19 January 1993 Income Tax Severed Letter 9301246 - Structuring Gold Mining Operations

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.

NOTES FOR PRESENTATION ON FINANCING GOLD MINING OPERATIONS
   INDUSTRY EXCHANGE OF INFORMATION MEETING—GOLD MINING
                   CANADA—UNITED STATES
                OTTAWA—JANUARY 19, 1993

PRESENTED BY:JOHN CHANFILE # 930124
         ACTING SECTION CHIEF
         RESOURCE INDUSTRIES SECTION
         MANUFACTURING INDUSTRIES, PARTNERSHIPS 
           AND TRUSTS DIVISION
         RULINGS DIRECTORATE

ON BEHALF OF THE RESOURCE INDUSTRIES SECTION, RULINGS DIRECTORATE, I WOULD LIKE TO THANK MR. R. CLOUTIER, INDUSTRY SPECIALIST SERVICES SECTION FOR INVITING US TO DESCRIBE SOME TECHNIQUES WHICH ARE USED TO STRUCTURE GOLD MINING OPERATIONS AND SOME OF THE INCOME TAX CONSIDERATIONS RELATED THERETO.

THE INCOME TAX LEGISLATION IN RESPECT OF CANADA'S MINING INDUSTRY, INDEED—BOTH MINING AND PETROLEUM INDUSTRIES, REFLECT THE HIGH RISK AND HIGH CAPITAL INVESTMENT ASSOCIATED WITH THE RESOURCE SECTOR. IN RELATION TO THE ABUNDANCE OF RISK AND THE SCARCITY OF CAPITAL IN THE RESOURCE SECTOR, EXPENDITURES INCURRED IN MINING EXPLORATION AND THE EXPENDITURES INCURRED TO BRING A NEWLY DISCOVERED MINE INTO PRODUCTION—THAT IS, CANADIAN EXPLORATION EXPENSES OR "CEE"—ARE DEDUCTIBLE IN COMPUTING NET INCOME FOR TAX PURPOSES AT A RATE OF 100% OF THE UNDEDUCTED AMOUNTS OF CEE. THE COST OF ACQUIRING MINING LEASES OR MINING RIGHTS AND THE EXPENDITURES TO DEVELOP A PRODUCING MINE ARE REFERRED TO AS CANADIAN DEVELOPMENT EXPENSES OR "CDE"- AVAILABLE FOR WRITE-OFF AT A RATE OF 30% OF THE UNDEDUCTED CDE. GENERALLY, THE COST OF MINING EQUIPMENT IS DEDUCTIBLE—AS CAPITAL COST ALLOWANCE OR "CCA"—AT A RATE OF 25% OF THE UNDEDUCTED COST. FOR MINING EQUIPMENT ACQUIRED FOR A NEW MINE OR FOR A MAJOR EXPANSION OF AN EXISTING MINE, HOWEVER, THE RATE OF WRITE-OFF IS 100% OF THE UNDEDUCTED COST.

MINING EXPLORATION, DEVELOPMENT AND PRODUCTION HAVE BEEN ACCOMPLISHED THROUGH MANY DIFFERENT TECHNIQUES. FOUR MECHANISMS WHICH HAVE BEEN USED TO STRUCTURE GOLD MINING OPERATIONS, AS WELL AS OTHER TYPES OF METAL AND MINERAL MINING, WILL BE DESCRIBED IN VERY GENERAL TERMS. THIS WILL BE FOLLOWED BY TWO HYPOTHETICAL EXAMPLES OF GOLD EXPLORATION AND DEVELOPMENT BEING ACCOMPLISHED BY A COMBINATION OF TECHNIQUES.

THE FOUR TECHNIQUES WHICH WILL BE DESCRIBED IN VERY GENERAL TERMS ARE: JOINT EXPLORATION CORPORATION OR "JEC", FLOW- THROUGH SHARES, FARMOUTS AND GOLD LOANS. OTHER TECHNIQUES, WHICH WILL BE ALLUDED TO BUT WHICH WILL NOT BE DESCRIBED, INCLUDE OPTION AGREEMENTS, PARTNERSHIPS AND JOINT VENTURES, ROYALTIES AND NET PROFIT INTERESTS, AMONG OTHERS.

JOINT EXPLORATION CORPORATION (JEC)

THE JEC TECHNIQUE ENABLES AN INVESTOR TO BENEFIT FROM THE EXPLORATION AND DEVELOPMENT TAX WRITE-OFFS AVAILABLE FROM A GOLD MINING VENTURE WHERE THE GOLD MINING CORPORATION DOES NOT ITSELF HAVE INCOME FROM WHICH TO DEDUCT THE WRITE-OFFS. INDEED, IN VIEW OF THE HIGH RISK IN GOLD MINING, THE GOLD MINING CORPORATION MAY NEVER HAVE THE OPPORTUNITY TO CLAIM THE WRITE-OFFS.

A GOLD MINING CORPORATION, THAT IS A CORPORATION THE PRINCIPAL BUSINESS OF WHICH IS MINING FOR GOLD, WHICH HAS NEVER HAD MORE THAN 10 SHAREHOLDERS AT ANY INSTANT IN TIME SINCE ITS INCORPORATION WOULD QUALIFY FOR TREATMENT AS A JEC. AN INVESTOR CORPORATION WHICH IS A SHAREHOLDER CORPORATION OF THE JEC MAY MAKE A PAYMENT TO THE JEC IN RESPECT OF EXPLORATION AND DEVELOPMENT EXPENSES (CEE AND/OR CDE) INCURRED OR TO BE INCURRED BY THE JEC. THE PAYMENT MAY BE IN EXCHANGE FOR SHARES OR DEBT OF THE JEC. THE EXPLORATION AND DEVELOPMENT EXPENSES WOULD HAVE TO BE INCURRED BY THE JEC DURING A PERIOD THROUGHOUT WHICH THE INVESTOR CORPORATION WAS A SHAREHOLDER CORPORATION OF THE JEC.

AFTER COMPLYING WITH ALL NECESSARY ADMINISTRATIVE REQUIREMENTS, THE JEC MAY RENOUNCE TO THE INVESTOR CORPORATION THE INCURRED CEE AND/OR CDE, REDUCED BY ANY ASSISTANCE RELATED TO SUCH EXPENSES, UP TO THE AMOUNT OF THE PAYMENT BY THE INVESTOR CORPORATION. THE RENOUNCED AMOUNT OF CEE/CDE WOULD REDUCE THE COST BASIS OF THE SHARES OR DEBT WHICH THE INVESTOR CORPORATION RECEIVED IN EXCHANGE FOR ITS PAYMENT TO THE JEC. THE INVESTOR CORPORATION MAY THEN BE ABLE TO DEDUCT THE RENOUNCED AMOUNT OF CEE/CDE IN COMPUTING ITS INCOME FOR TAX PURPOSES. THE RENOUNCED AMOUNT IS TREATED AS HAVING ALREADY BEEN DEDUCTED BY THE JEC.

THE JEC MECHANISM DOES NOT PERMIT RENUNCIATION OF THE COSTS OF MINING EQUIPMENT.

FLOW-THROUGH SHARES

ALTHOUGH AN INDIVIDUAL CAN BE A SHAREHOLDER OF A JEC, A RENUNCIATION CANNOT BE MADE BY THE JEC IN RESPECT OF AN INDIVIDUAL. FLOW-THROUGH SHARES, HOWEVER, PROVIDE FOR RENUNCIATIONS OF EXPLORATION AND DEVELOPMENT EXPENSES (CEE AND CDE) BY A GOLD MINING CORPORATION TO AN INVESTOR, IRRESPECTIVE OF WHETHER THE INVESTOR IS A CORPORATION, A PARTNERSHIP, A TRUST OR AN INDIVIDUAL.

LIKE THE RENUNCIATIONS BY A JEC, CEE AND CDE RENOUNCED BY THE GOLD MINING CORPORATION THAT ISSUES THE FLOW-THROUGH SHARE WOULD BE ELIGIBLE FOR DEDUCTION BY THE INVESTOR IN COMPUTING THE INVESTOR'S OWN NET INCOME FOR TAX PURPOSES,

A FLOW-THROUGH SHARE IS A SHARE OR A RIGHT TO RECEIVE A SHARE (SUCH AS A WARRANT OR OPTION) WHICH IS ISSUED BY THE GOLD MINING CORPORATION TO A SUBSCRIBER (THE INVESTOR) PURSUANT TO A WRITTEN AGREEMENT. THE WRITTEN AGREEMENT MUST PROVIDE THAT THE GOLD MINING CORPORATION WILL INCUR THE EXPLORATION AND DEVELOPMENT EXPENSES WITHIN A 24 MONTH PERIOD COMMENCING FROM THE MONTH IN WHICH THE AGREEMENT IS SIGNED. THE AGREEMENT MUST ALSO PROVIDE THAT THE AMOUNT OF EXPLORATION AND DEVELOPMENT EXPENSES WHICH WILL BE INCURRED WILL NOT BE LESS THAN THE AMOUNT PAID BY THE INVESTOR FOR THE FLOW-THROUGH SHARES. ALSO, THE EXPENSES MUST BE RENOUNCED BY THE CORPORATION TO THE INVESTOR WITHIN THE 24 MONTH PERIOD OR WITHIN 30 DAYS AFTER THAT PERIOD.

THERE ARE ALSO RULES KNOWN AS THE "PRESCRIBED SHARE" RULES, THE PURPOSE OF WHICH IS TO ENSURE THAT THE INVESTOR BEARS NORMAL MARKET RISKS WITH RESPECT TO THE SUCCESS OF THE GOLD MINING VENTURE. IF A SHARE FALLS WITHIN THE AMBIT OF A PRESCRIBED SHARE, IT WILL BE PRECLUDED FROM TREATMENT AS A FLOW-THROUGH SHARE. GENERALLY, A FLOW-THROUGH SHARE WOULD FALL WITHIN THE AMBIT OF THE PRESCRIBED SHARE RULES IF THERE ARE PREFERENTIAL DIVIDEND OR LIQUIDATION ENTITLEMENTS OR GUARANTEED BUY-OUT ARRANGEMENTS. IN ADDITION, THE PRICE FOR WHICH THE FLOW-THROUGH SHARE WILL BE ISSUED MUST BE FIXED WITHIN 60 DAYS OF ENTERING INTO THE FLOW-THROUGH SHARE AGREEMENT.

FARMOUT TRANSACTIONS

A FARMOUT ARRANGEMENT IS TYPICAL WHERE THE OWNER OF A MINING CLAIM OR MINING LEASE IS CASH POOR AND THUS UNABLE TO MEET THE PROVINCIAL "WORK REQUIREMENTS" ON THE CLAIM OR LEASE. PARTICULARLY IF THE OWNER IS IN DANGER OF SEEING ITS RIGHTS UNDER THE MINING CLAIM OR LEASE EXPIRE, SHARING ITS INTEREST WITH AN INVESTOR WHO CAN SAVE THE CLAIM OR LEASE BY PERFORMING THE WORK REQUIREMENTS ON TIME WILL CLEARLY BE A SUPERIOR ALTERNATIVE TO LOSING THE CLAIM OR LEASE ALTOGETHER. IN OTHER SITUATIONS, THE OWNER OF THE MINING CLAIM OR LEASE MAY BE EAGER TO PROCURE GEOPHYSICAL INFORMATION CONCERNING A PARTICULAR AREA AND A FARMOUT MAY PROVIDE THE MEANS OF DOING SO WITHOUT CASH EXPENDITURE BY THE OWNER.

REVENUE CANADA'S TREATMENT OF FARMOUTS IS AS FOLLOWS.

SIMPLE FARMOUT—IN A SIMPLE FARMOUT ARRANGEMENT, THE OWNER (THE FARMOR) OF UNPROVEN RESOURCE PROPERTY TRANSFERS AN INTEREST IN THAT PROPERTY TO ANOTHER PERSON (THE FARMEE) WHO CONDUCTS EXPLORATION AND DEVELOPMENT ON THE PROPERTY. REVENUE CANADA WILL TREAT THIS TRANSFER OF OWNERSHIP INTEREST AS NOT GIVING RISE TO PROCEEDS OF DISPOSITION, THAT IS, A NON-TAXABLE EVENT.

TYPICAL FARMOUT—IN A TYPICAL FARMOUT, THE FARMOR TRANSFERS ALL OF THE WORKING INTEREST TO THE FARMEE AND TAKES BACK A PERCENTAGE ROYALTY IN THE UNPROVEN RESOURCE PROPERTY WHICH WAS TRANSFERRED. THE FARMEE AGREES TO INCUR EXPLORATION AND DEVELOPMENT COSTS AND EQUIPMENT COSTS. SUBSEQUENTLY, UPON PAYOUT OF THE FARMEE, A PERCENTAGE OF THE WORKING INTEREST REVERTS TO THE FARMOR TOGETHER WITH A PRO RATA OWNERSHIP INTEREST IN THE EQUIPMENT THAT WAS ACQUIRED FOR THE MINE. REVENUE CANADA WILL TREAT THE OWNERSHIP TRANSFER OF THE PERCENTAGE INTEREST IN THE RESOURCE PROPERTY AND THE MINING EQUIPMENT AS NOT GIVING RISE TO PROCEEDS OF DISPOSITION.

WIDESPREAD FARMOUT—IN A WIDESPREAD FARMOUT, THE FARMEE AGREES TO CONDUCT EXPLORATION AND DEVELOPMENT ON THE FARMOR'S UNPROVEN RESOURCE PROPERTY IN EXCHANGE FOR AN INTEREST IN SOME OTHER PROPERTY OF THE FARMOR. REVENUE CANADA WILL TREAT WIDESPREAD FARMOUTS IN WHICH THE FARMEE RECEIVES UNPROVEN RESOURCE PROPERTY OF THE FARMOR AS NOT GIVING RISE TO PROCEEDS OF DISPOSITION IRRESPECTIVE OF WHETHER OR NOT THE UNPROVEN RESOURCE PROPERTY IS CONTIGUOUS TO THE PROPERTY BEING EXPLORED OR DEVELOPED BY THE FARMEE. WIDESPREAD FARMOUTS IN WHICH THE FARMOR TRANSFERS PROPERTY OTHER THAN UNPROVEN RESOURCE PROPERTY WILL BE TREATED AS A DISPOSITION BY THE FARMOR FOR PROCEEDS EQUAL TO FAIR MARKET VALUE OF THE PROPERTY TRANSFERRED; THE FARMEE'S COST OF THE TRANSFERRED PROPERTY WILL EQUATE THE PROCEEDS OF THE FARMOR; AND THERE WILL BE A REDUCTION OF THE EXPLORATION AND DEVELOPMENT EXPENSES INCURRED BY THE FARMEE FOR THE TRANSFERRED PROPERTY.

GOLD LOANS

GOLD LOANS ARE USED BY GOLD PRODUCERS TO FINANCE ORDINARY BUSINESS OPERATIONS IN ADDITION TO GOLD EXPLORATION AND MINE DEVELOPMENT. THE TERMS OF A GOLD LOAN ARE AS VARIED AS THOSE RELATING TO ANY FINANCIAL INSTRUMENT. HOWEVER, IN GENERAL TERMS, A GOLD LOAN MAY BE DESCRIBED AS FOLLOWS.

A GOLD PRODUCER BORROWS A QUANTITY OF OUNCES OF GOLD FROM A FINANCIAL INSTITUTION AND SELLS THE GOLD ON THE SPOT MARKET, RECEIVING THE CASH EQUIVALENT OF THE VALUE OF THE BORROWED GOLD. DURING THE TERM OF THE LOAN, THE GOLD PRODUCER PAYS INTEREST AT A FIXED OR FLUCTUATING NOMINAL RATE (USUALLY 1% TO 3%, DEPENDING ON THE FINANCIAL INSTITUTION'S COST OF OBTAINING THE GOLD) ON THE VALUE OF THE OUTSTANDING AMOUNT OF BORROWED GOLD MEASURED EITHER BY REFERENCE TO THE PRICE OF GOLD AT THE TIME OF BORROWING OR THE CURRENT (FLUCTUATING) PRICE OF GOLD. TYPICALLY, THE GOLD PRODUCER REPAYS THE GOLD LOAN ACCORDING TO A PREDETERMINED SCHEDULE BY DELIVERING GOLD THAT IT HAS PRODUCED TO THE FINANCIAL INSTITUTION, OR ALTERNATIVELY, THE PRODUCER REPAYS THE FINANCIAL INSTITUTION WITH THE CASH EQUIVALENT OF THE QUANTITY OF GOLD THAT IS DUE.

THE PRIMARY TAX ISSUES WITH RESPECT TO GOLD LOANS ARE: CHARACTERIZATION OF THE GOLD LOAN, DEDUCTIBILITY OF THE INTEREST AND TREATMENT OF THE UNREALIZED GAINS/LOSSES ON THE PRODUCER'S LIABILITY TO THE FINANCIAL INSTITUTION.

REVENUE CANADA TREATS THE GOLD LOAN AS A LOAN FOR CONSUMPTION, THAT IS, ONE IN WHICH THE ACTUAL SPECIFIC ASSET IS NOT TO BE RETURNED. THIS RESULTS IN THE DISPOSITION OF GOLD BY THE FINANCIAL INSTITUTION AND AN ACQUISITION OF GOLD BY THE BORROWER.

THE INCOME TAX TREATMENT WITH RESPECT TO INTEREST PAID BY THE GOLD PRODUCER ON THE GOLD LOAN DEPENDS ON THE USE OF THE CASH REALIZED BY THE PRODUCER FROM THE LOAN.

WITH RESPECT TO THE GOLD PRODUCER'S LIABILITY, REVENUE CANADA'S VIEW IS THAT THE LIABILITY SHOULD BE VALUED AT EACH YEAR-END AND ANY GAIN OR LOSS INDICATED BY SO VALUING THE DEBT SHOULD BE REFLECTED IN THE GOLD PRODUCER'S INCOME FOR THAT YEAR.

HYPOTHETICAL EXAMPLES

DIRECT EQUITY FINANCING/JEC/JOINT VENTURE

-        "A.CO" AND "B.CO" ARE UNRELATED CORPORATIONS, EACH
         OWNING MINING CLAIMS LOCATED IN THE SAME AREA.

-        A.CO AND B.CO WISH TO POOL THEIR MINING INTERESTS
         IN THE PARTICULAR AREA AND TO EXPLORE AND DEVELOP
         THE CLAIMS.  ACCORDINGLY, A.CO AND B.CO TRANSFER
         THEIR MINERAL INTERESTS TO A NEW CORPORATION "C.CO"
         IN EXCHANGE FOR SHARES OF C.CO.  THIS TRANSFER IS
         DONE ON A TAX DEFERRED BASIS.

-        A.CO AND B.CO ENTER INTO AN AGREEMENT FOR B.CO TO
         INCUR AND PAY THE ENTIRE COST OF CARRYING OUT
         FURTHER PROSPECTING AND EXPLORATION ACTIVITIES IN
         SEARCHING FOR GOLD ON THE CLAIMS.  IN CONSIDERATION
         FOR INCURRING THESE COSTS, C.CO AGREES TO ISSUE
         ADDITIONAL SHARES FROM ITS TREASURY TO B.CO.  THE
         JEC MECHANISM IS THEN USED TO RENOUNCE THE
         EXPLORATION DEDUCTIONS TO B.CO.

-        THUS, EXPLORATION OF THE CLAIMS WAS ACCOMPLISHED
         WITH B.CO INCURRING THE EXPLORATION COSTS AND
         RECEIVING A GREATER INTEREST IN THE SHARES OF C.CO.

-        A.CO AND B.CO DETERMINED THAT THE AAGREEMENT UNDER
         WHICH EXPLORATION WAS CARRIED ON WAS DEFICIENT WITH
         RESPECT TO DEVELOPMENT OF THE CLAIMS AND PRODUCTION
         OF GOLD FROM THE CLAIMS.  FOR EXAMPLE, THE
         AGREEMENT DID NOT PROVIDE FOR CASH CALLS.  THEY
         DECIDED TO RESTRUCTURE THE ARRANGEMENT AS A JOINT
         VENTURE, WHICH IS CURRENTLY THE MOST COMMONLY USED
         VEHICLE FOR JOINT EXPLORATION AND DEVELOPMENT OF
         MINING CLAIMS.  THIS WOULD PERMIT THE PARTICIPANTS
         TO TAKE ADVANTAGE OF THE BENEFITS RELATING TO
         DIRECT OWNERSHIP SUCH AS THE ABILITY TO FINANCE
         ONE'S INTEREST IN THE DEVELOPMENT AND PRODUCING
         ACTIVITIES MORE EASILY AND WITHOUT THE INVOLVEMENT
         OF THE OTHER PARTICIPANT AND THE ABILITY OF EACH
         PARTICIPANT TO TAKE PRODUCT-IN-KIND, FOR EXAMPLE,
         A.CO OR B.CO MAY FIND IT EASIER TO OBTAIN A GOLD
         LOAN IF THEY ARE THE GOLD PRODUCERS, RATHER THAN
         C.CO.

-        THERE ARE ALSO INCOME TAX BENEFITS TO DIRECT
         OWNERSHIP, INCLUDING THE ABILITY OF EACH
         PARTICIPANT TO CLAIM CAPITAL COST ALLOWANCE AND THE
         ABILITY TO DIRECTLY USE LOSSES GENERATED BY THE
         ACTIVITIES.

FARMOUT/JEC

-        "X.CO" IS SEEKING TO EXPAND ITS GOLD MINING
         OPERATIONS, PARTICULARLY IN ITS PRINCIPAL GOLD
         PRODUCING AREAS.  "Y.CO" IS SEEKING TO DIVEST
         ITSELF OF NON-STRATEGIC GOLD PRODUCING PROPERTIES.

-        AS PART OF ITS DIVESTITURE PROGRAM, Y.CO WILL SELL
         ITS GOLD PRODUCING PROPERTIES LOCATED IN X.CO'S
         PRINCIPAL GOLD PRODUCING AREAS.  Y.CO WILL SELL
         THESE CLAIMS TO X.CO. FOR CASH.

-        X.CO WILL INCORPORATE A SUBSIDIARY CORPORATION,
         "SUB.CO".

-        THE FARMOUT TECHNIQUE IS THEN USED BY SUB.CO AND
         X.CO.  SUB.CO ENTERS INTO A SIMPLE FARMOUT
         AGREEMENT WITH X.CO PURSUANT TO WHICH SUB.CO WILL
         INCUR EXPLORATION EXPENSES ON X.CO'S EXPLORATORY
         CLAIMS IN CONSIDERATION FOR WHICH SUB.CO WILL EARN
         A WORKING INTEREST IN THOSE CLAIMS.

-        Y.CO WILL USE THE CASH FROM SALE OF ITS MINING
         CLAIMS TO X.CO TO SUBSCRIBE FOR PREFERRED SHARES OF
         SUB.CO UNDER CIRCUMSTANCES SUCH THAT JEC
         RENUNCIATIONS CAN BE MADE.  SUB.CO USES THE SHARE
         SUBSCRIPTION PROCEEDS TO INCUR THE EXPLORATION
         EXPENSES AND RENOUNCES THESE EXPLORATION DEDUCTIONS
         TO Y.CO USING THE JEC TECHNIQUE.

-        THUS, X.CO IS ABLE TO BROADEN ITS OWNERSHIP OF GOLD
         CLAIMS WHILE FINANCING ITS OWN EXPLORATION PROGRAM. 
         Y.CO IS ABLE TO INVEST IN THE POTENTIAL SUCCESS OF
         THE EXPLORATION PROGRAM ON X.CO'S MINING CLAIMS AND
         TO RECEIVE THE TAX WRITE-OFFS RESULTING FROM THE
         EXPLORATION EXPENSES INCURRED IN THE EXPLORATION
         PROGRAM.
         -END-
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