9 November 1992 External T.I. 9134055 F - Change in Use - Property - Canada-US Treaty - Article XIII

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.

XXXXXXXXXX

Attention:  XXXXXXXXXX

Dear Sirs:

RE:  Taxation of Non-Residents

This is in reply to your letter of December 5, 1991, wherein you requested a technical interpretation regarding the tax implications of transactions involving a non-resident's change in use of vacation property when mineral exploration and development activities occur thereon.

In this regard, we can provide you with the following general comments which may be of assistance to you. In making these comments we have assumed that Mr. X is in all instances a U.S. resident since the application of the change in use rule does not depend on the residency status of a taxpayer. Our comments should not be construed as confirming the income tax effects of any particular situation. We apologize for the delay in our response.

Change In Use of Property

We agree with your view that when Mr. X acquired the vacation property for his personal use, he acquired two properties, i.e., the surface right which is a capital property and the mineral right which is a Canadian resource property ("CRP"). It is a question of fact to be determined at the time Mr. X originally acquired the property whether the mineral right had any value for purposes of subparagraghs 66.2(5)(a)(iii) and (b)(i) of the Income Tax Act (the "Act").

Subsection 45(1) of the Act provides a rule for the deemed disposition and reacquisition of property when its use, or the proportion of its use, is altered from personal use to income earning or producing use, or vice versa.

In our view, the application of the subsection 45(1) deemed disposition rule is limited to capital property for purposes of capital gains and losses that are determined in accordance with subdivision c of the Act. Accordingly, the rule is not relevant to the mineral right since CRP is not capital property for purposes of the Act. However, the rule is relevant to any discussion involving the surface right.

We agree with your view that the mere granting of the exploration and development rights under the mining lease by Mr. X to Mineco would not, in and of itself, constitute a change in the use of the surface right by Mr. X provided that he continues to enjoy the unfettered personal use of the vacation property through the surface right. It is a question of fact, however, whether a partial disposition of the surface right may have occurred given that in order to be able to conduct exploration and development activities on the vacation property, Mineco must receive some form of surface right from Mr. X.

However, in the situation wherein the mining lease requires Mr. X to cease and desist entirely in his personal use and enjoyment of the vacation property, it is a question of fact whether a change in use and deemed disposition of the surface right pursuant to subsection 45(1) of the Act has occurred. Your letter makes no mention of whether Mr. X is entitled to receive any income in the form of surface lease rentals when he relinquishes the surface right to Mineco. It is arguable that Mr. X has not commenced to use the surface right for the purpose of gaining or producing income therefrom in the absence of there being any income from a business or property - in this regard, consideration should be given to our comments regarding "carrying on business" which appear under the heading "Royalties". However, any provision by Mineco for the payment of surface lease rentals to Mr. X is prima facie evidence that a change in the use of Mr. X's surface right has occurred.

If a change in the use of the surface right has occurred, Mr. X would be entitled to elect under subsection 45(2) of the Act to override the application of the deemed disposition rule to the surface right. If Mr. X makes the election, the effect is a cancellation of the application of the deemed disposition rule to the surface right. This would have similar effect for the Canada-U.S. Income Tax Convention, 1980 (the "Treaty") in that there would be no alienation of property to be considered for the purposes thereof including the relieving provision specified in paragraph 9 of Article XIII. In the event of a second change in use, i.e., Mineco cancels the mining lease and the vacation property reverts to its prior status as personal use capital property of Mr. X, there would not be a deemed disposition of the vacation property for purposes of subparagragh 45(1)(a)(ii) of the Act as a result of the subsection 45(2) election having been filed on the first change in use.

If Mr. X does not make the election under subsection 45(2) of the Act, any capital gain or loss arising from the application of the deemed disposition rule to the surface right would be included in his income and would be subject to tax under Part I of the Act by virtue of subparagragh 115(1)(b)(i) thereof in respect of the disposition of a "taxable Canadian property" that is real property situated in Canada.

Pursuant to subsection 116(3) of the Act, Mr. X is required to report the details of any deemed disposition of the surface right to the Minister within 10 days following the disposition and, pursuant to subsection 116(4) of the Act, pay 33 1/3% of any capital gain arising therefrom in return for the issuance of a certificate by the Minister.

Mr. X would generally not receive any protection under the Treaty for any proceeds deemed to be received in respect of the disposition of the surface right by virtue of paragraph 1 of Article XIII of the Treaty - consideration should be given to the application of paragraph 9 of Article XIII of the Treaty which provides for a reduction of any gain which is subject to tax on the disposition of property that was held prior to December 31, 1984, the date the Treaty came into effect (this is sometimes referred to as the "fresh-start rule").

In any event, the application of the change in use rule to the surface right will have no impact on Mr. X's mineral right insofar as determining whether he is entitled to an addition to or reduction in his cumulative Canadian development expense ("CCDE"). In other words, it is erroneous to assume that the portion of the vacation property that is the surface right can somehow be transformed into CRP on its deemed reacquisition pursuant to the application of the change in use rule as the surface right and the mineral right which together comprise the vacation property are considered to be two separate properties for tax purposes.

We note that your letter is silent on the issue of whether Mr. X retains or disposes of the mineral right when he grants Mineco the exploration and development rights under the mining lease. We also note that your letter does not mention if the mining lease calls for the usual bonus payment to be paid to Mr. X by Mineco for entering into the lease. If Mr. X is entitled to receive such a payment, he would be required to include the payment received in the calculation of his CCDE pursuant to subparagragh 66.2(5)(b)(v) of the Act after giving due consideration to whether a portion of the payment should instead be allocated to proceeds of disposition in respect of the surface right. The following provisions should be considered regarding the portion of any bonus attributable to a disposition of CRP, i.e., subsections 116(5.1), (5.2) and subparagragh 115(1)(a)(ii), (iii.1) or (iii.3) of the Act - in this latter regard, consideration should be given to our comments regarding "carrying on business" which appear under the heading "Royalties" - and, paragraph 1 and clause 3(b)(i) of Article XIII and paragraph 2 of Article VI of the Treaty.

Mineral Lease Rentals

We note that Mineco agrees to make annual payments, referred to in the mining lease agreement as "rent", to Mr. X for the right to undertake exploration and development activities on Mr. X's vacation property. We also note that the primary lease term is only for one year which can be extended annually at Mineco's option but which cannot be cancelled by Mr. X.

The right to undertake exploration and development activities on Mr. X's property is a "profit a prendre" and, accordingly, a CRP for purposes of clause 66(15)(c)(ii)(B) of the Act - a profit a prendre is not a CRP for purposes of subparagragh 66(15)(c)(v) of the Act because while it is arguable that a profit a prendre is an interest in real property, the holder of a profit a prendre does not own the minerals in situ which is the property of the freehold mineral owner; the holder is only entitled to the minerals once they have been severed from the land; hence, the test that the principal value of the property must relate to its "mineral resource" content can never be met in the case of a profit a prendre. See, by analogy, McInosh v. Lechie, (1906), 13 O.L.R. 54, R E Dawson and Bell, (1945) O.R. 835 (ONT. C.A.) and Berkheiser v. Berkheiser, (1957) S.C.R. 387.

It appears to us that the so-called "rent" is more in the nature of a payment made to Mr. X by Mineco for the preservation of Mineco's rights in respect of the profit a prendre (in other words, a "delay rental" in the nomenclature of the resource industry). Accordingly, the receipt by Mr. X of the amount of the annual rent is nothing more than additional consideration for granting the profit a prendre to Mineco - not a true "rental" but rather a payment analogous to exercising an option - and should be included by Mr. X in calculating his CCDE pursuant to subparagragh 66.2(5)(b)(iv) of the Act as proceeds of disposition of CRP. See by analogy, Sparrow, 57 DTC 453, TAB, at 455, Duncan v. Joslin, (1965), 51 W.W.R. 346 (ALTA S.C. APP. DIV.) at 348 and East Crest Oil Co. Ltd. v. Strohschien, (1952) 2 D.L.R. 432 (ALTA S.C. APP. DIV.) at 437.

Any negative balance in Mr. X's CCDE would be included in his income and would be subject to tax under Part I of the Act by virtue of subparagragh 115(1)(a)(ii), (iii.1) or (iii.3) as the case may be - in this regard, consideration should be given to our comments regarding "carrying on business" which appear under the heading "Royalties".

Pursuant to subsection 805(1) of the Regulations, paragraph 212(1)(d) of the Act will not apply instead of Part I to tax the rent under Part XIII of the Act since it is arguable that Mr. X is carrying on business in Canada and the rent can be attributed to the business carried on by him through a permanent establishment in Canada by virtue of subsection 400(2) of the Regulations (refer to our comments regarding "carrying on business" which appear under the heading "Royalties").

While tax under Part XIII of the Act may not be exigible on the rent, pursuant to subsection 805(2) of the Regulations, unless the Minister is satisfied that Part XIII will not apply in the circumstances, Mineco is still required to withhold tax under section 215 of the Act on the payment of any rent to Mr. X which amount withheld can be claimed by Mr. X in computing his Part I tax liability.

Pursuant to subsection 116(5.1) of the Act, Mr. X is free to report the details of the disposition of the mining lease to the Minister before or after the disposition, without time limitations and, pursuant to subsection 116(5.2) of the Act, procure the issuance of a certificate on a basis similar to that described for the surface right, upon the payment to the Minister of such amount as is acceptable to him.

Mr. X would generally not receive any protection under the Treaty for any proceeds received on the disposition of Canadian resource property by virtue of paragraph 1 and clause 3(b)(i) of Article XIII and paragraph 2 of Article VI of the Treaty - consideration should be given, however, to the application of the fresh-start rule in paragraph 9 of Article XIII of the Treaty.

Royalties

We note that should the property reach commercial production, Mineco will be obligated to pay Mr. X an overriding royalty. (It is unclear to us from your letter whether the overriding royalty is a "lessor's royalty", i.e., a royalty which is an interest in land with a right to take minerals in kind that is created out of the mineral right and retained by a freehold mineral owner upon granting a profit a prendre to another person, or a true "gross overriding royalty", i.e., a royalty which is a contractual interest and not an interest in land with no right to take minerals in kind that is created out of a profit a prendre and retained by a lessee upon assignment, part assignment or a sublease of a lease to another person. Since there is no mention in your letter that Mr. X has disposed of the minerals in situ, i.e., the mineral right, to Mineco, we have assumed that you are referring to a lessor's royalty when you refer to the overriding royalty. We have also assumed that the value of the overriding royalty to Mr. X does not constitute proceeds of disposition arising from the assignment of the profit a prendre by Mr. X to Mineco.)

When Mr. X receives an amount that is in respect of the overriding royalty, he will be deemed to be carrying on business in Canada pursuant to paragraph 253(a) of the Act by virtue of the fact that he is a non- resident who "produced" anything in Canada. A non-resident will be considered to be a person who "produced" where the royalty is an interest in land as is generally the case with a lessor's royalty. See, by analogy, Bensette and Campbell v. Reece, (1973) 2 W.W.R. 492 (SASK C.A.), Smith v. Englefield Oil & Gas, (1910) 10 W.N. 944 and Vanguard Petroleum Ltd. v. Vermont Oil and Gas Ltd., (1977) 2 W.N.R. 66 (ALTA S.C.T.D.)..

Since Mr. X is deemed to be carrying on business in Canada regarding his receipt of the overriding royalty, he will be subject to tax under Part I of the Act by virtue of subparagragh 115(1)(a)(ii) thereof. Pursuant to subsection 805(1) of the Regulations, paragraph 212(1)(d) of the Act will not apply to tax the overriding royalty under Part XIII rather than Part I of the Act since Mr. X is carrying on business in Canada and the royalty can be attributed to the business carried on by him through a permanent establishment in Canada by virtue of subsection 400(2) of the Regulations.

While tax under Part XIII of the Act may not be exigible on the overriding royalty, pursuant to subsection 805(2) of the Regulations, unless the Minister is satisfied that Part XIII will not apply in the circumstances, Mineco is still required to withhold tax under section 215 of the Act on the payment of any overriding royalty to Mr. X which amount withheld can be claimed by Mr. X in computing his Part I tax liability.

Mr. X will not receive any protection under the Treaty for any amount of the overriding royalty payable to him since he will be considered to be carrying on business in Canada through a permanent establishment situated therein by virtue of Article VII and subparagragh 2(f) of Article V of the Treaty.

Surface Lease Rentals

Your letter makes no mention of whether Mr. X is entitled to receive any surface lease rentals.

Normally, when persons explore for minerals they obtain a lease from the owner of land covering several years in respect of certain surface rights. Sometimes, the first year's payment may be in a lump sum for such things as damage to land, crop damage, land improvements, inconvenience, severance and the first year's rent. For the second and subsequent years, the lease may require a periodic payment or payments for recurring items such as rental, severance, or inconvenience. In these circumstances, the portion of the lump sum paid in the first year that is equal to the periodic payments to be made in subsequent years is considered to be income within the meaning of subsection 9(1) of the Act. The remainder of the lump sum payment is generally considered to be capital as compensation for property injuriously affected, damaged or destroyed and is "proceeds of disposition" within the meaning of paragraph 54(h) of the Act and may result in a capital gain or loss.

Normally, paragraph 212(1)(d) of Part XIII of the Act provides that a non-resident receiving, inter alia, rents from Canada is subject to a 25% withholding tax on the gross rental income without deducting any expenses attributable to the earning of that income. This rate is not reduced by Article VI of the Treaty. In the case of rent for real property situated in Canada, the non-resident may elect pursuant to subsection 216(1) of the Act to file a return and pay tax under Part I of the Act on the rents received as if he were a resident, on a net income basis.

However, paragraph 805(1)(a) of the Regulations states that a non- resident who carries on business in Canada will not be taxable under Part XIII of the Act on all amounts otherwise taxable thereunder where those amounts are attributed to the business carried on by him through a permanent establishment (within the meaning assigned by subsection 400(2) of the Regulations) in Canada. In regards to determining whether Part I or XIII of the Act apply to the taxation of any surface lease rentals received by Mr. X, please refer to our comments regarding "carrying on business" which appear under the heading "Royalties".

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 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 22 of Information Circular 70-6R2.

Yours truly,

Section Chief Resource Industries Section Manufacturing Industries, Partnerships and Trusts DivisionRulings Directorate