18 April 1990 Income Tax Severed Letter 5-9647 - Request for Technical Interpretation—paragraph 66(15)(c) of the Income Tax Act—treatment of a payment made to purchase or cancel a royalty interest

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.

We are writing in reply to your request of February 23, 1990, for our comments with respect to the treatment of a payment made to purchase or cancel a royalty interest under certain circumstances described herein.

FACTS

You submit the hypothetical fact situation therein:

• 1. Company A owns a mineral property which qualifies as a Canadian resource property pursuant to Paragraph 66(15)(c) of the Act,
• 2. Company a owns a royalty interest in respect of the production from this resource property. The royalty interest entitles Company B to share in the proceeds of production and sale of minerals from the mineral property. The royalty constitutes a Canadian resource property Pursuant to subparagraph 66(15)(c)(v) of the Act,
• 3. Company A wishes to make a payment to Company a so that the production from the mineral property would no longer be subject to the royalty,
• 4. Company A would enter into an arrangement with Company B whereby the royalty interest would be purchased by Company A or cancelled, and
• 5. Notwithstanding the particular arrangement, ie. purchase vs cancellation, Company A would hold a greater interest in its mineral property than it did before the Payment.

YOUR OPINION

You suggest that if the royalty interest described above is purchased, as a question of law, it may merge with the underlying interest in the property held by Company A immediately following acquisition.

It is also your view that Company A's payment to Company B to cancel the royalty interest rather than to acquire it may be fully deductible by Company A in computing its income for income tax purposes, and further, that such payment would not be deducted in computing "resource profits" for purposes of section 1204 and 1210 of the Income Tax Regulations (the "Regulations").

You then ask for our comments as to the income tax consequences to Company B in both the acquisition and cancellation scenarios and whether our views on the deductibility of the cancellation payment under the cancellation scenario would be different if the royalty interest did not qualify as a Canadian resource property under paragraph 66(15)(c) of the Act.

COMMENTS

Whether or not any particular payment or expense will be classified as a deductible business expense or a resource expense contemplated at section 66 of the Act is a question of fact that can only be resolved by examining all of the relevant facts of the particular situation. However, we offer the following general comments which may be of assistance to you.

A. Company B

• Whether Company B yields his royalty interest to Company A by sale or cancellation thereof, it is our view that Company B would have disposed of Canadian resource property which he previously owned. As to the meaning of disposition" see by analogy subparagraph 54(c)(ii)(A) which states that "disposition" (for the purposes of subdivision c of the Act) of any property includes any transaction or event by which any property of a taxpayer that is, inter alia, a share bond or similar property, or an interest therein, is redeemed or cancelled.

That the amount received upon cancellation or extinguishment of Company B's royalty interest would fall within the ambit of subparagraph 66.2(5)(b)(v) as

• "... an amount in respect of a Property described in subparagraph 66(15)(c)(ii), (v) or (vii)... disposed of by the taxpayer..."

is supported by the following court cases.

• 1. In Victory Hotels Ltd. vs M.N.R., 62 DTC 136, (Exchequer Court of Canada), at page 1385, Noel J, stated that the words "disposed of" are of the widest meaning and should, in his opinion, be given their widest ordinary or popular meaning which would be "to part with" or "to pass over control of the thing to someone else" so that the person disposing no longer has the use of the property. He wrote at the same place
• "The expressions "disposed of", "lost" or "destroyed" were dealt with in the Australian case of Hentey Howe P.T.V. Ltd. vs Federal Commissioner of Taxation, 68 C.L.R. 151, and from that decision it will be seen that the words "disposed of" are given a very wide meaning. May I add that the section of the Australian Income Tax Act in which these expressions were found is very similar to our S.20. It was therein stated that:
• The entitled expression "disposed of", "lost" or "destroyed" is apt to embrace every event by which property ceases to be available to the taxpayer for use in producing assessable income, either because it ceases to be his, or because it ceases to be physically accessible to him, or because it ceases to exist."
• 2. In The Queen vs Compagnie Immobiliere BCN Limitee, 79 DTC 5068, (Supreme Court of Canada), the taxpayer became the lessee of a certain piece of land in 1964. In 1965 the taxpayer acquired the land and the issue was whether the leasehold interest which terminated upon the acquisition of the land should be regarded as having been "disposed of" for purposes of claiming capital cost allowance. Pratte J. had this to say on behalf of the Supreme Court at page 5075:
• "As already indicated, the verb "to dispose of", in its first meaning, encompasses the idea of destruction; one of the meanings of the verb "to destroy is "to put an end to, to do away with" (Shorter Oxford English Dictionary, see Destroy).
• The extinction of a right through merger is but one method of "destroying" that right, that is of putting an end to its existence. In Re Leven, (1954) 3 All E.R. 81, it was said that the word "disposition" taken by itself and used in its most extended meaning was "wide enough to include the act of extinguishment"."

The Supreme Court concluded that since acquisition of the land brought about the automatic termination of the leasehold interest; such interest was extinguished, it was destroyed and should be regarded as having been "disposed of".

Having disposed of a property described in subparagraph 66(15)(c)(v), it is our view that the payment which Company B receives would reduce its cumulative CDE pursuant to subparagraph 66.2(5)(b)(v) of the Act and would not be included in eligible resource profits for purposes of sections 1204 and 1210 of the Regulations.

B. Company A - Interest in Land

Provided that the subject royalty interest constitutes an interest in the underlying real property, i.e. an interest in land, we concur with your opinion that Company A's payment to acquire Company B's royalty interest could be classified as the cost of a Canadian resource property. Given that the royalty interest qualifies as a Canadian resource property under subparagraph 66(15)(c)(v) of the Act, there seems little doubt that Company A has "acquired" a property in consideration for its payment to Company B. This is evident in Company A's greater interest in the mineral property after the payment.

Canadian development expense ("CDE") as defined in paragraph 66.2(5)(b) of the Act provides, inter alia, by virtue of subparagraph (iii) thereof, for inclusion therein of the cost of a property described in subparagraph 66(15)(c)(v) - such as the subject royalty interest in Company A's mineral property, where the royalty interest constitutes an interest in land.

Regarding your suggestion of merger, Black's Law Dictionary, Fifth Edition, defines merger with respect to property interests as follows:

• It is a general principle of law that where a greater estate and a less coincide and meet in one and the same person, without any intermediate estate, the less is immediately annihilated, or, in the law phrase, is said to be merged; that is, sunk or drowned, in the greater. Thus, if there be tenant for years, and the reversion in fee-simple descends to or is purchased by him, the term of years is merged in the inheritance, and shall never exist any more. Similarly, a lesser interest in real estate merges into a greater interest when lessee purchases leased property."

Although this question of law is beyond the scope of this letter, we understand that the doctrine of merger is viewed differently at common law than in Equity. Cheshire & Burns, Modern Law of Real Property, Thirteenth Edition, states at page 852:

• "At common law merger results automatically from the union of two estates in the circumstances we have mentioned, and intention does not affect the result. But Equity looks to the intention and to the duties of the parties. If an intention is expressly declared to the effect that the lesser estate shall be kept alive, there is no difficulty; but even in the absence of such an express declaration Equity will presume an intention against merger if it is clearly advantageous to the person in whom the estates are united, or if it is consistent with his duty, that the lesser interest shall not be destroyed."

Anger and Honsberger Law of Real Property, second edition, states at page 1215 that the Supreme Court of Canada affirmed in two recent cases that the court must look to the intention of the parties in deciding whether a contractual term is merged or not. Thus, provided that the royalty interest which is an interest in land can merge with Company A's interest in the mineral property, the merger hinges on whether Company A intends that the royalty interest should so merge.

We reiterate that application of the doctrine of merger is a question of law that is beyond the scope of this letter.

It is our view that the particular income tax result to Company A with respect to its payment upon purchase, ie. classification of the cost of the royalty interest which constitutes an interest in land as CDE, would not be altered as a consequence of the foregoing merger, in and by itself. Thus, the payment would not be included in the computation of eligible resource profits for purposes of sections 1204 and 1210 of the Regulations.

With respect to the cancellation scenario, we do not share your view that where a payment by Company A to Company B is made to cancel the royalty interest which constitutes an interest in land, such payment would be fully deductible by Company A.

Notwithstanding that Company A's payment may be structured so as to be construed as a cancellation or extinguisment of the royalty interest, Company A has nonetheless increased its interest in the underlying mineral property. It is our view that a payment by Company A to effect this result, ie. to enhance its ownership of the mineral property, which constitutes an interest in land, by incurring the cost of a property described in subparagraph 66(15)(c)(v) of the Act, would fall within the ambit of the definition of CDE by virtue of subparagraph 66.2(5)(a)(iii) of the Act.

C. Company A - Contractual Obligation

In situations where the royalty interest is not an interest in land but rather a contractual obligation pursuant to which Company A is obligated to make royalty payments to Company B, it is our view that provided that the royalties are deductible payments in computing Company A's income under the provisions of the Act, Company A's payment to extinguish this obligation, whether by acquisition of the contract which imposes the obligation or by cancellation thereof, could be deductible by Company A.

The payment by Company A to acquire or cancel the royalty interest that is not an interest in land would have to be related to a source of income in order to be deductible. If there is no source of income, there is no deduction. Where Company A's sources of income consist solely of those described in paragraphs (b) and (b.i) of subsection 1204(1) of the Regulations, the payment would reasonably be regarded as applicable thereto and, as a consequence thereof, would fall within the ambit of paragraph 1204(1)(f) of the Regulations. Thus, the payment would reduce resource profits computed for purposes of section 1210 of the Regulations.

If Company A has sources of income in addition to those described in paragraphs 1204(1)(b) and (b.1) of the Regulations, then resource profits would be reduced pursuant to paragraph l204(1)(f) of the Regulations by the portion of the payment which is reasonably attributable to the latter sources.

It is also our view that Company A's payment to extinguish its contractual royalty obligation would not itself constitute a royalty. We would consider the payment as having been made to enable a breach of the royalty obligation rather than being incurred in respect of a royalty. Thus, Company A's payment would not be considered a royalty contemplated at section 1210 of the Regulations.

D. Other Royalty Interests

You have asked for our comments with respect to the deductibility of a payment by Company A to cancel Company B's royalty interest as described in the hypothetical fact situation except that the royalty interest does not constitute a Canadian resource property.

Company B's royalty interest would not qualify for treatment as a Canadian resource property under paragraph 66(15)(c) where, for example, the royalty interest not only entitles Company B to share in the net proceeds of production and sale of the mineral resource but also provides Company B with the right to share in other non-production sources of income such as the proceeds from sale of depreciables, investment income, other business income, etc.

Provided that Company A's payments to discharge its obligation with respect to the royalty interest are deductible in computing income, then in accordance with paragraph 15 of Interpretation Bulletin IT-467, Company A's payment to cancel or terminate such an obligation would be considered deductible.

Our comments above with respect to sections 1204 and 1210 of the Regulations would be relevant to Company A's payment to cancel a royalty interest which does not constitute a Canadian resource property. Consequently, the payment would reduce resource profits pursuant to paragraph 1204(1)(f) of the Regulations to the extent of the portion of the payment that may reasonably be applicable to the sources of income described at paragraphs 1204(1)(b) and (b.1) of the Regulations. Further, the payment would not be considered a royalty for purposes of section 1210 of the Regulations.

The above comments are merely the expressions of opinion of those Revenue Canada officials named herein and as such should not be construed as advance income tax rulings, nor are they binding on the Department. Our practice is to make this specific disclaimer in all instances in which we provide an opinion. We refer you in this respect to paragraphs 21 and 24 of Information Circular 70-6R.