28 August 1980 Income Tax Severed Letter 3-6901 - [Earned Depletion Base]

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.

August 28, 1980

EDMONTON DISTRICT OFFICE

HEAD OFFICE Corporate Rulings Directorate M.A. Hilts Gene Kindrachuk Basic Files Section

Earned Depletion Base

This is in reply to your letter of May 7, 1980.

XXXX Interest payable to that time on monies borrowed to acquire depreciable property and to conduct exploration and development activities was capitalized, supposedly in accordance with the principle stated in Sherritt Gordon Mines Limited v MNR 68 DTC 5181. In the absence of this principle, interest on monies borrowed for the purposes aforesaid could only have been capitalized pursuant to section 85J of the former Act which applies in respect of the 1968 and subsequent taxation years. Although your memo is silent on the point, we have assumed that some of the interest capitalized was referable to operations and not to the acquisition of depreciable property or the conduct of exploration and development activities.

XXXX has included all of the capitalized interest in computing its earned depletion base and you have requested an opinion with respect to this inclusion.

Capitalization of Interest

Interest expense incurred in respect of monies borrowed to construct depreciable property or to conduct exploration and development work prior to the commencement of business may be capitalized as part of the capital cost of depreciable property or as exploration and development expense in accordance with the Sherritt Gordon principle. However, this case does not stand for the proposition that business commences at the time that commercial production is achieved; the court in this case held that business commenced when production from the mine commenced. Our memorandum of September 25, 1979 is therefore incorrect to the extent which it states that interest expense incurred between the time of commencement of production and the attainment of commercial production may be capitalized pursuant to the Sherritt Gordon principle.

Interest expense incurred in respect to depreciable property acquisitions or exploration and development activities after the commencement of business could not be capitalized except in respect to the 1968 and subsequent taxation years pursuant to section 83J of the former Act. Such interest was deductible in computing the income of XXXX pursuant to paragraph 11(1)(c) of the former Act and the deduction of such interest might have created a loss governed by paragraph 27(1) (e) of the former Act.

We have assumed, as mentioned in paragraph 2, that interest referable to operations was capitalized, supposedly in accordance with the reasoning in Sherritt Gordon. There is no provision permitting the capitalization of such interest as the capital cost of property or exploration and development expense.

Earned depletion base

XXXX is entitled to include in its EDB by virtue of Regulation 1205(d) interest expense referable to exploration and development. In addition Regulation 1205(c) permits it to include interest with respect to depreciable property capitalized in accordance with the correct interpretation of Sherritt Gordon. Such interest will not be excluded from the EDB by Regulation 1205(f), since that provision excludes only interest capitalized under section 85J of the former Act.

The issue arises with respect to the inclusion XXXX of interest expense incurred after the commencement of production referable to the acquisition of depreciable property and to operations. Interest expense referable to operations may not be included and although interest expense referable to depreciable property may be capitalized pursuant to section 85J, it will be excluded from the EDB by Regulation 1205(f). (We have assumed that XXXX did not make an election under section 85J.)

XXXX may argue that it may include all or part of this interest in its EDB pursuant to the Departmental practice which permits the classification as development expense of all expenses incurred prior to commercial production less income earned in this period. This practice prevents the creation of non-capital losses and permits the inclusion in the EDB of net operating expenses. Since the unqualified application of this practice would result in the circumvention of the prohibition in respect to inclusion of interest in the EDB, we will not agree to the application of this practice where any part of the net operating expenses may reasonably be considered to consist of interest expense.

Recommendations:

1. Interest expense incurred after commencement of production but before the 1968 taxation year of XXXX in respect to depreciable property, exploration and development and operations should not be capitalized as capital cost or exploration and development. It should be deducted pursuant to paragraph 11(1)(c). We recommend that your office accept an election made in accordance with section 85J in respect to interest incurred in the 1968 taxation year of XXXX on money borrowed to acquire depreciable property and used for the purpose of exploration and development.

2. Interest expense incurred after the commencement of production referable to depreciable property and to operations should not be included in the EDB of XXXX.

Chief Mines, Oils & Forest Industries Section Specialty Corporations Rulings Division MAR/mj