23 December 2004 Internal T.I. 2004-0095621I7 - Royalty Offsets - Government Assistance

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: Whether amounts arising under the Saskatchewan Petroleum Research Incentive and Alberta's Innovative Technologies Royalty Program constitute "government assistance" for purposes of subsection 127(18).

Position: Yes.

Reasons: Based upon our understanding of these programs, the relevant provisions of the Act and jurisprudence.

December 23, 2004

Compliance Programs Branch Resources Industry Section
Industry Specialist Services A.A. Cameron
Christine Savage (613) 347-1361
Co-ordinator, Resource Industries
Attention: Zul Ladak
2004-009562

Amounts arising under certain provincial programs

We are writing further to your electronic mail message of September 21, 2004 wherein you requested our views with regard to amounts arising under two government programs: the Saskatchewan Petroleum Research Incentive and the Innovative Technologies Royalty Program (the "ITRP", this program having been announced by the government of Alberta during 2004.). In particular, you have asked whether we agree with your view that these "incentives reduce the SR&ED expenditures pursuant to subsection 127(18)" of the Income Tax Act (the "Act").

You have referred us to the respective government websites regarding these two programs and, from information available through those sites, our understanding regarding these respective programs is as follows:

1. Saskatchewan Petroleum Research Incentive (the "SPRI")

This program was created in 1998 as a five-year program applicable to approved expenses incurred after March 19, 1998. However, it was extended in 2002 such that projects approved by March 31, 2007 may qualify, subject to a $7 million overall limitation for projects approved since April 1, 2002.

According to the website of Saskatchewan Industry and Resources the SPRI is "intended to encourage research, development and demonstration of new technologies that facilitate the expanded production of Saskatchewan's oil and natural gas resources." A News Release issued by Saskatchewan Energy and Mines dated March 19, 1998 indicates that the SPRI would "provide oil and natural gas royalty tax credits to offset up to 30 per cent of approved industry costs for field projects in rural Saskatchewan."

The SPRI is governed by the Petroleum Research Incentive Regulations (R.R.S. c. F-13.4 Reg. 20; the "PRI Regulations"), and section 6 thereof states:

6(1) If an agreement is entered into with respect to a field pilot project, the operator will earn credits towards the remission of royalties and taxes equivalent to 30% of eligible research costs approved by the minister.

(3) Credits earned pursuant to this section are to be applied in accordance with:

(a) sections 6.1 and 6.2 of The Freehold Oil and Gas Production Tax Regulations, 1995;

(b) sections 7.1 and 7.2 of The Crown Oil and Gas Royalty Regulations; and

(c) sections 13 and 14 of The Recovered Crude Oil Tax Regulations.

Section 2 to the PRI Regulations defines the words "royalties" and "taxes" as used therein to mean, respectively, "royalties payable on Crown minerals pursuant to The Crown Oil and Gas Royalty Regulations" (essentially, royalties payable on oil or gas production in respect of Crown lands) and "taxes imposed by sections 3 and 32.11 of The Freehold Oil and Gas Production Tax Act" (essentially, taxes imposed on oil or gas production in respect of freehold lands and on certain oil recovered from a crude oil recovery facility). In addition, the term "eligible research costs" is defined as costs described as such in an agreement relating to an approved field pilot project and incurred within the relevant time limits. Information relating to the submission of an application for project approval suggests that the itemized cost estimate for the project should utilize categories including: labour costs for the operator, corporate overhead costs, subcontracting expenses, materials and supplies, travel and living expenses and capital equipment costs.

As noted in subsection 6(1) of the PRI Regulations quoted above, it is the "operator" which earns credits under the SPRI with this term being defined, in section 2 of those regulations, as an operator or special operator under certain provisions to the three sets of regulations referred to in subsection 6(3) of the PRI Regulations (also as quoted above). Under those provisions, the "operator" would generally be the person designated as the operator of an oil or gas well for the purposes of remitting royalties on behalf of persons (other than special operators) owning an interest in the production therefrom. A "special operator" would generally be a person owning an interest in the production from the relevant well who disposes of such production separately from the operator and becomes responsible for calculating and remitting the royalties payable in respect of their portion of the production.

Pursuant to subsection 6(3) of the PRI Regulations quoted above, credits arising under the SPRI "are to be applied in accordance with" certain sections from the three sets of regulations. These provisions provide, essentially, that the operator, or the special operator as the case may be, may "in lieu of" or "instead of" remitting any portion of the relevant royalties or taxes, "elect to apply" the SPRI credits in an amount equal to that portion.

Under the heading "Project Implementation" it is indicated at the website regarding SPRI that:

The applicant calculates the royalty payments that would normally be submitted for the various properties operated by the applicant and then adjusts the amount of the total royalty payment by the amount of the Incentive due. In other words, the calculation of royalties from individual properties is unaffected by the Incentive. The applicant recovers the Incentive from the total royalty cash flow he/she would otherwise submit to Saskatchewan.

The website regarding SPRI also indicates, under the heading "Conditions Applying to the Incentive", that "Saskatchewan will not acquire any rights to own or use technology involved in approved projects" and that: "A company will be allowed to claim a deduction on its natural gas royalties for an oil research project and vice versa".

2. Innovative Technologies Royalty Program (the "ITRP")

In a News release from the Government of Alberta dated June 2, 2004, an "expanded royalty reduction program" was announced which would help provide "the impetus for the energy industry to develop new technologies that increase resource recoveries and improve project economics". In particular, it was indicated that under the ITRP:

...the Alberta government will make available up to $200 million over five years in royalty offsets. The funds will be used to offset 30 per cent of eligible costs from approved innovative pilot and demonstration projects in the energy sector.

A Backgrounder to the release indicates that approved projects would qualify for up to 30 per cent of eligible capital and operating costs to a maximum of $10 million per project. In addition, it was indicated that the ITRP included the $15 million CO2 Projects Royalty Credit Program (the "CO2 Program").

The above release also indicates that applications for the ITRP would be "available in the late fall of 2004", however, it is our understanding that such applications and further program details have not been released to date. The "Application Package" previously established by the Alberta Department of Energy for the CO2 Program indicates in the "Introduction" section that such department "understands that it sometimes should share the risk of development and demonstration of new energy projects required to produce the resource" and that: "The reduction of royalties offsets some financial risk, to encourage producers to undertake the projects." The "General Conditions Applying to Approvals" section of that package indicates that "Alberta will not acquire any rights to own or use technology involved in approved projects" and that: "Credits earned in relation to an oil project may be applied in satisfaction of Alberta Crown natural gas royalties, and vice versa".

Our Comments

Subsection 127(18) of the Act provides as follows:

Where on or before the filing-due date for a taxation year of a person or partnership (referred to in this subsection as the "taxpayer") the taxpayer has received, is entitled to receive or can reasonably be expected to receive a particular amount that is government assistance, non-government assistance or a contract payment that can reasonably be considered to be in respect of scientific research and experimental development, the amount by which the particular amount exceeds all amounts applied for preceding taxation years under this subsection or subsection (19) or (20) in respect of the particular amount shall be applied to reduce the taxpayer's qualified expenditures otherwise incurred in the year that can reasonably be considered to be in respect of the scientific research and experimental development.

In addition, the term "government assistance", as used in section 127 of the Act, is defined in subsection 127(9) thereof as follows:

"government assistance" means assistance from a government, municipality or other public authority whether as a grant, subsidy, forgivable loan, deduction from tax, investment allowance or as any other form of assistance other than as a deduction under subsection (5) or (6)

In deciding that a refund of provincial sales tax was encompassed by subparagraph 12(1)(x)(iv) of the Act, the Federal Court of Appeal (the "FCA") in the Iron Ore Company of Canada case (2001 DTC 5411 at page 5414) considered the inclusion under that subparagraph of amounts received as "assistance, whether as a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of assistance" (essentially the same test contained in the above definition of "government assistance") with it being indicated in part, that:

...the words "any other form of assistance" found in the subparagraph clearly refer to an amount received "as assistance" and broaden the form of assistance enumerated in the subparagraph.

In addition, in the CCLC Technologies Inc. case (96 DTC 6527) the FCA considered a situation involving amounts received by the taxpayer under a "Coal Research Agreement" with the Province of Alberta concerning a coal and heavy oil project. The FCA found that the payments constituted both "government assistance", as defined in paragraph 127(9) of the Act, and "any other form of assistance" for purposes of subparagraph 12(1)(x)(iv) thereof. At page 6528 of the decision the FCA contrasted "government assistance" with "payments made for advancing the business interests of the payor". The FCA indicated that the above agreement did not "establish an ordinary business arrangement between the parties" indicating, in part, that:

... While in the short term the government obtained an equity interest, if the project were to prove commercially successful the Government would be obliged to sell its interest to the respondent, the price being simply the return of its money contribution plus its interest costs in having made that contribution. If the project did not prove to have commercial value, as in fact it did not during the period in question, the Government was entitled to nothing except an equity interest in a technology demonstrated not to have present commercial value. We find it impossible to characterize this as an ordinary business arrangement. ...

In the language of the Income Tax Act, subparagraph 12(1)(x)(iv), and the definition of "government assistance" in subsection 127(9), the government payments under the Coal Research Agreement became, in the circumstances of non-commercialization of the technology, a grant, subsidy, a forgivable loan, or similar form of assistance.

In other words, in the absence of the establishment of "commercial value", such that government would be entitled to a return of its contributions, the FCA was clearly of the view that those contributions would constitute "government assistance".

The information and regulations described above in respect of the SPRI indicates that this program was established to encourage the undertaking of approved projects by providing funds to offset up to 30% of qualifying costs with such funding to be delivered by way of the remission of the amount payable in respect of certain royalties and taxes, i.e., by extinguishing the obligation to pay the amount of such royalties and taxes as otherwise determined. In our view, given this factor, as well as the legislative provisions and jurisprudence referred to above, the credits arising under the SPRI would constitute "government assistance" within the meaning of 127(9) of the Act. Similarly, based upon our understanding of the ITRP as described above, it is our preliminary view, subject to consideration of the final arrangements and regulations relating thereto, that "royalty offsets" arising under the ITRP would also constitute "government assistance" within the meaning of 127(9) of the Act.

As such, it is also our view that amounts arising under the SPRI or the ITRP which are in respect of scientific research and experimental development would, pursuant to subsection 127(18) of the Act and subject to the limitations contained therein, reduce a taxpayer's qualified expenditures otherwise incurred in a particular taxation year that can reasonably be considered to be in respect of the scientific research and experimental development. It would be a question to be determined with reference to the circumstances, agreements, etc., relevant to a particular situation: whether a taxpayer "has received, is entitled to receive or can reasonably be expected to receive" such an amount "on or before the filing-due date" for a particular taxation year; whether amounts in respect of such an amount have been applied for preceding taxation years under any of subsections 127(18) through (20); and the extent to which such an amount "can reasonably be considered to be in respect of scientific research and experimental development". This latter determination may need to be made with the assistance of the Scientific Research & Experimental Development Directorate.

This memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

If we can be of further assistance with regard to this matter, please contact the writer.

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