12 June 1992 Income Tax Severed Letter 9216345 - Over-reimbursement of costs under unitization

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

SUBJECT: OVER-REIMBURSEMENT OF COSTS UNDER UNITIZATION SECTION: 66(12.2), 66(12.3), 66(12.5), 66(12.1)]

1992 CPTS ROUNDTABLE

QUESTION

• 1. A Canadian controlled private corporation (the "taxpayer") and several other corporations agree to unitize an oil and gas field in Canada and certain amounts have become receivable by the taxpayer by virtue of the unitization agreement. The unitization agreement does not specify how the amounts are to be treated for income tax purposes. Costs in respect of drilling and completing the wells were estimated for purposes of determining amounts receivable and payable between the parties under the unitization agreement. Accordingly, the taxpayer may have spent more or less on drilling and other costs than the amount being reimbursed for such costs under the unitization agreement. This is a result of using averages to determine the cost of drilling the wells within the oil or gas field.
• For example, the taxpayer may have spent $50,000 to drill a well when the average cost to drill a well in the area was approximately $75,000. Under the terms of the unitization agreement, the taxpayer is reimbursed the $75,000 average cost.
• Clearly, the $50,000 reimbursement in respect of drilling costs incurred by the taxpayer results in a reduction of cumulative Canadian exploration expense or the cumulative Canadian development expense (CCDE) of the taxpayer by virtue of subsections 66(12.2) or (12.3) of the Income Tax Act, respectively. Since the additional $25,000 received by the taxpayer is not in respect of costs incurred by the taxpayer, i.e., the taxpayer incurred only $50,000 of CEE and CDE, subsections 66(12.2) and (12.3) do not apply.
• Arguably, since the taxpayer did not incur drilling and completion expenses to the extent of the payments by the other parties and the overpayment is not required to be refunded, it appears the other parties in the unitization agreement may in fact be paying a premium over and above the drilling and completion expenses incurred by the taxpayer for some economic benefit which they will obtain from the taxpayer under the unitization agreement, i.e., a benefit that constitutes a Canadian oil and gas property.
• Would it be reasonable to treat the $25,000 overpayment as an amount receivable in respect of Canadian oil and gas property expense under subsection 66(12.5)?

ANSWER

• 1. Normally, the $25,000 overpayment in the above example would be refunded to the payors by the taxpayer under the terms of the unitization agreement. We are unable to determine the precise nature of the overpayment without examining all of the circumstances and agreements pursuant to which the overpayment is made and without ascertaining the intent of the parties with respect to the overpayment. If the overpayment is attributable to a reduction of the taxpayer's percentage interest in the unit and a corresponding increase in the other participants' interest in the unit, it would be reasonable to consider the overpayment as proceeds of disposition of Canadian oil and gas property by the taxpayer and cost of acquisition of the same by the other participants.

Prepared by: John Chan

ISSUE SHEET

1992 CPTS Roundtable John Chan
Question 1 5-921634
June 12, 1992

Issue

Under the terms of a unitization agreement, a taxpayer is obligated to incur drilling expenses which qualify for treatment as CEE or CDE. The taxpayer's reimbursement by other unit holders is determined on the basis of estimated drilling costs.

The estimated drilling costs exceed actual drilling costs and the resulting overpayment is not refunded to the payors, but is kept by the taxpayer. The question is whether we would consider the overpayment as an amount that has become receivable by the taxpayer "in respect of Canadian oil and gas property expense incurred by the taxpayer" for purposes of applying 66(12.5). If 66(12.5) applies, the overpayment would grind the taxpayer's CCOGPE and would be added to the payors' CCOGPE.

Unitization

Unitization involves an arrangement (the "unit agreement") by owners of oil and gas rights in tracts of land overlying a common oil and gas pool so that the pool or field can be operated as a unit.{1} Upon approval of the applicable provincial regulatory authority, a field-wide unit is usually sponsored by several of the leading producers in the field to be unitized. Normally, one producer is elected as the "unit operator" and assumes responsibility for operating the lease under a participation formula which is designed to allocate costs and revenues among participants.{2} From the effective date of the unitization which usually occurs upon approval of the unitization by the applicable provincial regulatory authority, the unit operator assumes full responsibility for all unit operations and must account to the participants for all expenditures and production of oil and gas in accordance with the "unit operating agreement". The unit operator submits a billing each month to the participants for their proportion of all unit expenditures during the preceding month. (Reference: Oil and Gas Law in Canada; Canadian Taxation of Oil and Gas Income; Oil and Gas Taxation in Canada; Canadian Oil and Gas; Alberta Oil and Gas Conservation Act ("AOGCA")). ------------------------------------------------------------------------ {1} Unitization is covered by section 71 of the Alberta Oil and Gas Conservation Act (AOGCA). This differs from pooling tracts of land to establish spacing units of specified size. Owners of tracts within a drilling spacing unit can enter into a "pooling" in order to operate the separate tracts on the spacing unit as a single unit (sections 72 to 74 of the AOGCA). This pooled unit is sometimes included in the broader unitization (section 76 of the AOGCA). Canadian Taxation of Oil and Gas Income explains that "pooling" refers to combining leases within a spacing unit, whereas "unitization" refers to consolidation of several producing leases (generally comprising a producing field) into one operating unit. {2} The unit operator acts as agent for the working interest holders in the unit [subsection 71(5) of the Alberta Oil and Gas Conservation Act]. ------------------------------------------------------------------------

In some situations, one participant may incur the exploration and drilling costs and is reimbursed by the other participants under terms agreed to by the participants. (Source: page 4.29, Oil and Gas Taxation in Canada and paragraph 148, Canadian Oil and Gas Law, Vol.1).

The separate working interest owners in the unitized field do not relinquish any of their rights under the lease nor does a cross assignment (like kind exchange) take place. Generally, the percentage of participation of each working interest owner in the unit is deemed to be that which is applicable to the total of the individual properties he contributed to the unit. (Source: page 22, Canadian Taxation of Oil and Gas Income).

Analysis

It is not clear why the taxpayer/driller does not refund the overpayment to the participants. Normally, the overpayment of $25,000 in the example would be refunded by the taxpayer to the payor participants - see the portion of the model Unit Operating Agreement approved by the Petroleum and Natural Gas Committee set up under the Mines Ministers Conference. The reasons for not having to refund the overpayment to the participants may very well dictate the income tax treatment for the taxpayer/driller.

The submitted Roundtable question suggests that a reasonable approach would be to treat the overpayment as an amount in respect of COGPE under subsection 66(12.5). The reasons given are stated as follows:

• • The taxpayer paid additional amounts to acquire the property prior to drilling because the value of the particular property would be higher since drilling costs were anticipated to be lower than average for the field.
• • The taxpayer did not incur drilling expenses to the extent of the payments by the other parties. Therefore it appears the other parties in the unitization agreement may in fact be gaining some additional economic benefit by unitizing the well (i.e., the value of the property). Thus, they are paying a premium over and above the expenses incurred by the taxpayer for this benefit. This would normally be a disposition of COGPE by the taxpayer.

The meaning of these reasons is less than clear.

The first reason presumes that the taxpayer is being reimbursed his acquisition cost of his working interest. This presumes that the taxpayer acquired its working interest in the field at an excessive price in anticipation of being granted the drilling rights and being able to charge the other unit participants drilling fees in excess of actual drilling costs. This is purely conjecture. All of the particular circumstances and the terms of the unitization agreement would have to be examined in order to establish the relationship between the taxpayer's acquisition of his working interest and the overpayments under the unitization agreement.

The second reason submitted assumes that the participants are paying a drilling premium for additional economic benefit which they will obtain from the taxpayer under the unitization agreement. Again, it would be necessary to examine the unitization agreement to determine if the agreement supports this reasoning.

The second reason also presumes that the taxpayer has some economic benefit which constitutes a Canadian resource property and which he is relinquishing to the other participants who are making the overpayment in consideration therefor. Again, the agreement would have to be examined to see if this is in fact what is taking place.

In any event, there is no ownership change in the participants' respective working interests as a consequence of the drilling and it is difficult to fathom the overpayment as being in respect of the acquisition or disposition of an oil and gas property without additional information.

Furthermore, no COGPE has been incurred by the taxpayer under the unitization agreement to which the overpayment can be attributed under 66(12.5). This is the same as no CDE nor CEE being incurred, insofar as the overpayment of $25,000 in the example is concerned, to which the overpayment can be attributed under 66(12.3) and (12.2).

Bharat Patel, Specialized Industries Section at the Calgary D.O. said that he asked others in the Audit Division and Appeals Division if they are aware of how the overpayments are being treated by taxpayers and auditors. Mr Patel said Audit and Appeals have not encountered these types of overpayments. He also said that he spoke to John Kurrant, Oil and Gas Specialist and Mr Kurrant agrees that the unitization agreement would have to be examined in order to find out the appropriate treatment for the overpayments.

Conclusion

The $50,000 incurred by the taxpayer/driller in the example would fall within the ambit of subsections 66(12.2) and (12.3) with respect to the CEE and CDE incurred.

It would be necessary to examine the agreement pursuant to which the overpayment of $25,000 in the example is made to the taxpayer in order to determine how such overpayments should be treated. If the overpayment can be attributed to a reduction of the driller's percentage interest in the unit and a corresponding increase in the other participants' interest in the unit, it would be reasonable to consider the overpayment as a disposition of Canadian oil and gas property by the taxpayer and an acquisition of the same by the other participants. This acquisition/disposition of COGPE would be subject to the provisions of paragraph 66.4(5)(b).

John Chan discussed the question and answer with Mr. John Bentley at his office on June 10, 1992 and he does not have any concerns about the question and answer.

A copy of the question and answer together with the issue sheet was sent by fax to Simon Thompson, Dept. of Finance on June 9, 1992 and John Chan spoke to Mr Thompson on June 10. Mr. Thompson said that Finance does not have any concerns about the question and answer.

The question and answer was reviewed by John Kurrant, Oil & Gas Specialist on June 12 and he said that he does not have any concerns.