20 July 1989 Ministerial Correspondence 58084 F - Carved Out Property/Farm Out

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.

July 20, 1989

Dear Sirs:

We are writing in reply to your letter to us dated May 10, 1989, wherein you requested our interpretation of how the following hypothetical transactions should be recorded for income tax purposes:

1.     Taxpayer A owns oil and gas leases.  Taxpayer B will incur 100% of the exploration, development and equipping costs associated with bringing the leases into production and as a consequence will receive 90% of all revenues until he has recovered his costs ("payout") after which he will own a 30% working interest.  For discussion purposes assume that B will incur $300 of CEE, $500 of CDE and $200 on Class 41 assets.

2.     Assume the same facts in 1. above except that B will incur $300 of CEE and $500 of CDE while taxpayer A will incur $200 on Class 41 assets.

     During the period from commencement of production to payout 100% of additional development or equipment expenditures will be paid out of revenues.  After payout A will be responsible for 70% of ongoing expenditures and B will be responsible for 30% of ongoing expenditures.

We are unable to respond directly to your queries raised in respect of the above scenarios as we are unable to pre-determine all of the relevant facts necessary to do so.  However, we can provide you with the following general comments which may be of assistance to you.  It should be remembered that these comments could be affected by any change to the particular facts, as ultimately determined in an actual situation.

A.      Part XII.1 tax imposed by subsection 209(2) of the Act will apply to a person who is a farmee in a farm-out arrangement, inter alia, where the farmee incurs equipping costs in addition to exploration and development expenses in respect of a particular property, and where the terms of the farm-out arrangement provide that the farmer's interest in the income attributable to the property will be reduced substantially within the time periods referred to in clauses 209(1)(a)(iii)(A) and (B) of the definition of "carved-out property".

     The exclusion from the carved-out property rules, provided by paragraph 209(1)(c) of the Act, would not be met in this instance because the farmee's interest in the property was not acquired solely in consideration of his undertaking to incur Canadian exploration expense or Canadian development expense in respect of the property (i.e. the equipping costs taint the exclusion).

     We would view the "reduction" as being substantial in a situation similar to your example 1. where the farmee receives 90% of all revenues until payback after which time his interest in the income is reduced to 30%.

B.     It is the Department's position, as outlined in paragraph 11 of Interpretation Bulletin 125R3, that to the extent that an owner of a resource property (the "farmor") transfers a part interest therein to another person "the farmee") in consideration of the farmee's agreement to incur exploration and development expenses on that property, the proceeds of disposition to the farmor and the acquisition cost to the farmee of the resource property will be viewed as being nil.

     However, where the farmee incurs 100% of the equipping costs on the particular property, in addition to the exploration and development expenses, all in return for the farmee earning a less than 100% interest in the equipment and the resource property (for example say a 10% interest in each), then the farmor will have proceeds of disposition and the resource property, equal in amount to the value of the interest in the equipment paid for by the farmee but received by the farmor (i.e. in this case 90% of the equipping costs).  This would result in an addition or reduction to the respective person's resource pools, as the case may be.

C.     Where, pursuant to a farm-out arrangement, a farmee receives a working interest in a non-producing resource property and an interest in the project's depreciable properties that were acquired by the farmor, all in return for the farmee incurring the project's exploration and development expenditures (i.e. the farmee is not acting as an agent for the farmor), there will be a disposition and acquisition at fair market value of the applicable interest in the depreciable property by the farmor and farmee, respectively.  In addition, the farmee will be considered to have an amount receivable for the purposes of subsection 66(12.1) of the Act, equal to the fair market value of the depreciable property so received.

The above comments are expressions of opinion only and as such are not to be construed as advance income tax rulings, nor are they binding on the Department.

Yours truly,

for Director Bilingual Services andResource Industries DivisionRulings Directorate