19 February 1988 Income Tax Severed Letter 8-0141 - Appeals & Referrals Division

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.

J. Yu Appeals & Referrals Division

"Income or Profit Tax"

This is in reply to your memorandum dated December 16, 1987 to Mr. R. D'Aurelio, Director, Provincial and International Relations Division, which was forwarded to this Directorate for reply. You enquiry relates to royalties paid to XXX in the 1984 taxation year from 19(1)

Whether a "severance" tax imposed by a state in the United States can be classified as an "income or profit tax" as these words are used in subsection 20(11) and paragraph 126(7)(c) of the Income Tax Act (the "Act") is a question to be decided on the basis of the particular legislation imposing such tax. Section 150.4996-2(b) of the U.S. Temporary Regulations provides, with regard to the availability of the deduction for state severance- tax paid in computing federal Crude Oil Windfall Profits Tax, that "severance tax" is any tax imposed by a State (not including a political subdivision 'of a State) with respect to the extraction of oil that is determined on the basis of the gross value of the extracted oil and that this tax does not include a tax levied on the value of reserves in'the ground or a tax levied on the basis of net proceeds from production. In discussing the windfall profits tax on crude oil, the Congressional Committee Reports use the terms "excise" and "severance tax" interchangeably. Based on the foregoing, it is our opinion that a severance tax that is deductible in computing U.S. Crude Oil Windfall Profits Tax would, prima facie, not be considered an "income or profits tax" for the purposes 'of subsection 20(11) or paragraph 126(7)(c) of the Act.

Chapter 202, "Oil Production Tax", of the Texas Codes contains the following relevant provisions:

"202.51 There is imposed a tax on the production of oil.

202.52     The tax imposed by this chapter is at the rate of 4.6 
           percent of the market value of oil produced in this
           state or 4.6 cents for each barrel of 42 standard gallons 
           of oil produced in this state, whichever rate results 
           in the greater amount of tax.

202.153(a) A first purchaser shall pay the tax imposed by this 
           chapter on oil that the first purchaser purchases from 
           a producer and takes delivery on the premises where 
           the oil is produced.

202.154    If the producer does not sell oil produced in the same 
           month it is produced, the producer shall pay the tax 
           imposed by this chapter as if the oil were sold that 
           month

202.156    The tax shall be borne ratably by all interested parties, 
           including royalty interests. Producers or purchasers 
           of oil, or both, are authorized and required to withhold 
           from any payment due interested parties the proportionate 
           amount of tax due."

Based on the foregoing XXX are of the-opinion that the severance tax imposed by the State of Texas on crude oil production is not in the nature of an "income or profits tax". Our library advises that it is not possible to obtain (in Canada) the relevant legislation for the State of Pennsylvania. However, if the Pennsylvania severance tax is deductible in computing the federal windfall profits tax and is similar in nature to the severance tax imposed in Texas on crude oil production, we would similarly conclude that it is not an "income or profits tax".

Accordingly, neither the foreign tax credit described in section 126 of the Act nor the deduction described in subsection 20(11) of the Act (which, if applicable, would have reduced a section 126 claim) would apply in respect of the severance tax. A section 126 claim would therefore be limited to amounts paid as withholding tax.

In addition to our view that subsection 20(11) of the Act is inapplicable in respect of the aforementioned severance tax because it is not an "income or profits tax", it is our opinion that this subsection of the Act would not be relevant in any event in respect of this severance tax because subsection 20(11) of the Act only applies in respect of income "from a property other than real property" and, as opined in our memorandum to your Division dated August 9, 1982, the ownership of mineral rights constitute ownership of an interest in real property (a profit … prendre).

You have advised that it appears that, with regard to and the 1984 taxation year, XXX withheld 15% on royalties after deducting state severance-tax whereas XXX withheld 15% on "gross royalties". Although this issue does not appear to be significant for the purposes of allowing a section 126 credit for withholding tax paid it is, in our view, relevant for the purposes of computing Income. Whether severance tax paid is deductible in determining a taxpayer's gross royalty would depend upon the terms and provisions of the royalty agreement as well as the provisions of the legislation imposing such tax. In the State of Texas, we would refer you to section 202.156 of the Texas Code which provides that the severance tax is borne by all interested parties, including royalty owners, and that producers and purchasers of oil are authorized to withhold the relevant severance tax from payments due to interested parties. In such situations, although the royalty owner receives a cheque for a net amount (i.e., his share of production less relevant withholding and severance taxes), his gross royalty is considered to be his share of production. For the purposes of computing his Canadian income pursuant to subsection 9(1) of the Act, his income would be equal to the amount of the gross royalty less the severance tax paid (provided it is not an "income or profits tax") in order to generate that royalty income (see The Exolon Co, v. MNR, 51 DTC 205; Roenisch v. MNR, 1 DTC 199; paragraphs 18(1)(1.1) and 18(l)(m) and subsections 20(11), (12) of the Act).

The following are examples of the income tax consequences in situations where severance taxes are and are not borne by the royalty owner:

I Severance Tax Borne by Royalty Owner (e.g., Texas)

 $110           Royalty Owner's Share of Production (gross royalty)
 $ 10           Severance Tax Borne by Royalty Owner
 $ 16.50        15% Withholding on gross royalty
 $ 16.50        Foreign Tax Credit 
 $110-$10=$100  Subsection 9(1) royalty income

II Severance Tax Not Borne by Royalty Owner

 $110-$10=100   Royalty Owner's Share or Production less severance 
                tax (gross royalty) 
 $15            15% Withholding on Gross Royalty
 $15            Foreign Tax Credit
 $100           Subsection 9(1) royalty income

We hope our comments will assist you and we herewith enclose your Orange Appeal file.

ORIGINAL SIGNED BY ORIGINAL SIGNE PAR R.J.L. READ

Director General Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch

CONFIDENTIAL

Department of National Defence 101 Colonel By Drive Ourlde Nove.rercvence Ottawa, Ontario K1A OK2