29 March 1994 External T.I. 9333335 - CROWN ROYALTY ON FARMOUT PROPERTY

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.

Principal Issues:

Application of 18(1)(m)(v) to oil production from farm-out wells.

Position TAKEN:

18(1)(m)(v) applies to extent the production is owned.

80.2 may apply, where conditions are satisfied, to deem royalty to be paid by a party that is required to reimburse the owner of the production.

Reasons FOR POSITION TAKEN:

Crown royalty is paid in cash.

18(1)(m)(v) applies to owner of production.

XXXXXXXXXX 5-933333

Attention: XXXXXXXXXX

March 29, 1994

Dear Sirs:

Re: Crown Royalties in Oil and Gas Farmouts

This is in reply to your letter of August 18, 1993 to the Calgary District Office wherein you ask for our interpretation of certain provisions of the Income Tax Act (Canada) concerning the treatment of Crown royalty paid on production of oil from wells drilled under the terms of farmout agreements.

Unless otherwise stated, all references to statute are to the Income Tax Act S.C. 1970-71-72,c.63 as amended, consolidated to June 10, 1993 (the "Act").

In this regard we provide you with the following general comments which may be of assistance to you. Our comments, however, should not be construed as confirming the income tax consequences for a particular transaction.

We have assumed that in the following hypothetical cases the farmee is an Alberta corporation and a "principal business corporation" in accordance with definition found in paragraph 66(15)(h) of the Act. It is also assumed that in paying the Crown royalty share directly to the Province of Alberta, the operator acts as agent for working interest owners who are responsible for the Crown royalty related to their respective shares of the production.

In Case 1, the farmee incurs costs of drilling a well in return for 100% of the working interest and production from that well. Upon reaching payout of the drilling costs, the royalty reserved by the farmor is exchanged for a 50% working interest with the remaining 50% working interest in the well held by the farmee. We agree that Crown royalty applicable to post payout production will be subject to paragraph 18(1)(m) and the farmee will add back his share of the Crown royalties paid pursuant to subparagraph 18(1)(m)(v).

In Case 2, the farmee incurs costs of drilling and equipping a well in return for 100% of the working interest and production from that well. Upon reaching payout of the drilling and equipping costs, the royalty reserved by the farmor is exchanged for a 50% working interest with the remaining 50% working interest in the well held by the farmee. We agree that Crown royalty applicable to the production before payout will be subject to paragraph 18(1)(m) and the farmee will add back his share of the Crown royalties paid pursuant to subparagraph 18(1)(m)(v).

In Case 3, the farmee incurs costs of drilling and equipping 5 wells on the farmout lands in return for 50% of the working interest and production from those wells and the farmout lands. The remaining 50% working interest is owned by a third party unrelated to the farmor and farmee. Upon reaching payout of the drilling and equipping costs, the royalty reserved by the farmor on its farmout interest is exchanged for a 25% working interest with a 25% working interest in the farmout wells and farmout lands held by the farmee and 50% by the third party. We agree that to the extent the farmee earns the interest in the lands and wells as the farmout wells are drilled and completed for production, Crown royalty applicable to the farmee's share of production before payout will be subject to subparagraph 18(1)(m)(v). Where the farmout drilling program is not complete with the result that the farmee has not earned an interest in the farmout lands or production, the production from the completed wells may be for the account of the owners of the working interest at the time of production. As a result, subparagraph 18(1)(m)(v) would apply to the Crown royalty related to each owner's share of the production.

In the above situations, where the farmee acquires all or a portion of the farmor's working interest in the well, the Crown royalty on the oil produced and attributed to the farmee's working interest in the property would be subject to subsection 80.2, paragraph 12(1)(o)(v) or subparagraph 18(1)(m)(v), as the case may be, in the farmee's hands. The particular provision that would apply to the farmee would depend on the terms of the agreement between the farmor and farmee with respect to the payment of Crown royalties. As described in the hypothetical examples, the Crown royalty is paid in cash from sale proceeds for the production from the Crown property. In our view, subparagraph 18(1)(m)(v) would apply to the respective owners of the production. In the alternative, where the requirements are met, section 80.2 may apply to deem the Crown royalty to have been paid by the farmee or farmor, as the case may be.

Our comments herein are confined to the treatment of the Crown royalties on production from farmout wells and lands. We are not commenting on any other income tax consequences to the farmor or farmee which may result from the farmout arrangement as this will depend on the particular facts of each situation.

The foregoing comments represent our general views with respect to the subject matter referred to herein. As indicated in paragraph 21 of Information Circular 70-6R2, the above comments do not constitute an advance income tax ruling and accordingly are not binding on the Department.

Yours truly,

for Director
Manufacturing Industries,
Partnerships and Trusts Division
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch