22 June 1988 Income Tax Severed Letter 5-5562 - [880622]

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.

TO Calgary District Office

FROM Specialty Rulings Directorate K.B. Harding (613) 957-2129

G. C. Hoard Chief of Audit

We are attaching a copy of a letter dated February 12, 1988 which we received from XXXX in Calgary.

Since XXXX requested we review a fact situation on which your office had previously expressed an opinion, we are outlining our views so that you may reply to the XXXX provided you are in agreement with our position:

The situation outlined in their letter is as follows:

1. Certain U.S. residents own subsurface rights ("the Rights") with respect to freehold land situated in Alberta. They received these Rights upon the deaths of certain U.S. resident relatives, the Rights having been "in the family" (all U.S. residents) for several decades. The related surface rights are owned by Canadian resident freeholders who farm or otherwise occupy the land and who deal at arm's length with the U.S. resident owners of the Rights. At no time has there been active prospecting or any drilling activities on the lands to which such Rights relate.

2. The U.S. residents sell the Rights to a Canadian oil and gas exploration/production company for cash. This is an outright sale, being prompted purely by the Canadian company's desire to own the Rights, which it regards as a "prospect" in its search for hydrocarbons.

XXXX has requested our opinion whether the "fresh start" rules set out in paragraph 9 of Article XIII of the Canada-U.S.. Income Tax Convention (new Treaty) would apply to the above fact situation.

Prior to this review our argument was that resource properties were not eligible for the "fresh start" rule for the following reasons.

The Department took the position that the capital gains exemption in Article VIII of the old Treaty applied to the proceeds derived by U.S. residents from the disposition of Canadian resource properties as defined in paragraph 66(15)(c) of the Act provided the U.S. resident did not have a permanent establishment in Canada. The justification for such treatment was that in 1942 when the old Treaty was entered into, resource properties were considered to be capital assets.

Paragraph 9 of Article XIII of the new Treaty refers to the alienation of a "capital asset". At the time the new Treaty was entered into, resource properties were clearly not considered to be capital assets for Canadian tax purposes and therefore the claim for treating them as capital assets can no longer be justified as was formerly the case under the old Treaty. For these reasons it is our view that an alienation of resource properties will not qualify for the benefits under paragraph 9 of Article XIII of the new Treaty.

Article VI of the new Treaty provides that "income" from real property situated in Canada may be taxed in Canada. The term "income" is not defined in the new Treaty and therefore it takes on the meaning which it has under the domestic law. Paragraph 2 of Article VI provides that the term "real property" includes resource property. Accordingly, proceeds from the disposition of a Canadian resource property by a resident of the United States which are included in income for Canadian tax purposes would be subject to taxation in Canada as income under Article VI of the new Treaty and, on the basis stated above, paragraph 9 of Article XIII would not be applicable to such a disposition.

The Technical Explanation is intended to reflect the policies behind the provisions of the new Treaty. However, it is our view the provisions of Articles VI and XIII of the new Treaty are sufficiently clear with respect to the taxation of gains on the alienation of resource properties and accordingly, the provisions of the Technical Explanation do not affect our interpretation of these Articles as set forth above.

We have recently been advised by the Department of Finance that the purpose of the passage in the Technical Explanation which reads

"... paragraph 9 applies to a gain described in paragraph 1, even though such gain is also income within the meaning of paragraph 3 of Article VI."

was to extend the transitional relief for capital gains to resource properties (no permanent establishment) to which the exemption in Article VIII of the old Treaty applied even though for Canadian tax purposes such properties are not capital properties.

In view of the above comments it is clear that the intention of the Department of Finance was to have paragraph 9 of Article XIII of the Treaty apply to gains arising on the disposition of such resource properties.

On the other hand, the Department of Finance clearly indicated that the portion of the proceeds of disposition of real property that represents depreciation recapture would fall within the scope of Article VI of the Treaty and be treated as income from real property rather than Article XIII which is confined to the portion that represents a gain.

Since the interpretation of tax agreements or conventions can take into account the intention of the negotiators when negotiating such treaties, we have now taken the view that paragraph 9 of Article XIII may be applied to the disposition of a resource property provided such properties are not excluded by virtue of paragraphs 9(c), (d) and (e) of Article XIII of the Treaty.

We request your reply to the attached letter as soon as possible since the letter is dated approximately three months ago.

for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch