30 June 1994 External T.I. 9410805 - CROWN ROYALTY IN OIL AND GAS FARM-OUT

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		5-941080

Attention: XXXXXXXXXX

June 30, 1994

Dear Sirs:

Re: Crown Royalties in Oil and Gas Farm-outs

Further to your letter of August 18, 1993 and our letter of March 29, 1994, this is in reply to your letter of April 19, 1994 wherein you requested clarification of certain comments made in our letter of March 29, 1994 concerning the treatment of Crown royalty paid on production of oil from wells drilled under the terms of farm-out agreements.

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 of a particular transaction.

We have assumed that 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 payor acts as agent for the owners who are responsible for the Crown royalty related to their respective interest in the production.

In Case 3, described in your letter dated August 18, 1993, the farmee agreed to incur costs of drilling and equipping 5 wells on the farm-out lands in return for the farmor's 50% interest in the farm-out lands and the farm-out wells. We understand that the farmee has drilled two wells and intends to drill the other three wells in accordance with the farm-out agreement. Thus, the farmee is still in the earning stage of the farm-out agreement. During the payout period (i.e. prior to the payout of the drilling and equipment costs incurred by the farmee), the farmee receives 50% of the "net revenues" from the farm-out wells. "Net revenues" are gross receipts from the production and sale of petroleum from a farm-out well or wells less operating costs and Crown royalties. It is not clear if the farmee obtains the right to 50% of net revenues as each farm-out well is drilled and completed, or if all five farm-out wells must be drilled and completed before the farmee's interest in the net revenues, farm-out wells and the farm-out lands is obtained. Upon reaching payout of the drilling and equipping costs, the farmee's 50% interest in the farm-out lands and the farm-out wells is reduced to a 25% working interest, with 25% held by the farmor, and 50% by the third party.

We understand that you are concerned with the treatment for Crown royalty applicable to production from the farm-out wells during the earning period and before all five farm-out wells have been drilled.

Your August 18, 1993 letter explains that the Crown royalty applicable to the production from the farm-out wells and farm-out properties is paid or payable by a third party refiner or pipeline. In our view, subparagraph 18(1)(m)(v) of the Act is relevant because the Crown royalty is paid or payable to a province by virtue of an obligation imposed by statute. We acknowledge that for the purposes of subparagraph 12(1)(o)(v) of the Act the farmee may have an interest in the property. However, we do not feel that the Crown royalty in Case 3 is subject to paragraph 12(1)(o) of the Act because of the requirement therein that the amount be other than an amount referred to in paragraph 18(1)(m) of the Act.

Generally, the provincial regulation and paragraph 18(1)(m) of the Act provide that the Crown royalty and the treatment thereof under paragraph 18(1)(m) of the Act is to the account of the party that has the right to produce petroleum from the Crown lands. In Case 3, this appears to be the farmor, since the farmee's interest in the farm-out property has not been earned at the time the petroleum is produced. Upon completing all of the wells, the farmee will obtain ownership of a share of the production by virtue of earning the 50% farm-out interest, which is generally described as a working interest. Thus, we feel that our March 29, 1994 references to working interest are relevant to the application of subparagraph 18(1)(m)(v) of the Act to the Crown royalty on production from the farm-out wells. Where the farmee does not earn the farm-out interest in any of the five farm-out wells and the farm-out property until all of the farm-out wells have been drilled, the farmee does not appear to own a share in the production. The ownership of production from the farm-out wells is a question of fact determined on the facts and circumstances relevant to the parties to the farm-out transaction and the farm-out wells and properties.

Where subparagraph 18(1)(m)(v) of the Act does not apply to the farmee because the Crown charge is not paid or payable in respect of the farmee's share of the production, section 80.2 of the Act may apply to deem the farmee to have paid the amount that was reimbursed to the farmor in respect of a Crown royalty described in paragraph 18(1)(m) of the Act. In order for section 80.2 of the Act to apply, the farmee is required to make the reimbursement under the terms of a contract. It is also required that the reimbursement be paid by a taxpayer resident in Canada or carrying on business in Canada, in respect of the recipient's Crown charge described in paragraphs 18(1)(m) or 12(1)(o) of the Act. Thus, where the farmee and farmor have agreed, the farmee may be deemed to have paid the Crown royalty and the farmor would be deemed neither to have received nor paid that Crown royalty.

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