2 February 2004 Internal T.I. 2003-0031111I7 - Resource Allowance and s. 80.2

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.

Principal Issues: Impact of payment of royalties by producer to freehold owner of mineral rights under standard petroleum and natural gas lease on producer's "adjusted resource profits".

Position: Royalties will not be considered to be "production royalties" pursuant to s. 1206(1) of the Income Tax Regulations.

Reasons: The recipient of the royalty payment is not subject to any "Crown royalty" that is described within the production royalty definition. In particular, it is unlikely that the holder of the royalty is liable to the tax imposed under The Freehold Oil and Gas Production Tax Act (Saskatchewan) since the royalty does not fall within the definition of a working interest under that legislation. Furthermore, the standard lease agreement cannot be interpreted as containing an obligation for the recipient of the royalty to reimburse the payor for taxes paid by the payor in respect of the related oil and gas production pursuant to The Freehold Oil and Gas Production Tax Act (Saskatchewan).

Christine Savage
Industry Specialist Services
Tower "B" Place de Ville 2003-003111
112 Kent Street, 13th Floor J. MacGillivray
Ottawa ON K1A 0L5

February 2, 2004

Dear Ms. Savage:

Re: Resource Allowance and Freehold Royalties

We are writing in response to your memorandum of June 21, 2003 in which you requested a technical interpretation with respect to the income tax consequences arising from the payment of royalties in accordance with the terms of a lease of freehold petroleum, natural gas and related hydrocarbon rights pertaining to lands situated in the Province of Saskatchewan ("Saskatchewan PNG Rights"). In particular, you have sought our views as to whether such royalties are "production royalties" pursuant to s. 1206(1) of the Income Tax Regulations (the "Regulations"), which, in turn, determines whether such royalties are included in computing the lessee's adjusted resource profits as prescribed by s. 1210(2)(c) of the Regulations.

Essentially, your enquiry focuses on whether royalties received by a lessor of Saskatchewan PNG Rights are subject to tax under the The Freehold Oil and Gas Production Tax Act,¹ or whether the lessor has agreed in accordance with the terms of the lease to reimburse the lessee for taxes imposed on the lessee under the SFTA. If the lessor is taxed on royalties received from the lease of Saskatchewan PNG Rights under the SFTA or reimburses the lessee for any portion of the SFTA payable by the lessee in accordance with the terms of the lease, then the royalties will be production royalties since the lessor will have a "Crown royalty" in respect of production, as defined under s. 1206(1) and s. 1206(9) of the Regulations.

If it is determined that the lessor has an obligation to reimburse the lessee for any portion of taxes payable by the lessee under the SFTA, you questioned whether the ability of the lessee to seek reimbursement from the lessor constitutes payment for the purposes of applying s. 80.2 of the Act.

The CAPL Lease

To address these issues, you have asked us to consider the terms of a lease of Saskatchewan PNG Rights that closely resemble the terms of the standard form 1988 Saskatchewan P&NG Lease published by the Canadian Association of Petroleum Landmen ("CAPL Lease"). Typically, the grant and lease of Saskatchewan PNG Rights is worded in the following manner in a CAPL Lease:

'THE LESSOR...in consideration of the sum of Dollars paid to the Lessor by the Lessee. and in consideration of the covenants of the Lessee hereinafter contained, DOTH HEREBY GRANT AND LEASE unto the Lessee all petroleum, natural gas and related hyrdrocarbons (except coal and valuable stone), all other gases, and all minerals and substances (whether liquid or solid and whether hydrocarbons or not) produced in association with any of the foregoing or found in any water contained in an oil and gas reservoir (all hereinafter referred to as the "leased substances"), subject to the royalties hereinafter reserved, within, upon or under the lands hereinbefore described....'

The royalty reserved by the lessor under the terms of a CAPL Lease is a gross royalty of a fixed percentage of the leased substances produced from the lands subject to the lease. On a monthly basis, the lessor is entitled to be paid an amount equal to the current market value of all oil and gas produced, saved and marketed from the relevant lands multiplied by the percentage of the royalty. None of the terms of the lease impose an obligation on the lessor to contribute or otherwise share in any part of the costs of producing oil and gas; the lessee is solely liable to pay such costs.

A CAPL Lease contains the following provisions (which are referred to as clauses 7 and 8, respectively) that discuss certain tax obligations of the lessor and lessee:

7. Taxes Payable by the Lessor:- The Lessor shall promptly satisfy all taxes, rates and assessments that may be assessed or levied, directly or indirectly, against the Lessor by reason of the Lessor's interest in production obtained from the demised estate or the Lessor's ownership of mineral rights in the said lands. For greater clarity, it is acknowledged that for the purposes of clauses 7 and 8 hereof, the Lessor has a percentage interest in production obtained from the demised estate equal to the percentage royalty payable to it pursuant to clause .

8. Taxes Payable by the Lessee: - The Lessee shall pay all taxes, rates and assessments that may be assessed or levied in respect of the works, undertakings and operations of the Lessee on, in, over, or under the said lands, and shall further pay all taxes, rates, and assessments that may be assessed or levied, directly or indirectly, against the Lessee by reason of the Lessee's interest in production from the demised estate. The Lessee, shall, within twenty (20) days after receipt of the written request of the Lessor, accompanied by such receipts, statements or notices as the Lessee may require, reimburse the Lessor for:

(i) Percent to the extent based upon gas; and

(ii) Percent to the extent based upon petroleum²

of all taxes, rates, and assessments assessed or levied directly or indirectly against the Lessor during the currency of this Lease by reason of the Lessor being the owner of the mineral rights in the said lands and notwithstanding that the method of calculation of such taxes, rates and assessments may be based upon production from the demised estate.'

The SFTA

Liability to pay tax on freehold oil and gas produced in Saskatchewan under the SFTA is imposed on holders of "working interests". Section 6 of the SFTA provides that the holders of working interests must pay tax on oil and gas produced from a well in accordance with each holder's proportionate working interest in the well. Generally, the operator of the particular well is responsible for ensuring that tax is paid to the Province of Saskatchewan by the holders of working interests. The term "working interest" is defined in s. 2 of the SFTA as follows:

'"working interest" means an interest in a well, or in any freehold oil or freehold gas produced therefrom or allocated thereto, that is subject to any part of the costs of producing freehold oil or freehold gas or that requires the holder thereof to bear or contribute to the payment of any part of those costs....'

Our Comments

It is our view that tax would be exigible under the SFTA on royalties received by a lessor pursuant to a CAPL Lease only if the lessor's royalty constitutes an interest in

(a) a well falling within the scope of the lease; or

(b) the freehold oil or gas produced from wells falling within the scope of the lease,

and either the royalty was subject to any part of the production costs from the such wells or the lessor was required to bear or contribute to the payment of any costs of producing oil or gas from the wells falling within the scope of the lease.

Interest In Wells or Production

It is our view that a freehold royalty granted under a CAPL Lease would likely constitute an interest in an oil or gas well or an interest in production from oil and gas wells. However, there has been considerable litigation in which courts have been asked to determine whether a freehold royalty constitutes an interest in land. In our view, the cases that have considered whether freehold royalties are interests in land would be relevant to determining whether such royalties are working interests under the SFTA.

Some cases support the position that freehold royalties paid from the proceeds of oil and gas substances that are produced, saved and marketed are merely contractual rights to a payment of money calculated from sales of produced oil and gas and therefore do not constitute interests in land.³ If freehold royalties granted under a CAPL Lease are to be characterized in this manner, it would be difficult to conclude the such royalties would be working interests under the SFTA. A royalty that does not provide its holder with an interest in land would similarly not provide the holder with an interest in any oil and gas wells since a well is essentially a portion of land from which oil and gas substances could be extracted. However, there is good authority for the proposition that a royalty can be an interest in land even if the lessor is only entitled to money payments out of the proceeds of produced oil or gas that has been sold, provided the freehold owner and the lessee intended that the lessor's royalty was to be an interest in land.⁴

In our view, the fact that the freehold royalty is reserved out of the lessor's Saskatchewan PNG Rights, which are clearly fee simple interests in land, combined with the fact that the freehold royalty is expressed to be a percentage of the oil and gas substances produced from the leased lands suggests that the lessor's royalty is an interest in the leased lands. Therefore it is our view that a lessor's royalty under a CAPL Lease constitutes an interest in the wells situated on the leased lands for the purposes of the working interest definition in s. 2 of the SFTA.

Similarly, where a freehold royalty does not give the holder any rights to take the produced oil and gas in kind, but only to a cash payment based on the value of the produced oil and gas, there is a question of whether the holder has any interest in the produced substances. However, clause 7 of the CAPL Lease suggests that the parties to the lease acknowledge (and therefore intend) that the lessor has an interest in the production from the wells on the leased lands. Given the importance of the intent of the parties in characterizing the nature of the freehold royalty, and taking the other aspects of a CAPL Lease into account, it is likely that a lessor's royalty would also be an interest in production from the oil and gas wells falling within the scope of the lease.

Subject to Production Costs

Although a royalty granted under a CAPL Lease may be considered to be an interest in the wells described under the lease (and the production from those wells) for the purposes of the "working interest" definition in the SFTA, it is our view that such royalties would not be "working interests" within the meaning of that definition because the holder of the royalty is not required to bear or contribute to the payment of any production costs. A royalty granted under a CAPL Lease is based on the gross proceeds from oil and gas produced by the lessee. Consequently, amounts received in respect of the freehold royalty would not be subject to tax under the SFTA.⁵

In support of this conclusion, we note that freehold royalties received by a lessor from the lease of Saskatchewan PNG Rights were previously subject to tax under The Oil Well Income Tax Act.⁶ With the introduction of the SFTA in 1982, the taxation of freehold royalty income under the previous legislation was discontinued. With the introduction of the SFTA, there was a clear decision in Saskatchewan to cease imposing production taxes on freehold royalty holders in favour of imposing freehold production taxes solely on producers (i.e., working interest holders).

Reimbursement of SFTA Payable by Lessee

Having regard to the above conclusion, it would only be possible to characterize freehold royalties paid by a lessee to a lessor under a CAPL Lease as production royalties if the lessor reimburses the lessee for taxes paid or payable by the lessee under the SFTA.⁷ If the lessor is obligated by the terms of the CAPL Lease to reimburse the lessee for any portion of such taxes and the lessor pays a reimbursement the lessee, the lessor will be deemed pursuant to s. 80.2 of the Act to have paid an amount described in s. 18(1)(m). As a consequence, the lessor would have a Crown royalty, thus changing the lessor's royalty from a resource royalty to a production royalty.

As part of your inquiry, you questioned whether a lessor has effectively agreed to reimburse a lessee or has otherwise agreed to be liable for tax under SFTA by virtue of its acknowledgment that the lessor's royalty constitutes "an interest in production" in clause 7 of the CAPL Lease. Our interpretation of the CAPL Lease does not invite this conclusion. We do not agree that clauses 7 and 8 of the CAPL Lease compel a lessor to reimburse a lessee for any portion of the taxes paid or payable by the lessee pursuant to the SFTA. We are of the view that clauses 7 and 8 simply provide that both the lessor and lessee will ensure that each party will pay the taxes that they would ordinarily be responsible for under statute or regulation provided that, in the case of the lessor, the tax is imposed in relation to the freehold royalty or the lessor's fee simple interest in the lands affected by a CAPL Lease (including surface rights). These clauses do not, in our view, extend a lessor's obligations to pay taxes beyond the obligations imposed on the lessor by statute or regulation. It is only the obligations of a lessee that may be extended beyond such statutory requirements under clauses 7 and 8 of the CAPL Lease. This would only occur where a lessor has been assessed taxes in respect of the lessor's registered fee simple interest in the lands subject to the lease (or in respect of the lessor's entitlement to become the holder of that interest), in which case the lessor can request reimbursement of a portion of those taxes by the lessee under clause 8 (equal to the percentage agreed to by the parties). Absent a similar provision that specifically permits a lessee to request a reimbursement from the lessor for taxes paid by the lessee, the lessor has no obligation to reimburse or contribute to the payment of the lessee's tax liability. Therefore, the lessor will not be deemed to have a Crown royalty by operation of s. 80.2 of the Act.

The Interest in Production Phrase

Furthermore, it is our view that the acknowledgment of the lessor's interest in production contained in the closing words of clause 7 does not mean that a lessor acknowledges liability to pay taxes under the SFTA. In freehold lease agreements that contain clauses similar to clauses 7 and 8 of a CAPL Lease, but do not contain the acknowledgement language, a lessor's obligation to pay taxes is also restricted to taxes assessed or levied by reason of the lessor's interest in production. As a consequence, it is our view that the acknowledgment language is simply employed in the CAPL Lease to make it abundantly clear that the taxes to be paid by a lessor under clause 7 are the taxes assessed or levied against the lessor by reason of the lessor's royalty.

It is our view that this clarification is intended to protect the lessee's rights to exploit oil and gas substances under the lease, rather than extend the lessor's exposure to liability for taxes under the SFTA. If a lessor was in default of its statutory obligations to pay oil and gas production taxes, the lessee could be in jeopardy of losing its rights under the lease as a consequence of an action taken by governmental authorities to collect the amount of the unpaid taxes from the lessor.⁸ In the absence of clause 7, a lessee may not have recourse to seek compensation from a lessor if the lessee's rights are adversely affected as a consequence of such collection actions. By adding the acknowledgment language in clause 7, a lessor will be precluded from successfully asserting that clause 7 was not applicable to the lessor because the lessor's royalty was not an interest in production but merely a right to receive money based on the value of production.

Comments Regarding Clause 8

Clause 8 of the CAPL Lease, when read in conjunction with clause 7, should not be construed to suggest that the lessor is liable to pay tax under the SFTA simply because clause 8 contemplates the assessment or levy of freehold production taxes against a lessor. It is still necessary to determine whether the lessor has such liability under a particular statute or regulation. As discussed above, it is our view that taxes will not be assessed or levied against the lessor under the SFTA.

It is worth mentioning that Clause 8 of the CAPL Lease was adopted from standard language used in leases of Alberta freehold oil and gas rights. We believe the language used in that clause specifically contemplates the procedure under the AFTA for the collection of freehold production taxes in Alberta. Under that legislation, the Province of Alberta sends a statement to the owner of each taxable mineral right (i.e., the freehold owner of the land) outlining the amount of tax payable in respect of the taxable mineral right for the taxation year. Absent a provision in the lease such as clause 8 of the CAPL Lease, it would probably be difficult for the owner/lessor to recover any portion of the taxes levied under the AFTA from lessees, even though the amount of tax levied against the owner would be disproportionate to its interest in the production that gives rise to the underlying tax liability (i.e., the owner/lessor would be paying 100% of the freehold production taxes while receiving a percentage royalty well below 100%). Therefore, while clause 8 definitely plays an important role in allowing a lessor to recover Alberta freehold production taxes from a lessee, the clause is of little importance in the context of Saskatchewan freehold production taxes since taxes under the SFTA are imposed on the lessee.⁹

The Meaning of Payment

Assuming we had concluded that clauses 7 and 8 of a CAPL Lease imposed an obligation on the lessor to reimburse the lessee for taxes assessed or levied pursuant to the SFTA, you asked us to consider whether the lessor would be considered to pay an amount pursuant to s. 80.2(a) of the Act due to the fact that the lessee has the ability to request reimbursement from the lessor. In our view, this would not amount to a payment. No amount would be irrevocably parted with by the lessor until such time as the lessor made an actual payment of an amount to be reimbursed or the lessee set-off the amount against any amounts owed by the lessee to the lessor.

If you have any questions with respect to the foregoing, please do not hesitate to contact Jackson MacGillivray at (613) 948-5274.

Yours truly,

for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch

ENDNOTES

¹ S.S. 1982-83, c. F-22.1 (hereinafter the "SFTA").

² Typically, the percentage reimbursement that the lessor is entitled to obtain from the lessee pursuant to clause 8 is reduced by the royalty percentage of petroleum and/or gas reserved by the lessor under the lease. For example, where a lessor holds a royalty of 15% of gas and petroleum produced from the lands subject to the lease, the lessee would typically be required to reimburse the lessor for 85% of the taxes payable by the lessor by reason of its ownership of the lands.

³ Emerald Resources v. Sterling Oil Properties Management Ltd., (1969) 3 D.L.R. (3d) 630 (Alta. C.A.).

⁴ Saskatchewan Minerals v. Keyes, [1972] S.C.R. 703.

⁵ Furthermore, it is not likely that typical "net royalties" or "net profits interests" would be considered working interests under the SFTA. Amounts payable to holders of "net royalties" or "net profits interests" are calculated as a percentage of proceeds from the sale of oil and/or gas production net of certain production expenses. However, the payor of the royalty still bears sole liability for the payment the production expenses. By implication, the recipient is not legally liable for the payment of such expenses. If the recipient of a royalty would be considered to bear or be required to contribute to the payment of any production costs, one would expect that the recipient would be required to reimburse the payor for costs incurred. The decision of the Alberta Court of Appeal in Excel Energy Inc. v. Alberta, (1997) 196 A.R. 67, appears to support this position. It should also be noted that some net profits interests described as "royalties" in the context of publicly-traded oil and gas "royalty trusts" specifically provide that a reimbursement by the grantor (i.e., the trust) of Crown charges incurred by a grantee (i.e., the operating corporation) are to be set-off against amounts owing by the operating corporation to the trust in respect of the royalty. If instead such amounts reduced the amount of the royalty otherwise payable (as opposed to being used as partial payment of the royalty payable to the trust by way of set-off), the trust would not have made a payment described in s. 80.2(a) of the Act.

⁶ R.S.S. 1978, c. O-3.1 (repealed S.S. 2000, c. 16).

⁷ A lessee's rights under a CAPL Lease would most definitely constitute a working interest under the SFTA, thereby subjecting the lessee to the imposition of such taxes.

⁸ For example, in the Province of Alberta, freehold production taxes are imposed on the registered owners of mineral rights pursuant to the Freehold Mineral Rights Tax Act, R.S.A. 2000, c. F-26 (hereinafter the "AFTA"). If registered owners fail to pay taxes assessed in respect of freehold oil and gas production under this legislation, the Province of Alberta can, among other things, cancel the title of the registered owner to the particular mineral rights pursuant to s. 14(6) of the AFTA. Once cancelled, s. 15(1) of the AFTA states that title to the mineral rights vest in the Crown clear of all other interests, including those of a lessee, thereby eliminating all exploration and exploitation rights enjoyed by the lessee under the freehold lease.

⁹ However, it is possible that a landowner could recover a portion of taxes paid pursuant to The Mineral Taxation Act, 1983, S.S. 1983-84. c. M-17.1, as amended (hereinafter the "MTA) under clause 8 of the CAPL Lease because those taxes are imposed on the registered owners of mineral rights. But as discussed in your memorandum of June 21, 2003, the potential obligation of a landowner/lessor of Saskatchewan PNG Rights to pay tax under the MTA will not cause the payment of royalties by the lessee to the landowner/lessor to be production royalties since the tax under the MTA is levied on the basis of the nominal area of land owned and not by the amount of production from the lands held by the owner.