12 June 1990 Ministerial Letter 59768 F - Canadian Resource Property and Qualified Farm Property

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.

June 12, 1990

Dear Sirs:

Re:  Request for Technical Interpretation - Canadian Resource Property and' Qualified Farm Property under the Income Tax Act (the "Act")

We are writing in reply to your letter dated March 12, 1990, wherein you requested a technical interpretation of the meaning of Canadian resource property ("CRP") and qualified farm property under paragraph 66(15)(c) and subsection 110.6(1) of the Act, respectively, in relation to a hypothetical situation herein described.

Hypothetical Situation

For purposes of the ensuing discussion, you have asked us to assume the following facts:

1.     Mr. X is an individual resident in Canada who directly owns a 50 acre parcel of real property (the "land").

2.     Mr. X has owned the land for a period of 10 years and throughout that time the entire 50 acres was used by him in carrying on business as a farmer.

3.     A 10 acre section (the "property") of the land once contained deposits of natural gas, but any commercial quantities have been extracted such that, at the time of acquisition of the property by Mr. X, the best and highest value for the property was derived from its use in the business of farming.

4.     The property may be severed from the land and outright title and ownership may be sold to Company A, a corporation resident in Canada which deals at arm's length with Mr. X

5.     Company A intends to acquire the property in order to utilize caverns beneath the surface (which once contained commercial quantities of natural gas prior to Mr. X's acquisition of the property) for underground storage of natural gas.  There is presently no separate right, licence or privilege for such storage activities and Company A will be required to apply for the relevant provincial licence or other form of governmental permission.

6.     Company A is willing to pay Mr. X an amount that is significantly higher than farm land value for the property, due to the potential use of the property for underground storage of natural gas.

7.     The land owned by Mr. X would otherwise be characterized as a capital property pursuant to paragraph 54(b) of the Act but for the application of subparagraph 39(1)(a)(ii) to the property, which excludes Canadian resource property from capital property.

Based on these assumed facts (or as modified below), you then ask for our comments with respect to four questions.

Question 1

Does Mr. X realize a capital gain on the sale of the 10 acre section of the land, i.e. the property?

It is your view that on the assumption that Mr. X owns the property, notwithstanding that the property has the potential to be used as an underground storage facility for natural gas, there is no separate existing specific right, licence or privilege to store underground natural gas within the meaning of clause 66(15)(c)(ii)(A) or subparagraph 66(15)(c)(vii) of the Act. Hence, no portion of the gain on sale of the property would be attributable to a disposition of a CRP and Mr. X's entire gain on sale of the property would be a capital gain pursuant to subsection 39(1) of the Act.

It is also your view that under these circumstances, i.e. sale of the property which has the potential for use as an underground natural gas storage facility but in which there is no specific right, licence or privilege to do so under paragraph 66(15)(c) of the Act, the acquisition cost to Company A, which intends to use the property for underground storage of natural gas, would not constitute a Canadian development expense ("CDE") nor a Canadian oil and gas property expense ("COGPE") as defined at paragraphs 66.2(5)(a) aid 66.4(5)(a) of the Act, respectively.  Instead, Company A's cost of acquiring the property would constitute a non-depreciable capital property which Company A will use in its business of underground storage of natural gas.

We concur with your views.  The entire gain on sale of the property under the foregoing assumptions would be treated as a capital gain realized by Mr. X pursuant to subsection 39(1) of the Act and the cost incurred by Company A to acquire the property, which will be used by Company A in its natural gas storage business, would be treated as a capital property under paragraph 54(b) of the Act.

It is our view that while a right to use the subsurface of the property for storage of natural gas may be inherent in Mr. X's freehold interest in the property, his freehold interest includes much more than that particular right.  Clause 66(15)(c)(ii)(A) of the definition of CRP in paragraph 66(15)(c) of the Act refers to "any right, licence or privilege to store underground petroleum, natural gas or related hydrocarbons in Canada..." and implies a leasing or licencing arrangement.  An example of a "right" referred to in this clause would be where Mr. X retains ownership of the property and leases the subsurface to Company A for underground storage of natural gas.  This lease would constitute a right" referred to in clause 66(15)(c)(ii)(A) of the definition of Canadian resource property.

Since a right, licence or privilege to store underground natural gas under subparagraph 66(15)(c)(ii) does not exist, we share your view that subparagraph 66(15)(c)(vii) would not apply to the property.

Consequently, Mr. X would not be considered to have owned, nor would Company A be considered to have acquired, a CRP as defined at paragraph 66(15)(c) of the Act.

Question 2

Is the answer to Question 111 different if specific underground storage rights presently exist?  Assuming that applicable provincial legislation requires a licence or right to be granted prior to using the property for underground storage, and further assuming that Mr. X is in possession of such a right or licence, does the answer to 111 above change if such right or licence is conveyed to Company A in addition to the property itself?

Your opinion is that the right or licence granted to Mr. X under provincial legislation for underground storage of natural gas would constitute a CRP under clause 66(15)(c)(ii)(A) of the Act which is a separate property from Mr. X's freehold interest in the property.

We share your view that the right or licence granted by a provincial authority would constitute a separate property which would be a CRP by virtue of clause 66(15)(c)(ii)(A) of the Act.

We also concur with your view that the portion of Mr. X's proceeds reasonably attributable to his sale of the property would be considered as proceeds of disposition of a capital property and, as a consequence thereof, would result in a capital gain or loss, as the case may be.  The proceeds reasonably attributable to Mr. X's sale of the licence or right which constitutes a CRP would be included in income under paragraph 59(3.2)(c) of the Act, assuming that Mr. X's cumulative CDE computed in accordance with paragraph 66.2(5)(b) of the Act is nil.

Where the licence or right was sold by Mr. X in the course of a business of selling such properties or as an adventure in the nature of trade, the proceeds reasonably attributable thereto would be included in the computation of his income pursuant to section 9 of the Act.

Question 3

Can the character of the property change from being a Canadian resource property to something else?

(a)     You stated that on the assumption that the commercial quantities of natural gas were extracted prior to acquisition of the property by Mr. X, who would have paid a  purchase price based on its farmland value only, it would appear that the property should be treated as a capital property and not a CRP by Mr. X.

     It is our view that irrespective of the basis on which Mr. X  may have determined the amount that he was willing to pay for the property, whether the farmland value or some other value, the property would be a capital property of Mr. X provided that it was acquired for use in a farming business   and does not qualify as a CRP under the provisions of paragraph 66(15)(c) of the Act.  Since the property does not  contain any natural gas and the assumed facts indicate that   the property does not qualify as a CRP, the property would be treated as a capital property of Mr. X.

(b)     If instead Mr. X were the person who owned the property at the time the natural gas was extracted, you ask whether the character of the property has changed to a capital property so that upon disposition to Company A, Mr. X is considered to have disposed of a capital property.

Your views:

1.     There would not be a deemed disposition pursuant to paragraph 45(1)(a) of the Act because at the time the property is converted by Mr. X from being used in-a resource business to a farming business, the change in use is from one business use to another business use to which section 45 does not apply. Further, section 45 may be irrelevant because a CRP is not a capital property. 

2.     The determination of how the proceeds of disposition of the property should be treated for income tax purposes at the time of sale to Company A would be based on the character of  the property at that time, i.e. CRP vs capital property at the time of sale to Company A.  Since the property is not a CRP at the time of sale to Company A, such sale would result  in a capital gain of Mr. X.

3.     On the assumption that the property was originally a CRP, the property would not have an adjusted cost base ("ACB") as  defined in paragraph 54(a) of the Act, hence the entire proceeds would constitute a capital gain.

Our comments:

The amendment to subparagraph 66(15)(c)(iii), provided for the inclusion therein of any real property in Canada the principal value of which depends upon its petroleum or natural gas content, applicable to taxation years ending after March, 1985.  Prior to this time, real property, the principal value of which depended upon its natural gas content, was not included in the definition of CRP under paragraph 66(15)(c) of the Act.

Since the assumed facts indicate that Mr. X acquired the property prior to the above amendment, the property would not have qualified as a CRP under subparagraph 66(15)(c)(iii) which applied only to oil or gas wells in Canada and not to real property.

It is our view that real property, in and of itself, does not constitute "any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada" pursuant to subparagraph 66(15)(c)(i) of the Act, notwithstanding that a "right" to perform such activities on the real property may be inherent in the ownership of the real property.  A "right, licence or privilege" as these words are used in subparagraphs 66(15)(c)(i) and (ii) implies a leasing or licencing arrangement and does not, in our view, include real property.  For the purposes of the definition of CRP, real property is specifically provided for at subparagraphs 66(15)(c)(iii) and (vi) of the Act.         

For the above reasons and on the basis of the assumptions mentioned above, we concur with your view that the property would be treated as capital property of Mr. X upon its disposition to Company A.

Assuming that the property was acquired by Mr. X subsequent to the amendment to sub paragraph 66(15)(c)(iii) and, as a consequence thereof, the property qualified as a CRP, i.e. real property the principal value of which depended upon its natural gas content; and further assuming that the commercial quantities of natural gas were extracted such that the property ceases to be real property the principal value of which depends upon its natural resource content; it is our view that Mr. X's disposition of the property would be analogous to circumstances described in Interpretation Bulletin IT-218R.

Therein, the comments at paragraphs 11 and 15 pertaining to the conversion of real property from capital property to inventory and to the actual disposition of the real property, respectively, would be relevant to the conversion of the property from a resource business use to a farming business use and to Mr. X's sale of the property to Company A.

Upon ceasing to be a CRP under subparagraph 66(15)(iii) of the Act, i.e., at the time that the commercial quantities of natural gas have been extracted, whereupon the property was converted by Mr. X for use primarily in his farming business, Mr. X would be considered to have a notional disposition and notional proceeds of disposition of a CRP. The conversion  would also result in a notional acquisition of a capital property by Mr. X. 

For the reasons which you stipulated, viz. that the conversion of the property is from one business use to another business use and the property is a CRP, we agree that section 45 would not apply to deem a disposition of the property to have taken place at the time of the conversion.

The amount of the notional proceeds would be equal to the fair market value of the property at the time of conversion.  This amount would also be considered as the capital cost of the capital property for purposes of computing the notional adjusted cost base of the capital property as defined in paragraph 54(a) of the Act. 

At the time that Mr. X sells the capital property to Company A, Mr. X would reduce his cumulative C0GPE pursuant to subparagraph 66.4(5)(b)(v) of the Act by the amount of the notional proceeds of disposition of the property which was determined at the time of conversion of the property from a CRP to a capital property.  The difference between the proceeds on Mr. X's sale of the property to Company A and Mr. X's notional adjusted cost base of the property would determine Mr. X's capital gain or loss from the property.

Thus, Mr. X would realize a gain on the property only to the extent of any increase in value of the property from the date of conversion of the property to the date of sale of the property to Company A.  In this respect, we refer you to paragraphs 23 and 24 of IT-218R which describe certain circumstances in which the Department would consider that the sale of farmland results in a capital gain or an income gain.

Question 4

Would the capital gain arising on sale of the property be "qualified farm property' as defined in subsection 110.6(1) of the Act for the purpose of claiming the capital gains exemption pursuant to subsection 110.6(2) of the Act?

Although whether or not the property meets the definition of qualified farm property under subsection 110.6(1) of the Act is a question of fact, we concur with your view that on the basis of the assumed facts, viz. the property is a capital property of Mr. X used by him in the business of farming in Canada, said property would so qualify, provided that all of the other provisions of the definition of qualified farm property have been satisfied.

The capital gain, if any, which arises on sale of the property (which qualifies as qualified farm property) would not be precluded from qualifying for the capital gains exemption under subsection 110.6(2) of the Act by virtue of the fact that only a portion of the land is being sold and the remaining 40 acres will continue to be used in the farming business.  In this respect, we again refer you to IT-218R wherein it is stated at paragraph 23 that the sale, en bloc or piecemeal, by a taxpayer of farmland regularly used by the taxpayer for the purpose of gaining or producing income from a farming business carried on by the taxpayer will generally give rise to a capital gain or loss, as the case may be, except where, for example the taxpayer converts such land to a trading property or acquired the land with the intention of reselling it for profit at a propitious time.  In accordance with paragraph 24 of IT-218R, a gain on the sale of farmland will remain a capital gain if an examination of all other facts, both before and after subdivision of the land, establishes this to be so.

The fact that Company A intends to use the property for a purpose other than farming would not, in and by itself, alter the results described above to Mr. X. 

The fact that the proceeds received by Mr. X are partially in respect of the sale of the farmland and partially in respect of the sale of a right, licence or privilege to store underground natural gas would not, in and by itself, alter the above comments with respect to question 4 provided that the proceeds reasonably attributable to the former which qualifies as a capital property, and the latter which qualifies as a CRP, are treated accordingly under sections 39 and 66 of the Act, respectively. In this case, the resulting capital gain on sale of the farmland would remain a gain on the disposition of qualified farm property, provided it so qualifies as discussed above, even though the remaining proceeds are for the disposition of a CRP.

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.

Yours truly,

ChiefResource Industries SectionBilingual Services and Resource Industries DivisionRulings Directorate