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: What is the tax treatment of payments made by an oil and gas company to a landowner with regard to a right of way, exploration rights, and compensation for damages?
Position: (1) Generally, payments received by a landowner as compensation for damage to crops and compensation for additional costs and losses of a property owner who carries on farming operations around structures situated on the owner's property would be included in computing the property owner's income from farming operations, rather than capital. Non-recurring amounts, often paid in the first year of a lease as compensation for damaged or destroyed property constitute "proceeds of disposition" within the meaning of section 54 and may result in a capital gain or loss. (2) Generally, the granting of an easement or a public right of way is considered a disposition of a part of the property in respect of which it is granted, and a reasonable portion of the adjusted cost base of the whole property attributable to the part disposed of is required to be allocated to the disposition pursuant to section 43 of the Act. This could result in a capital gain or loss. (3) Payments received by a landowner from an oil and gas company for exploration rights or pursuant to a petroleum and natural gas lease should be treated as proceeds of disposition of a "Canadian resource property", defined in subsection 66(15) of the Act as including any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada.
Reasons: Review of the legislation, interpretation bulletins and previous technical interpretations.
XXXXXXXXXX 2008-029705
T. Lanzer
(613) 946-5357
February 17, 2009
Dear XXXXXXXXXX :
Re: Tax Treatment of Oil and Gas Company Payments to Landowners
We are writing in response to your e-mail of October 21, 2008 wherein you requested our comments on the tax treatment of various payments made by oil and gas companies to landowners in order to conduct exploration activities on their land. You advise that the oil and gas companies enter into various agreements with the landowners, including surface rental agreements, agreements granting easements or rights of way, and petroleum and natural gas leases.
Our Comments
Written confirmation of the income tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request, as described in Information Circular 70-6R5, dated May 17, 2002. The review of fact situations involving specific taxpayers and transactions or events that have already taken place is the responsibility of the local tax services office where the taxpayer resides and it is not the practice of the Canada Revenue Agency (the "Agency") to comment on such situations when the identity of the taxpayers is unknown. We can, however, provide the following general comments which we hope will be of assistance to you.
The position of the Agency regarding the tax treatment of payments made by oil and gas companies to landowners for certain surface rights, including compensation for damage to land, is set out in Interpretation Bulletin IT-200, Surface Rentals and Farming Operations, dated February 24, 1975.
Paragraphs 1 and 2 of IT-200 are particularly relevant to your situation and state as follows:
1. Persons exploring or drilling for petroleum or natural gas often obtain a lease from the owner of land covering certain surface rights. For example, the lease may cover several years in respect of a small acreage of land, possibly set in from the boundaries of the owner's land. The first year's payment may be in a lump sum for such things as damage to land, land improvements, inconvenience, severance and the first year's rent, without a specific amount being ascribed to any of these items. For the second and subsequent years, the lease may require a periodic payment or payments for rental, severance, or inconvenience. In these circumstances, the portion of the lump sum paid in the first year that is equal to the periodic payments to be made in subsequent years is considered to be income within the meaning of subsection 9(1). The remainder of the lump sum payment is generally considered to be capital.
2. The capital portion of the first year's payment, as compensation for property injuriously affected, damaged or destroyed, constitutes "proceeds of disposition" within the meaning of paragraph 54(h) and may result in a capital gain or loss. Under section 43, the adjusted cost base of the part of the property disposed of is that part of the adjusted cost base of the whole property that is reasonably attributable to the part. The adjusted cost base of the whole property is then decreased by that amount pursuant to paragraph 53(2)(d). Where the part disposed of is relatively small in relation to the property, the Department accepts any reasonable portion of the adjusted cost base that the taxpayer wishes to attribute to the proceeds.
Whether or not any portion of the payments made to a landowner in respect of a surface lease is on account of income or capital is a question of fact that can only be determined after reviewing all of the facts in a particular situation.
Generally, payments received by a landowner as compensation for damage to crops and compensation for additional costs and losses of a property owner who carries on farming operations around structures situated on the owner's property would be included in computing the property owner's income from farming operations. Compensation received for damage to fences and buildings would generally be capital in nature and therefore reduce the undepreciated capital cost of these assets.
Oil and gas companies may acquire and maintain many miles of pipeline, such as gathering systems to collect the oil or natural gas in the field, sales lines to connect to the main transmission line, injection lines from gas or steam plants to the well sites, and water source lines to the gas or steam plant. Since these pipelines traverse lands not owned by the company, it is necessary to obtain an easement or right of way from the owner of the land, in order to obtain right of access.
Generally, the granting of an easement or a public right of way is considered a disposition of a part of the property in respect of which it is granted, and a reasonable portion of the adjusted cost base of the whole property attributable to the part disposed of is required to be allocated to the disposition pursuant to section 43 of the Income Tax Act (the "Act"). This could result in a capital gain or loss. However, as noted in paragraph 2 of Interpretation Bulletin IT-264R, Part Dispositions, dated December 29, 1980, and the special release dated October 19, 1984 (a copy of each can be obtained on our website at www.cra-arc.gc.ca), the Agency will normally consider the adjusted cost base of the easement or right of way to be equal to the proceeds of disposition for granting it, provided that: (a) the area of the portion of the property in respect of which an easement or right of way was granted is not more than 20% of the area of the total property, and (b) the amount of the compensation received is not more than 20% of the amount of the adjusted cost base of the total property.
A landowner who owns the mineral rights to a parcel of land may grant exploration rights to an oil and gas company by means of a petroleum and natural gas lease (the "PNG Lease"). In a typical PNG Lease, the owner of the mineral rights (the "lessor") grants the oil and gas company (the "lessee") the exclusive right to explore for, drill for and take the petroleum, natural gas and related hydrocarbons that occur on or under a particular parcel of land in return for consideration consisting of lump sum rental payments and bonus payments. Since a "Canadian resource property" is defined in subsection 66(15) of the Act as including any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada, we believe that the consideration received by the lessor for entering into a PNG Lease should be treated as proceeds of disposition of a Canadian resource property. Where the Canadian resource property consists of oil and gas rights, these proceeds should be deducted from the taxpayer's cumulative Canadian oil and gas property expense ("CCOGPE") as defined in subsection 66.4(5) of the Act, pursuant to element F of that definition.
In the event that the amount in the taxpayer's CCOGPE pool is negative at the end of a taxation year, such negative amount is deducted from the taxpayer's cumulative Canadian development expense ("CCDE"), as defined in subsection 66.2(5) of the Act, pursuant to element L of that definition. If the taxpayer's CCDE pool is also negative at the end of the taxation year, this negative amount is included in the taxpayer's income for the taxation year through the operation of subsection 66.2(1) and paragraph 59(3.2)(c) of the Act. This treatment is described in paragraph 2 of Interpretation Bulletin IT-125R4, Dispositions of Resource Properties, dated April 21, 1995.
Therefore, unless the landowner has a balance in either the CCOGPE or CCDE pools as a result of having previously incurred any Canadian oil and gas property expense or Canadian development expense, as defined in subsections 66.4(5) and 66.2(5) of the Act, respectively, the full amount of the payments receivable by the taxpayer for entering into the PNG Lease should be included in computing the taxpayer's income for the year under paragraph 59(3.2)(c) of the Act.
We trust that our comments, provided in accordance with paragraph 22 of Information Circular 70-6R5, will be of assistance.
Yours truly,
for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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