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: Whether "Net Royalty" payments under a Saskatchewan Royalty Petroleum and Natural Gas Lease are included in COGPE.

Position: Qualified yes.

Reasons: The quantum of the royalty does not determine whether or not it is COGPE. Based on the information available, the "Net Royalty" "can reasonably be regarded as a cost of acquiring the lease" and therefore qualifies for inclusion in COGPE.

									October 28, 1998

	Len Serdachny							Resource Industries
	Large File Case Manager					   Section
	Regina TSO							A. Seidel
(613) 957-8974

982575

Saskatchewan Net Royalty Payments

This is in reply to your October 5, 1998 request concerning the inclusion of Saskatchewan Royalty Petroleum & Natural Gas Lease payments in the definition of Canadian oil and gas property expense (“COGPE”) in subsection 66.4(5) of the Income Tax Act (the “Act”).

Issue

Paragraph (a) of the definition of COGPE provides, amongst other things, that “an amount paid or payable to Her Majesty in right of the Province of Saskatchewan as a net royalty payment pursuant to a net royalty petroleum and natural gas lease that was in effect on March 31, 1977 to the extent it can reasonably be regarded as a cost of acquiring the lease,” is a cost that qualifies for inclusion in COGPE.

How does one determine whether or not an amount that satisfies the first part of the definition “can reasonably be regarded as a cost of acquiring the lease”?

Background

In your presentation at the 1998 Oil and Gas Tax Conference you indicated that these net royalty payments arose as the result of the decision by the Province of Saskatchewan to grant oil and gas leases to those operators who undertook to pay the highest percentage of production, net of a basic royalty, as a “super royalty.” You also indicated that the basic royalty was 16.66% of production and that the super royalty could be anywhere from 50% to 63.2% of production. You also advised that including these super royalties in COGPE resulted in a taxpayer being “put on par with bonus payments paid to the Alberta government or bonus payments to the Saskatchewan government under the present land administration practices.”

Generally, a “Net Royalty Petroleum and Natural Gas Lease,” hereinafter referred to as the “Lease,” provided that:

“in consideration of the rents and royalties hereinafter reserved, ..., the lessor does hereby grant, demise and lease unto the lessee all the naturally occurring fluid of hydrocarbon including natural gas ... Together With the exclusive right, license, privilege and authority to search, dig, bore and drill for, win, get, recover, procure and carry away the said petroleum”.

The rent was usually a fixed amount and the so called “basic royalty” was established pursuant to the regulations under the then Mineral Resources Act and neither of these payments is under dispute. The sole issue is whether any or all of the so called super royalty is COGPE .

Subparagraph 8.(4)(a) of the Lease generally provides the following:

“with respect to petroleum produced ..., the lessee shall, in addition to the royalty provided for in subsection (2) hereof [the basic royalty], pay to the lessor a royalty of [whatever the agreed percentage was] percent of the net proceeds of production (herein referred to as “Net Royalty”)”

The determination of whether something can reasonably be regarded as an acquisition cost is a question of fact and all relevant information should be considered in making such a determination. The Department has previously accepted that the full amount of the “net royalties” can be added to a taxpayer’s COGPE, that is, could “reasonably be regarded as a cost of acquiring the lease” and that no portion thereof was a non-deductible Crown royalty by virtue of paragraph 18(1)(m) of the Act. However, the amounts previously considered were less than $10,000 per year. In this particular case, the amounts involved are much greater, namely $600,000, $800,000 and $2,200,000. The prime reason for the substantial increase in “net proceeds” was the unusually high price of oil and gas in the early 1980’s.

Based on the information you have provided, an operator was required to “bid” for oil and gas leases and the Net Royalty represented the “bid” for a particular property. Therefore it would appear that, as a question of fact, the Net Royalty represents the actual acquisition cost of a lease. The fact that the amounts involved became substantially larger as a result of conditions that were unforeseen at the time the Lease was entered into would not, by itself, change the prior conclusion that the amount could “reasonably be regarded as a cost of acquiring the lease.”

If you wish to discuss any of the above, or if we can be of any further assistance, please contact the writer.

Manager
Resource Industries Section
Resources, Partnerships and Trusts Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch

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