a corporate taxpayer involved in a large-scale cattle ranching operation that entered into a log purchase agreement with a third party under which the taxpayer was to receive payment for 25,500 tonnes of timber at a price of $11.85 per tonne on the stump, with the timber to be removed within a specified period. After it was indicated on page 5190 of the decision that the sale in question was "an isolated transaction" and "was not a sale of inventory made in the ordinary course of business", it was indicated, at page 5191, with regard to the potential application of the provisions of paragraph 12(1)(g) of the Act that:

I agree with the learned Tax Court judge, however, that when one views the total context of the agreement it is not possible to accept the plaintiff's characterization of these receipts. As I view it, the essential purpose of the contract was to have all usable timber (all logs cut from trees of eight inches diameter at stump height, according to clause 6 of the contract) in a specified area (described in the Schedule to the contract) removed within a very limited period of time, namely between April 12 and December 31, 1979, there being some possibility for extension but only as long as the quantity of timber left allowed Holding to cut at the rate of at least 3,000 tonnes per month. I am satisfied from the evidence that the main objective of the defendant in making this arrangement was to have its timber lands cleared to the extent that they could be used for grazing, thus increasing its grazing area. The time limitation was imposed in order to minimize disruption of the ranching operation then being carried on by its tenant, Mr. Brady. While I am, with respect, unable to conclude as did the learned Tax Court judge that there was an "aggregate gross specified price", because of what appears to me to be a sale price linked to the quantity removed, I do not think that that alone defeats the defendant's case. This was a one-time contract for the removal of timber in a specified area within a specified time. It was eminently reasonable that the purchaser should pay, and the defendant should receive, a price related to the amount of usable timber actually cut and removed in the fulfilment of the objective of removing timber. In retrospect one can criticize the wording of the contract for not taking into account all the contingencies and thus not spelling out the consequences in each case. It is not, however, my role to enforce the contract but rather to characterize the transaction. It appears to me that when clause 1 was drafted it was the assumption of all concerned that there was approximately 25,500 tonnes of logs which could and should be removed from the area designated by the contract. Recognizing the difficulties of estimating quantities available this precisely, the price was fixed at a rate per tonne actually cut. But the main focus throughout was the objective of getting all usable timber removed from the area designated within the time specified. That the defendant realized some undoubtedly welcome proceeds from the clearing of its land for grazing does not make those proceeds revenues "dependent upon the use of or production from property" in my understanding of the jurisprudence.

							[Emphasis added.]

A relatively recent decision of the Federal Court of Appeal, the Jens Larsen case (99 DTC 5757), also concerned the sale of standing timber from land related to a ranching operation. In that situation, the taxpayers entered into a contract with a lumber company under which a right was granted to remove timber during a five-month period for consideration of $70 per cubic metre of timber removed.

After a discussion of the historic jurisprudence referred to above, and indicating (at page 5759 of the decision) that the Crown had conceded "that a lump sum payment would take the transaction outside the scope of paragraph 12(1)(g)", it was indicated that the decision in the Mel-Bar case could not be disregarded as had been requested on behalf of the Crown. It was further indicated on that page that, similar to the Mel-Bar case, the Trial Judge in the Jens Larsen case had found "that the amounts paid were consideration for the disposition of all specified timber within the designated area despite the manner in which the payments were computed." It was further indicated, in the next sentence of the decision, that:

The case law has consistently excluded from the ambit of 12(1)(g) receipts arising from a one-time contract for the removal of timber; I see no basis for disturbing this line of authority.

From the jurisprudence referred to above, it can be seen that the Courts have viewed the "dependent on the use of or production from property" test contained in paragraph 12(1)(g) of the Act, as connotating a situation involving an "on-going" right to take, i.e., that test not applying to a one-time sale for a fixed price and quantity. In addition, the Court may find that this test is not met even though the price for the timber "related to the amount of usable timber actually cut and removed" and the "one-time" sales entailed removal of timber over several months, as noted in the above excerpt from the decision in the Mel-Bar case.

In our view, this latter point highlights the difference between the "dependent on the use of or production from property" test contained in paragraph 12(1)(g) of the Act (which the Courts have traditionally interpreted as a "continuous / on-going" basis test consistent with the predecessor to that paragraph which expressly provided for the "continuous" nature of this test), and the test contained in paragraph 212(1)(e) of the Act. The latter test only requires that "the consideration is...dependent on, or computed by reference to, the amount of timber cut or taken", disregarding whether the timber is cut or taken on a "one-time" basis or "continuous / on-going" basis. Furthermore, if the tests in subparagraph 212(1)(d)(v) and paragraph 212(1)(e) of the Act were the same, such paragraph would be redundant and the intended correction in 1955 of the deficiency of the predecessor of such subparagraph would be ineffective.

Therefore, in our view, the provisions of paragraph 212(1)(e) of the Act may be applied to a situation involving a one-time sale where "the consideration is...computed by reference to, the amount of timber cut or taken". On the other hand, it is also our view that, this test would not be satisfied where a lump-sum is paid (even if based upon an estimate of timber which may be harvested) with no adjustment for the amount of timber actually cut or taken. Furthermore, in light of the comments regarding the meaning of "royalties" in the above excerpt from the Vauban Productions case, a "timber royalty" for purposes of paragraph 212(1)(e) of the Act would not exist in such a situation.

Of course, notwithstanding that the provisions of subsection 214(1) of the Act provide for the taxation under Part XIII thereof of the "gross" amount of a "timber royalty" described in paragraph 212(1)(e) of the Act, the non-resident may chose to be taxed under Part I of the Act on a "net" basis in the manner provided in section 216 thereof.

Part I of the Act

Pursuant to subsection 2(3) of the Act, a person who is not resident in Canada at any time in a taxation year but disposed of "taxable Canadian property", at any time in the year may be subject to income tax under Part I of the Act.

The above tax would be levied on the non-resident's "taxable income earned in Canada for the year determined in accordance with Division D" of the Act, with taxable capital gains and allowable capital losses for a particular taxation year from dispositions of taxable Canadian properties [other than "treaty-protected properties" as defined in subsection 248(1) of the Act] being included in the determination thereof for that year.

As used in the Act, the phrase "taxable Canadian property" ("TCP") is defined in subsection 248(1) thereof to mean certain specified property. In particular, paragraph (a) thereto expressly includes "real property situated in Canada" with paragraph (l) also including "an interest in or option in respect of" such property. Pursuant to paragraph (n) of the TCP definition, a "timber resource property" [as defined in subsection 13(21) of the Act] also constitutes a TCP for certain specified provisions of the Act including section 2. (It is our understanding that the situations under consideration would not involve timber resource property as they would not involve extension, renewal or substitution of a right or licence to cut or remove timber.)

In any case, in order for the provisions of paragraph 2(3)(c) of the Act to apply, the non-resident must have disposed of TCP (in the present context being "real property situated in Canada" or "an interest in or option in respect of" such property). Where the property disposed of by the non-resident is a "right to cut and remove timber", the question becomes whether that right constitutes "an interest in real property".

In our view, this question would have to be resolved based upon the facts and circumstances relevant to a particular situation, e.g., intentions of the parties and legislation governing real property transactions, etc.

However, we would note that in the relatively recent decision of the Federal Court of Appeal in the Larsen case referred to above (99 DTC 5757 at page 5760), it was indicated that:

The appellant also attacks Beaubier, J.T.C.C.'s subsequent conclusion to the effect that the right disposed of by the respondent and his siblings constitutes "qualified farm property". According to ss. 110.6(1), "qualified farm property" means "real property" that is used in the business of farming. In this respect, I have no doubt that a right to remove timber by severance is, at the time of the grant, an incorporeal hereditament in land which as such constitutes real property as was found by Beaubier, J.T.C.C.

							[Emphasis added.]

Although given in the context of the definition of "qualified farm property" found in subsection 110.6(1) of the Act, in our view the comments highlighted above suggest that it is appropriate to view the granting of "a right to remove timber by severance" as a disposition of an interest in real property.

As such, it is arguable that consideration received by a non-resident for the disposition of a right to cut and remove timber from a timber resource property or a timber limit in Canada, whether or not that consideration is a "timber royalty" pursuant to paragraph 212(1)(e) of the Act, may be subject to income tax under Part I of the Act.

Income Tax Conventions

The tax convention potentially relevant in many situations of the type addressed in your memorandum would be the Canada-U.S. Income Tax Convention (1980) (as amended by subsequent Protocols, the "Convention").

Article VI to the Convention expressly recognizes Canada's right to tax income from real property (including income from forestry) situated in Canada; provides that for purposes thereof the term "real property", with respect to such property situated in Canada, will have the meaning it has under the taxation laws of Canada but will in any case include rights to exploit natural resources (whether generating variable or fixed payments in accordance with the Technical Explanation of the Convention prepared by the Treasury Department of the United States); and will include income from the alienation of such property.

In addition, in accordance with section 5 of the Income Tax Conventions Interpretations Act, in the Convention:

"immovable property" and "real property", with respect to property in Canada, are hereby declared to include

(a) any right to explore for or exploit mineral deposits and sources in Canada and other natural resources in Canada; ...

							[Emphasis added.]

Therefore, where it is concluded that paragraph 212(1)(e) is the appropriate basis for taxation under the Act of consideration arising to a non-resident for a right to cut or remove timber from a timber limit in Canada, such taxation would be in accordance with the provisions of Article VI of the Convention (which expressly encompasses income from the alienation of a right to exploit natural resources).

In addition, "[g]ains derived by a resident of [the United States] from the alienation of real property situated in [Canada] may be taxed in" Canada pursuant to paragraph 1 to Article XIII of the Convention. Therefore, where it is concluded that subsection 2(3) is the appropriate basis for taxation under the Act of consideration arising to a non-resident for a right to cut or remove timber from a timber limit in Canada, i.e., the transaction is taxed as a disposition of taxable Canadian property, such taxation would be in accordance with the provisions of Article XIII of the Convention. However, where the provisions of Part I of the Act are so applied to a capital gain from a disposition of taxable Canadian property, the provisions of Article XIII of the Convention may alter the amount of the gain subject to tax in Canada.

As such, in our view, the Convention would not preclude the taxation under the Act, whether under Part XIII or Part I thereof as discussed above, of amounts received by a non-resident in the situations addressed by your memorandum.