29 October 2007 Internal T.I. 2007-0257121I7 - Cushion gas

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 cushion gas (or base pressure gas) is depreciable property or inventory

Position: generally depreciable property

Reasons: review of jurisprudence, accounting treatment and classification by various regulators

 									October 29, 2007

	Frans Heynen						HEADQUARTERS
	Appeals Division						Income Tax Rulings
	Calgary Tax Services Office	  			Directorate
	Room 820,							Ted Harris
	220 - 4 Ave SE						(613) 957-2114

									2007-025712

Cushion Gas

We are writing in response to your request of October 23, 2007 for a summary of our interpretation as to whether cushion gas (also known as base pressure gas) should be considered as inventory or depreciable property for purposes of the Income Tax Act (the "Act").

We were recently asked to consider this issue by Industry Specialist Services and our response, including the factors considered in arriving at our conclusion, are summarized below.

Background

Working Gas

Working gas is the gas that is consumed by customers typically over an annual cycle. It is considered the volume of gas in a reservoir that is in excess of a predetermined base pressure that is available for immediate withdrawal. Working gas generally consists of gas that a distributor of natural gas has purchased for sale to its customers.

Cushion Gas

Cushion gas in storage is the volume of gas stored to maintain the minimum base pressure for the operation of the storage reservoir and to ensure that reservoir integrity is maintained. Theoretically, it remains in the storage pool through injection and withdrawal cycles. Unlike working gas, cushion gas is not normally made available for regular consumption by consumers although it may occasionally be sold on the commodity market to natural gas brokers.

The pressure within the reservoir depends upon the volume of gas contained therein and as gas is withdrawn during the winter months the pressure declines until the point at which the field can no longer economically deliver the minimum quantities required. The gas remaining in the storage reservoir at this point is referred to by the industry as cushion gas and is retained in the reservoir as long as it is used as a storage facility and not sold outright.

Cushion gas has two components, native gas which is present in the reservoir at the time of designation for storage service and purchased gas that has subsequently been injected into the reservoir to bring the pressure up to base pressure. After the reservoir reaches a predetermined base pressure, the additional purchased gas that is injected into the storage reservoir is considered working gas, which is normal inventory for future delivery to customers. The three segments of gas are intermingled in the storage facility, that is, native gas, cushion gas and working gas are indistinguishable when gas is withdrawn. In the event that a storage facility was to be abandoned, it is not technically feasible to remove all of the cushion gas.

The ratio of cushion gas to working gas is a measure of the reservoir's effective utilization. Throughout North America, the average cushion to working gas ratio is 50%.

The amount of cushion gas required in any given reservoir is based on a technical and operating assessment to determine the minimum pressure required to maintain the integrity and performance of the reservoir. The lower the minimum operating pressure, the lower the cushion gas volume requirement and the greater the storage space of a reservoir.

Previous Opinions

The tax treatment for cushion gas was considered in 1983 by the Specialty Corporations Rulings Division, which expressed the opinion that the income tax treatment of base pressure gas costs will depend on the facts of a particular case and what these costs in essence represent (e.g. inventory, development costs, current costs). However, in the situation under consideration, the opinion expressed was that the native gas and any purchased gas injected into the underground storage area to build up the pressure to the required base pressure level at the time that the area was developed as a storage facility would constitute depreciable property.

It was the view that these costs were not of a recurring nature but were made once and for all with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade. Accordingly, these initial costs qualify as capital expenditures as that term has been defined by Viscount Cave in British Insulated and Helsby Cables, Limited v. Atherton. The view was also expressed that this base pressure gas was tangible capital property, relying on the decision of the Exchequer Court in the case of Irvin Charles Schacter vs. MNR 62 DTC 1271. In that case, tangible property was held to mean "perceptible to the senses; corporeal".

Audit's Opinion

Audit expressed the view that cushion gas contained in storage caverns or reservoirs should be characterized for tax purposes as part of a taxpayer's inventory and would, therefore, be excluded from the classes of property described in Schedule II pursuant to paragraph 1102(1)(b) of the Regulations. A summary of Audit's reasons is as follows:

• The taxpayer is engaged in the business of selling natural gas.
• Cushion gas is not readily identifiable as anything different from other gas contained in the reservoir. It cannot be segregated from the remainder of the inventory.
• Cushion gas is commingled with other purchased gas in the reservoir.
• Cushion gas is a readily saleable commodity and can be extracted and sold as such.
• Natural gas has no tangible properties. It is odourless, colourless, and non-tactile. In short, it is strictly a marketable commodity that can only be sold and used as a clean burning fuel.
• Natural gas has an infinite life and does not depreciate.
• Cushion gas can be compared to, and is definitely analogous to, "linefill" in a pipeline. Linefill is not allowed as an addition to any class of depreciable property pursuant to subsection 1102(1) of the Regulations.

Audit also noted that several definitions of cushion gas, including Ontario Regulation 263/02 to the Mining Act (Ontario) as well as those included on websites maintained by the U.S. Department of Energy define "cushion gas" as "permanent inventory", which supports its view that cushion gas is inventory for purposes of the Act.

Our Comments

As evidenced by several decisions of the Supreme Court of Canada (such as, Symes, 94 DTC 6003, Friesen 95 DTC 5551 and Canderel 98 DTC 6100) the Courts have found that profit, for the purposes of subsection 9(1) of the Act, is to be computed based on "well accepted business practices", subject to any express provision of the Act that may override these practices. This is evidenced by the following citation by Major J. at page 5558 of the Friesen decision that was cited with approval by Iaccobucci J. in Canderel:

The Act does not define "profit" nor does it provide any specific rules for the computation of profit. Tax jurisprudence has established that the determination of profit under s. 9(1) is a question of law to be determined according to the business test of "well-accepted principles of business (or accounting) practice" or "well-accepted principles of commercial trading" except where these are inconsistent with the specific provisions of the Income Tax Act. ...

With respect to the accounting treatment of cushion gas, we reviewed the information available on the websites of various provincial utility regulators and noted the following:

• The Alberta Energy and Utilities Board (EUB Decision 2001-110 [December 13, 2001] at page 18) considered that a sale of cushion gas "would be a disposition of a rate base asset subject to prior approval of the Board pursuant to a specific application. Under section 25.1 of the Gas Utilities Act (GUA) and section 91.1 of the Public Utilities Board Act (PUBA), the Board must approve the disposition of any property owned by a utility that is not in the ordinary course of business."
• A recent decision of the Ontario Energy Board (EB-2005-0211 [June 27, 2007] at page 3) commented that cushion gas "is the volume of gas required to maintain the minimum base pressure for the operation of the storage reservoir. Because cushion gas is always necessary to maintain the pressure, it is treated as a capital asset and capitalized as a cost of the storage reservoir assets. In the ordinary course, cushion gas would never be available for consumption. Cushion gas is valued at cost for accounting purposes and not revalued to reflect the current cost of gas."

Based on the positions stated in these decisions and the treatment of cushion gas for accounting purposes, we were of the view that under "well accepted business practices" cushion gas represents a non-depreciable capital asset. Consequently, it would be necessary to consider whether the provisions of the Act would result in a different treatment for tax purposes.

With respect to Audit's opinion that the cushion gas should be considered as part of the taxpayer's inventory, we had the following comments:

The term "inventory" is defined in subsection 248(1) of the Act to mean "a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year or would have been so relevant if the income from the business had not been computed in accordance with the cash method and, with respect to a farming business, includes all of the livestock held in the course of carrying on the business".

In Canadian Imperial Bank of Commerce v. the Queen, 2000 DTC 6207 (FCA), the Court stated:

Property is "described in" a taxpayer's inventory if it is inventory as a matter of fact and law. Inventory in its ordinary sense is simply stock in trade, or property held for sale in the ordinary course of a business. For income tax purposes inventory generally is any property the cost or value of which is relevant in determining income: Friesen v. Canada, [1995] 3 S.C.R. 103.

Also, in The Queen v. Bastion Management Limited (FCTD) 94 DTC 6272, Reed, J. made the following comments on this definition of inventory:

This is a very broad definition. On its face it seems to include all property owned by a taxpayer which is relevant to its business. I accept counsel for the plaintiff's argument that such a broad definition is not proper. What constitutes inventory must be interpreted in the commercial and accounting contexts within which that term is normally used. Inventory is usually acquired for the purpose of selling it to make a profit thereon. There is usually an opening inventory and closing inventory by reference to which a taxpayer's income for taxation year is calculated. In this case, the gold and silver bullion was not acquired for any trading purpose. The intention was not to try to make a profit therefrom.

Finally, in the Friesen decision referred to previously, Major, J. commented as follows on page 5557:

Thirdly, the interpretation proposed by the respondent is inconsistent with the commonly understood definition of the term. In the ordinary sense of the term, an item of property which a business keeps for the purpose of offering it for sale constitutes inventory at any time prior to the sale of that item. The ordinary sense of the word also reflects the definition of inventory which is accepted according to ordinary principles of commercial accounting and of business. The Canadian Institute of Chartered Accountants has defined "inventory" as including, inter alia "[i]tems of tangible property which are held for sale in the ordinary course of business": Terminology for Accountants (3rd ed. 1983), at p. 81. ....

........ I agree with my colleague that the express wording of the Income Tax Act is capable of overruling accounting and commercial principles where it is sufficiently explicit. Nevertheless, the Court should be cautious to adopt a[n] interpretation which is clearly inconsistent with the commonly accepted usage of a technical term particularly where an interpretation consistent with common usage is more natural on a plain reading of the definition.

These comments indicate that although the definition of "inventory" for purposes of the Act may be broad, the Courts have generally restricted its meaning to those items that are held for sale as part of the taxpayer's business.

In the case of cushion gas, for accounting and commercial purposes it is generally treated as capital property as it is considered to be a structural part of the storage cavern or reservoir and not to have been acquired for sale, notwithstanding that it is identical to working gas. In our view, the fact that the cushion gas is identical to and commingles with the working gas would not preclude it from treatment as a capital asset for tax purposes. As noted previously, there will always be a minimum level of cushion gas that is required for the efficient operation of the storage facility during the period that it is in operation.

In this regard, it is not unusual for a taxpayer whose business includes the sale of a certain type of property to hold similar property on capital account. For example, a real estate developer may hold certain real estate assets for sale, while others are being held as rental properties on capital account. This factor is also recognized in the definition of "inventory" itself in that it specifically includes all livestock held in the course of carrying on a farming business.

In our opinion, the fact that certain definitions of "cushion gas" may refer to it as "permanent inventory" would not affect the determination of whether cushion gas is inventory for purposes of the Act. We were unable to find any meaning for the term ""permanent inventory" in any accounting publications. However, Terminology for Accountants (4th ed. 1992) does define "permanent asset" as being a synonym for "capital asset", a term that it defines as "An asset, whether tangible or intangible, held for long-term use rather than for sale". This "permanent" nature of cushion gas would be consistent with a determination that it is not inventory for purposes of the Act, as it is not being held for sale in the ordinary course of business.

As we do not believe that the cushion gas may be considered to be inventory for purposes of the Act, paragraph 1102(1)(b) of the Regulations would not apply to exclude it from the classes of property described in Schedule II provided that it is otherwise described in one of those classes. In our opinion the classification of cushion gas as tangible capital property that is not included in another class in Schedule II and therefore as property included in Class 8 by virtue of paragraph (i) thereof was not inappropriate.

With respect to the view that cushion gas is not tangible property in that natural gas is odourless, colourless, and non-tactile, as well as having an infinite life such that it does not depreciate, we noted that:

Black's Law Dictionary, 6th Edition defines "tangible property" to include "property that has physical form and is not intangible". "Intangible asset" is defined as "property that is a 'right' such as a patent, copyright, trademark, etc., or one that is lacking physical existence, such as goodwill." Based on these definitions, we believe that although natural gas in its natural state may be odourless, colourless, and non-tactile, it does have physical form as evidenced by the fact that it may be measured, transported, sold and consumed. It may also be liquefied, in which case it may be seen and touched. Also, the fact that natural gas may have an infinite life and does not depreciate will not preclude it from inclusion in any of the classes in Schedule II.

We agreed that cushion gas may be compared to "linefill" in a pipeline and that linefill is not included in any class of depreciable property by virtue of paragraph 1102(1)(k) of the Regulations. However, there is no similar restriction that would exclude cushion gas from inclusion in any class of Schedule II provided that the requirements for inclusion in the particular class have been met. In this regard, we would note that although the court found in the Alberta Oil Sands Pipeline case (88 DTC 6059) that "linefill" was not part of the pipeline, it agreed with the taxpayer that the linefill was property described in paragraph (i) of Class 8. We understand that the exclusion in paragraph 1102(1)(k) of the Regulations was Parliament's response to this court decision.

Although there is no Canadian jurisprudence on this issue, the following decisions of US courts have considered the tax treatment of cushion gas for purposes of the Internal Revenue Code (the "Code"):

Transwestern Pipeline Co. v. United States, 639 F.2d 679 (Ct.Cl. 1980)

Arkla Inc. v. United States, 765 F.2d 487(5th Cir. 1985)

Pacific Enterprises v. Commissioner, 101 T.C. 1 (1993)

Arkla Inc. v. United States, 37 F.3d 621 (Fed. Cir. 1994)

Washington Energy Co. v. United States, 94 F.3d 1557 (Fed. Cir. 1996)

These decisions have all accepted that cushion gas is a capital asset and that under various provisions of the Code non-recoverable cushion gas is depreciable, whereas recoverable cushion gas, although capital property, is not generally eligible for depreciation. The case that we considered most relevant for our purposes was that of Pacific Enterprises in which the IRS challenged the taxpayer's classification of recoverable cushion gas as a non-depreciable capital property and classified it as inventory for purposes of the Code. Section 1.471-1 of the Code provides that in order to reflect income correctly, inventories at the beginning and end of each tax year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor. Inventories should include all finished and partly finished goods and, in the case of raw materials and supplies, only those that have been acquired for sale or that will physically become a part of merchandise intended for sale. Notwithstanding the broad reach of this provision, the US Tax Court held that both recoverable and non-recoverable cushion gas were capital expenditures and not inventory. The IRS has accepted this finding as outlined in Revenue Ruling 97-54.

In the Pacific Enterprises case, the IRS argued that the physical similarity or fungibility between recoverable cushion gas and working gas molecules meant that recoverable cushion gas was sold to customers in the ordinary course of business. The Court relying on the findings of the Court of Appeals for the Fifth Circuit in the 1985 Arkla decision found that recoverable cushion gas and working gas are physically identical does not require them to be treated identically for tax purposes as cushion gas is used for a different purpose than working gas. The Court also found that the fact that recoverable cushion gas could be sold when the reservoir was abandoned does not change it into inventory sold in the ordinary course of business.

Although the US jurisprudence may not be binding on a Canadian Court, we believe that it is still instructive since the concepts of inventory are quite similar.

Conclusion

In view of our findings that:

• under "well accepted business practices" cushion gas generally represents a capital asset;
• as cushion gas is not property held for sale, the jurisprudence indicates that it would not be considered to constitute inventory for purposes of the Act;
• natural gas, including cushion gas, is tangible property in that it has a physical existence as evidenced by the fact that it may be measured, transported, sold and consumed; and
• unlike linefill, cushion gas is not excluded from inclusion in any class pursuant to subsection 1102(1) of the Regulations,

we would not disagree with the position that cushion gas represents depreciable property that could be included in Class 8 by virtue of paragraph (i) thereof.

We trust that these comments will be of assistance.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch