19 November 1990 Internal T.I. 9015597 F - Resource Expenses Renounced under Flow-through Share Provisions

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.

SUBJECT:  Request for Technical Interpretation Subsections 66(12.61) and 66.1(6) of the Income Tax Act (the "Act")

We are writing in reply to your memorandum dated July 13, 1990 wherein you requested a technical interpretation of the above-noted subsections of the Act in relation to two issues involving Canadian exploration expenses ("CEE") and Canadian development expenses ("CDE") which have been renounced under the flow-through share provisions of the Act.

FIRST ISSUE

You ask whether the "taxation year" referred to in subparagraph 66.1(6)(a)(ii.1) of the definition of CEE refers to the principal-business corporation ("PBC") which incurred the CEE under the requirements of subsection 66(12.6) or to the investor by whom the CEE was deemed to have been incurred pursuant to paragraph 66(12.61)(a) of the Act.

Our Comments

In general terms, a taxpayer's CEE is relevant for determining the taxpayer's cumulative CEE under paragraph 66.1(6)(b). The cumulative CEE of a taxpayer at any time includes, inter alia, the aggregate of all CEE made or incurred by him before that time.

Under subparagraph 66.1(6)(a)(ii.1), the CEE of a taxpayer (whether an investor in flow-through shares of a PBC, the PBC that issued the flow-through shared or any other taxpayer) includes expenses described in that subparagraph which were incurred by him after March, 1987 and in a taxation year of the taxpayer.

Thus, where a PBC which has issued flow-through shares has incurred expenses which would qualify as CEE of the PBC under the provisions of subparagraph 66.1(6)(a)(ii.1), the "taxation year" in that subparagraph would refer to the taxation year of the PBC. Where the PBC has renounced these expenses to an investor under subsection 66(12.6), however, the CEE would be deemed, pursuant to paragraph 66(12.61)(b), on and after the effective date of the renunciation never to have been CEE incurred by the PBC. Hence, having renounced expenses which would otherwise have been included in the PBC's CEE by virtue of subparagraph 66.1(6)(a)(ii.1), these expenses would no longer qualify for inclusion in the PBC's CEE.

CEE which has been renounced to an investor by a PBC under subsection 66(12.6) and which qualified as CEE of the PBC by virtue of subparagraph 66.1(6)(a)(ii.1) would, on and after the effective date of the renunciation, be deemed to be CEE of the investor incurred on the effective date of the renunciation by virtue of paragraph 66(12.61)(a). These expenses would, pursuant to subparagraph 66.1(6)(a)(ii.1), be deemed to have been incurred in the "taxation year" of the investor which includes the effective date of the renunciation.

The "taxation year" in subparagraph 66.1(6)(a)(ii.1) therefore refers to the taxpayer in respect of which the subparagraph is being applied. In a flow-through share scenario, the relevant "taxpayer" would be the PBC prior to the effective date of renunciation and would be the investor on that date and thereafter.

SECOND ISSUE

You describe a hypothetical situation in which:

1.     A PBC enters into a flow-through share agreement with a limited partnership on October 1, 1989.

2.        During October 1, 1989 to December 31, 1989, the PBC incurred $500,000 of expenses to drill a natural gas well.

3.        On January 31, 1990 the PBC renounces the $500,000 of expenses to the partnership under subsection 66(12.62) at which time the status of the well is undefined, resulting in the expenses being categorized as CDE under clause 66.2(5)(a)(i)(B).

4.        The effective date of the renunciation is December 31, 1989 and the PBC, the partnership and its partners (the "investors") have calendar year-ends.

5.        On May 31, 1990 the well is abandoned without ever having produced, thereby qualifying for classification as a CEE well under clause 66.1(6)(a)(ii.1)(B).

You then ask whether there is any provision in the Act that would prevent the $500,000 of CDE described in the above hypothetical situation from being reclassified as CEE under subparagraph 66.1(6)(a)(ii.1) in computing the CEE of the investors for their 1989 taxation year.

Our Comments

Our position is that it is the status of an oil and gas well which determines whether the expenses incurred in drilling the well are classified as CEE or CDE and, in order to renounce these resource expenses under the flow-through share provisions of the Act, the classification of the expenses must be determined no later than the time of renunciation. Consequently, we concur that the drilling expenses renounced by the PBC on January 31, 1990, effective December 31, 1989, would be classified as CDE at that time under clause 66.2(5)(a)(i)(B).

It is also our view that CDE renounced by a resource corporation under the flow-through share provisions of the Act retains its category for purposes of determining the investor's CDE, i.e., an expense which qualified as CDE under clause 66.2(5)(a)(i)(B) and was incurred and renounced by a PBC would also be categorized as CDE under the same clause in computing the CDE of the partnership and the investors to which it is renounced and allocated, respectively.

Thus, on December 31, 1989, the $500,000 of drilling expenses would be deemed to be CDE incurred by the partnership pursuant to paragraph 66(12.63)(a). This CDE would be allocated to the investors, in the partnership pursuant to subparagraph 66.2(5)(a)(iv) on December 31, 1989 and would be considered as CDE of the investor on December 31, 1989 under these circumstances.

CDE renounced under the flow-through share provisions of the Act to a partnership and allocated to a partner in, the partnership retains its CDE categorization in the hands of the partner. Although such retention of categorization is not clearly provided for by subsection 66(12.62), we have adopted this view in order to make the flow-through share provisions work in accordance with the legislators' intent.

Under clause 66.1(6)(a)(ii.1)(B), the drilling expenses may be classified as CEE provided that the well is abandoned in the year or within six months after the end of the year without ever having produced otherwise than for specified purposes. The requirements of this provision would be satisfied on May 31, 1990 at which time the well in the hypothetical situation is abandoned.

In general terms, subsection 66.1(9) permits a taxpayer to reclassify its CDE, which was incurred in a preceding taxation year, as CEE referred to in subparagraph 66.1(6)(a)(ii.2) where at any time in the taxpayer's taxation year, an oil or gas well that has never produced is abandoned. Under 66.1(9) the reclassification of CDE to CEE would occur in the taxpayer's taxation year in which, inter alia, an oil or gas well is abandoned, provided that it has never produced otherwise than for specified purposes.

Under subsection 66.1(9), the investors' CDE would be deemed to be CEE referred to in subparagraph 66.1(6)(a)(ii.2) incurred by the investors at the time of abandonment of the well, i.e., at May 31, 1990. The reclassification from CDE to CEE would occur in the investors' 1990 taxation year.

We are not aware of any provision in the Act which would permit the investors in the above hypothetical situation to reclassify the renounced CDE as CEE for the 1989 taxation year.

We acknowledge that had the renunciation taken place on or after May 31, 1990 at which time the status of the well would have enabled the drilling expenses to be classified as CEE pursuant to clause 66.1(6)(a)(ii.1)(B), the PBC's renunciation of CEE would have resulted in the renounced CEE amounts being allocated to the investors for their 1989 taxation year.

A similar question in relation to renunciation of CEE versus CDE, pending classification of the expenses at the time of renunciation, was asked and a response was prepared by the Rulings Directorate for the 1990 Round table of 24(1) copy attached. This question was asked, however, in the context or the "clawback" rule in subsection 66(12.66) which does not apply to your hypothetical situation. The expenses therein were incurred prior to the effective date of renunciation, i.e. prior to December 31, 1989 whereas 66(12.66) would apply if, inter alia, CEE was incurred within 60 days after the end of a calendar year (January 1 to March 1, 1990) and the effective date of renunciation is December 31, 1989.

A/DirectorBilingual Services and Resource Industries DivisionRulings Directorate