31 May 2007 Internal T.I. 2007-0226251I7 - Income reasonably attributable to production

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 indirect expenses can be excluded from the determination of "income for the year" relevant for purposes of accessing deductions in respect of FEDE [subclause 66(4)(b)(ii)((A)(I)] or certain "successored" resource expenditure pools [e.g., clause 66.7(3)(b)(i)(C) with regard to successored CEE].

Position: No - A reasonable allocation should be made based upon the facts of the situation.

Reasons: Based upon the determination embodied in the relevant legislative provisions. In a business context, the "income for the year" referred to therein is, essentially, the profit for the year adjusted in accordance with Part I of the Act (modified to the extent provided in the provision in question). However, the part of such income "reasonably attributable to" the relevant production must be determined. As such, while the deduction of indirect expenses is not precluded, the allocation thereof must be reasonable in the circumstances.

								May 31, 2007

	Jane Stalker					HEADQUARTERS
	Co-ordinator, Resource Industries		Income Tax Rulings
	Industry Specialist Services 	  		Directorate
	Audit Professional Services Directorate	A.A. Cameron
(613) 347-1361
	Attention: Peter Lee / Zul Ladak
								2007-022625

Income Reasonably Attributable to Oil & Gas Production

We are writing in response to your memorandum of March 5, 2007 (the "Memorandum") wherein you requested our opinion as to whether indirect expenses, such as general administration, capital cost allowance ("CCA"), overhead, resource allowance and interest expenses, should be deducted in computing the amount of a taxpayer's income "that can reasonably be regarded as attributable to...the production of petroleum or natural gas...outside Canada" or "production from [a] particular [resource] property" for purposes of subsection 66(4) and section 66.7, respectively, of the Income Tax Act (the "Act").

We understand that certain taxpayers and their representatives (the "Parties") have argued that indirect expenses can be excluded from the determination of a taxpayer's income that is relevant for determining the deductions that may be claimed under subsection 66(4) of the Act in respect of foreign exploration and development expenses ("FEDE") and under subsections 66.7(3) and (4) of the Act with regard, respectively, to successored Canadian exploration expenses and successored Canadian development expenses.

These Parties submit that support for this position may be found in the decisions of the Federal Court of Appeal ("FCA") in the cases of Gulf Canada Limited (92 DTC 6123) and Gulf Canada Resources Limited (96 DTC 6065, collectively the "Gulf Cases").

The Gulf Cases involved the issue of whether certain amounts fell within the meaning of "such other deductions ...as may reasonably be regarded as applicable to the sources of income described in...." the relevant provision. The FCA agreed with the finding of the lower Courts that the source of income referred to in the relevant provision under consideration was "the production" (in the narrow sense of extraction from the ground) of "petroleum, natural gas or related hydrocarbons" from mineral resources in Canada "operated by" the taxpayer", which was more restrictive than the income sources provided for in sections 3 and 4 of the Act.

Essentially, these Parties are arguing that "income...that can reasonably be regarded as attributable to...the production" as used in the provisions described above should have the same narrow meaning as was given by the FCA to "income...from...the production" in the Gulf Cases.

These Parties further argue that their view is supported by the fact that although certain amendments were made to the Regulations to reduce the effect of the decisions in the Gulf Cases, including the addition of subsection 1204(1.1) to broaden the amounts to be deducted in computing "resource profits", no similar amendments have been made to subsection 66(4) or section 66.7 of the Act.

In your view, the computation of income referred to in clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act are to be made under provisions contained in Part I of the Act, rather than the narrower concept of "income from production" that was considered in the Gulf Cases.

In particular, you note that for purposes of Part I of the Act, under paragraph 3(a) and subsection 4(1), "the income of a taxpayer for a taxation year" is "the taxpayer's income for the year" calculated by determining "the total of all amounts each of which is the taxpayer's income for the year...from a source", e.g., a business source, such as an oil and gas business. Pursuant to subsection 9(1) of the Act, the taxpayer's income for the year from a business is, subject to Part I, the taxpayer's profit therefrom for the year.

In your view, all necessary deductions must be made in calculating the taxpayer's "profit", including indirect expenses, such as interest, CCA and general administrative expenses. Once this profit or net income has been calculated, you believe that the part of this amount that is reasonably attributable to the production of oil and gas from the particular properties would have to be isolated for purposes of clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act, as the case may be.

It is also your view that the decisions in the Gulf Cases are not relevant for purposes of interpreting clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act. However, even if the expression "income...that can reasonably be regarded as attributable to...the production" as referred therein were considered to have the narrower meaning as decided in the Gulf Cases, in your view the ratio decidendi of those cases does not stand for the view that all indirect expenses must be excluded from the calculation. In other words, the decisions in the Gulf Cases did not preclude deductions for general administration, overhead, resource allowance and CCA that would reasonably be attributed to a relevant production income "source". In addition, you believe that your views are supported by the response provided to question #16 at the roundtable to the 1999 Canadian Petroleum Tax Society conference, which was published in the Canadian Petroleum Tax Journal [2000] Vol. 13, No. 1. In response to the question of which costs are to be deducted in determining income from successored property, the CRA responded:

This is a notional production income calculation to determine the quantum of the claim for the successored pools. Accordingly, the deductions would, in addition to the direct costs associated with the production from the successored properties, include all prorated indirect costs such as interest expense, notional resource allowance, overhead, CCA etc. and is computed in accordance with Part I with the exception that no deductions were allowed under section 66.7 or any of sections 65 to 66.5.

Our Comments

The relevant portions of clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act read as follows:

(i) "the part of the taxpayer's income for the year...that can reasonably be regarded as attributable to...the production of petroleum or natural gas from natural accumulations outside Canada or from oil or gas wells outside Canada", [subclause 66(4)(b)(ii)(A)(I) of the Act - FEDE]; and

(ii) "the part of the successor's income for the year...that can reasonably be regarded as attributable to...production from the particular property", [clauses 66.7(3)(b)(i)(C) or 66.7(4)(b)(i)(B) of the Act].

We agree with your view that the "income for the year" referred to in each of these provisions would be to income determined under the provisions of Part I of the Act (modified to the extent provided in the particular provision in question). As you have noted, in a business context section 9 of the Act provides that a taxpayer's "income for the year" would be the taxpayer's profit from the business for the year (subject to adjustment by relevant provisions of Part I of the Act). Therefore, as discussed in more detail below, we agree that all expenses, including indirect expenses, appropriately deducted in the determination of the taxpayer's "income for the year" from the business that includes the relevant production activities would need to be considered in determining the part of the taxpayer's income described in (i) and (ii) above.

Furthermore, the fact that the restricted meaning of "income ...from...production" as found by the courts in the Gulf Cases differs from the determination of "income for the year" under Part I of the Act is clear from comments in those cases. For example, at page 6067 of the FCA decision in the second of the Gulf Cases, which concerned whether certain interest costs and CCA were to be deducted in the determination of "resource profits" for the taxpayer's 1978 taxation year, it is stated that:

...the issue to be resolved does not relate to the computation of the respondent's business income under Part I of the Act but to the computation of its resource profit under section 1204 of the Regulations. It is common ground that the respondent properly deducted the two sums in question in computing its business income. ... The question is whether these two deductions were allowed by section 1204 of the Regulations.

This citation indicates that the FCA did not disagree with the view expressed by the Federal Court-Trial Division ("FC-TD") (95 DTC 5189 at page 5198) that:

... Under the Income Tax Act calculation of resource profits is a separate code and distinguished from the calculation of income under Part I. ...

In light of the above, we agree with your view that the decisions in the Gulf Cases should not be of particular relevance in interpreting the provisions of clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act. In view of our opinion on this matter and the enactment of subsection 1204(1.1) of the Regulations which requires that "all amounts deducted in computing the taxpayer's income for the year other than" certain express exceptions are to be deducted in the determination of "resource profits", the question of whether the decisions in the Gulf Cases addressed the issue of deductions in respect of indirect expenses would not, in our view, be relevant to the issue under consideration.

We would, however, note that in Home Oil Co. Ltd. v. M.N.R. (1955), 55 DTC 1148 (S.C.C.), Rand J. indicated (at page 1150) that the phrase "may reasonably be regarded as applicable to" meant "specifically or directly related to". However, this case involved the determination of "the profits of the taxpayer for the year reasonably attributable to the production of oil or gas from the well" for purposes of calculating a depletion allowance under former section 1201 of the Regulations. In our view, the concept of "profits ...reasonably attributable to the production ...from the well" as considered in the Home Oil case can be differentiated from the concept of "the part of...income for the year...that can reasonably be regarded as attributable to...production" that is relevant to clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act as the depletion allowance under former section 1201 of the Regulations also involved a "separate scheme of inclusions and exclusions from income for purposes of special incentive programs" analogous to the finding of McNair, J. referred to above with regard to the determination of "taxable production profits". In addition, as noted at page 1150 of the decision, the determination in the Home Oil case was made in the context of the "profits" of a particular "well", a specific context that is different from the computation of "income" of a company. As stated by Judson, J. in The Queen v. International Nickel Company of Canada [1975] CTC 620 (SCC) at page 623:

"That profits and income are not interchangeable words in the Act and regulations is, of course, well established."

With regard to the representative's argument that their view is supported by the lack of amendments to subsection 66(4) and section 66.7 of the Act similar to the addition of subsection 1204(1.1) of the Regulations, we would note that such amendment was considered necessary as "resource profits" were formerly calculated on the basis that a taxpayer was not required to make any deductions in the calculation of it's income for these purposes other than certain specified deductions and, essentially, other deductions that could reasonably be regarded as applicable to a qualifying income source. Since there is no comparable general limitation on amounts to be deducted in the calculation of income for the purposes of clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act, in our view, an amendment comparable to subsection 1204(1.1) of the Regulations is not required to those provisions of the Act.

We would, however, note that clause 66(4)(b)(ii)(A) and subparagraphs 66.7(3)(b)(i) and 66.7(4)(b)(i) of the Act require a determination of "the part of...income for the year...that can reasonably be regarded as attributable to...production" either "outside Canada" or from a "particular property". Although the "income for the year" is that as calculated for purposes of Part I of the Act, it is necessary to determine the "part" of such income "that can reasonably be regarded as attributable to" the relevant production. In other words, it would appear that these calculations are trying to ascertain the contribution of the relevant "production" to the taxpayer's Part I income (essentially a "net" amount) for purposes of accessing certain deductions in respect of FEDE or successored resource pools. While as noted in the response to question #16 of the 1999 Canadian Petroleum Tax Society conference roundtable referred to above, an allocation of indirect expenses should be made for the purposes of determining the "part of...income...that can reasonably be regarded as attributable to" the relevant production, it would remain a question of fact whether and to what extent a particular indirect expense should be allocated to the particular "production". In other words, the indirect expense should be allocated on a "reasonable" basis. For example, we question whether it would be reasonable to allocate a portion of a deduction in respect of resource allowance in determining the amount under subclause 66(4)(b)(ii)(A)(I) of the Act for purposes of accessing a deduction in respect of FEDE where such foreign production could not give rise to "gross resource profits" and ultimately a deduction in respect of the resource allowance.

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.

We trust that our comments will be of assistance. 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
Legislative Policy and Regulatory Affairs Branch