15 June 2005 External T.I. 2005-0119731E5 - Paragraph (f) of CEE Definition

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: 1. Whether Agency's position regarding a simple farm-out transaction remains as stated in Interpretation Bulletin IT-125R4. 2. How payments made / received in a situation that does not involve a "farm-out" transaction of the type described in IT-125R4 are to be treated for income tax purposes.

Position: 1. Yes; where in a simple farm-out transaction a farmee obtains an interest in an unproven resource property solely as a result of incurring exploration expenditures (which otherwise meet the requirements of paragraph (f) to the definition of CEE) on that property, those expenditures will generally be accepted as constituting CEE to the farmee with the farmee having a nil acquisition cost for the interest earned in the unproven resource property. 2. Question to be determined from all of the facts and circumstances relevant to a particular situation.

Reasons: 1. No change has been made to the Agency's position regarding a simple farm-out transaction as described in IT-125R4. 2. Nature of the determination.

2005-011973
XXXXXXXXXX A.A. Cameron
(613) 347-1361
June 15, 2005

Dear XXXXXXXXXX:

We are writing in response to your facsimile of March 7, 2005 wherein you requested a technical interpretation with regard, primarily, to paragraph (f) to the definition of Canadian exploration expense ("CEE") in subsection 66.1(6) of the Income Tax Act (the "Act").

The two hypothetical situations you have outlined each involve a taxable Canadian corporation [within the meaning of subsection 89(1) of the Act, a "TCC"] which owns mining claims that encompass rights to prospect, explore, drill or mine for minerals in a mineral resource in Canada [the term "mineral resource" having the meaning assigned in subsection 248(1) of the Act and this TCC being referred to as the "Owner" herein]. The relevant mineral resource property (the "Property") would be an unproven resource property, i.e., proven reserves would not have been attributed thereto. Each of these two situations also involves another TCC, which deals at arm's length with the Owner for purposes of the Act, and which may acquire a portion of the Owner's interest in the Property (this TCC being the "Acquirer").

Under your first hypothetical situation, the Acquirer would enter into an agreement with the Owner whereby the Acquirer would plan, fund and undertake an exploration program on the Property. Provided the Acquirer incurred a certain amount of exploration expenditures on the Property by a specified date, the Acquirer would acquire an undivided percentage interest in the Property. No payments would be made to the Owner.

Under your second hypothetical scenario, the Owner would enter into an agreement with the Acquirer that provides the Acquirer the option to acquire an undivided percentage interest in the Property (the "Option") if it makes payments to the Owner of certain amounts by specified dates. The Acquirer would make an initial upfront payment to the Owner in cash and shares of the Acquirer and would make additional payments on a regular basis computed by reference to the actual amounts of exploration expenditures incurred by the Owner on the Property (the Owner would plan and undertake the exploration program on the Property). Provided the Acquirer made the payments when called, it would acquire the percentage interest in the Property on a specified date.

With regard to the above scenarios, you are seeking confirmation, essentially, that:

i) the exploration expenditures incurred by the Acquirer to earn an interest in the Property in the first scenario will not be considered Canadian development expense ["CDE", as defined in subsection 66.2(5) of the Act]; and

ii) any Canadian exploration expense ["CEE, as defined in subsection 66.1(6) of the Act] arising to the Owner from the exploration expenditures incurred by it in the second scenario will not be reduced by amounts paid by the Acquirer under the Option. Furthermore, that such amounts would represent the cost to the Acquirer of a Canadian resource property [a "CRP" as defined in subsection 66(15) of the Act] and the proceeds from the disposition of a CRP to the Owner.

Our Comments

The situation outlined in your letter appears to relate to proposed transactions involving specific taxpayers. Confirmation of the tax consequences of such proposed transactions will only be provided in response to a request for an advance income tax ruling and following a review of the relevant facts and documentation. The procedures for requesting an advance income tax ruling are set out in Information Circular 70-6R5 dated May 17, 2002. We can, however, provide you with the following general comments.

The final determination as to the appropriate classification for purposes of the Act of expenditures incurred, or amounts received, by a taxpayer must be made with reference to all of the facts and circumstances relevant to that taxpayer's situation. However, it continues to be the Agency's position that, as noted in paragraph 14 of Interpretation Bulletin IT-125R4, it is possible to have a disposition under a "farm-out" transaction that does not give rise to proceeds of disposition. That paragraph makes reference to a "simple farm-out transaction" whereby an owner (a "farmor") of an unproven resource property may transfer a part interest in the property to another person (a "farmee") in exchange for the farmee undertaking and paying for certain work, e.g., exploration work, on that property. It is further indicated in that paragraph with regard to a simple farm-out situation that, to the extent that the disposition by a farmor of an interest in an unproven resource property can be considered an exchange for farm-out services performed by the farmee on the property, e.g., exploration costs incurred by the farmee, the disposition is considered not to give rise to proceeds of disposition to the farmor that are to be accounted for as outlined in paragraph 2 of IT-125R4.

In light of the above, it is our view that where a farmee earns an interest in an unproven resource property solely as a result of incurring exploration expenditures (which otherwise meet the requirements of paragraph (f) to the definition of CEE) on that property in a simple farm-out transaction, those expenditures would generally be considered as constituting CEE to the farmee with the farmee having a nil acquisition cost for the interest earned in the unproven resource property. For greater certainty, where all of the relevant requirements are met, amounts may potentially be renounced, having reliance on subsection 66(12.66) of the Act [the so-called "look-back rule"], in respect of exploration expenditures so incurred by a corporate farmee [which is a principal-business corporation as defined in subsection 66(15) of the Act] and which constituted CEE to it under paragraph (f) to the definition thereof.

The income tax consequences flowing from a situation that does not involve a "farm-out" transaction of the type described in IT-125R4 must be determined from the facts and circumstances pertaining to that situation. In our view, those factors, including the legal rights and obligations arising from the relevant agreements and documents, will determine how the relevant transactions are to be treated for income tax purposes. Where the transactions in question relate to an acquisition of an interest in a property which constitutes a CRP, the consideration given for the acquisition of the interest would generally constitute the cost of a CRP to the purchaser [such interest being a CRP under paragraph (g) to the definition thereof in subsection 66(15) of the Act, subject to the exceptions contained therein] and proceeds of disposition of an interest in a CRP to the vendor [in a mineral resource context such proceeds being included in the determination of item F of the cumulative CDE of the vendor as defined under subsection 66.2(5) of the Act, subject to the express exceptions contained therein].

In a non "farm-out" situation where the transactions in question cannot be considered as relating to an acquisition of an interest in the relevant resource property, it must be considered whether payments made by a third party, pursuant to arrangements under which CEE is incurred by the owner of the property, may potentially constitute either amounts that became receivable by the owner of the resource property in circumstances such that paragraph 66(12.1)(a) of the Act has application or "assistance" as defined in subsection 66(15) of the Act (which term encompasses any form of assistance or benefit). Where paragraph 66(12.1)(a) of the Act has application, the payments will generally reduce the cumulative CEE of the owner of the property pursuant to item G to the definition of such term in subsection 66.1(6) of the Act. If the payments are found to constitute assistance in respect of the above CEE or that can reasonably be related to the relevant Canadian exploration activities, they will generally reduce the cumulative CEE of the owner of the property pursuant to item J to the definition of such term in subsection 66.1(6) of the Act. Similarly, where the payments are subject to the provisions of paragraph 66(12.1)(a) of the Act or are found to constitute assistance as described in the preceding sentence, they would generally reduce [taking into account the limitation contained in paragraph 66(12.6)(e) of the Act and the provisions of paragraph 66(12.6)(a) thereof, respectively] the amount that the owner may be able to renounce under subsection 66(12.6) of the Act in respect of the above CEE. If it were to be determined that the payments by the third party were not subject to the application of paragraph 66(12.6)(a) of the Act and did not constitute "assistance" under subsection 66(15) of the Act, it is our view that such payments would generally constitute a "reimbursement, contribution or allowance" in respect of the CEE incurred and as such would be encompassed by subparagraph 12(1)(x)(iv) of the Act.

Our comments are provided in accordance with the practice described in paragraph 22 of Information Circular 70-6R5.

Yours truly,

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