22 August 1987 Internal T.I. ACC8367 F - Flow-through Shares Audit Program Position Papers

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.

                                                            August 22, 1987

Subject: Flow-Through Shares Audit Program Position Papers

Attached hereto are our comments in respect to each of the twelve position papers submitted to us for our review with your letterof July 17, 1989.

If you require further clarification of same, please contact the writer.

DirectorBilingual Services and Resource  Industries DivisionRulings Directorate

Position Paper # 1 - Dual purpose Canadian Exploration Expenses 

                     (CEE) Subparagraph 66.1(6)(a)(iii) and(iii.1)

With respect to the issue of dual purpose CEE {which is an expense incurred for the purpose of both subparagraphs 66.1(6)(a)(iii) and (iii.1)}, we agree with your first position that a taxpayer may choose to classify such an expense incurred principally for the purpose of 66.1(6)(a)(iii.1) and a (iii) expense where a secondary purpose exists.

With respect to your second position, we acknowledge your position that expenses incurred all or substantially all for the purpose described in (iii.1) would be classified only as (iii.1) expenses even it there existed a secondary purpose which is described in (iii) since this secondary purpose would be very minor.  At this point it is difficult for us to determine whether the Courts would support such a position.  Paragraph 66.1(6)(a) does not have primary purpose test, which at first perusal would seem to be needed to support your position and would preclude an allocation of CEE which possess characteristics of both (iii) and (iii.1).  In the extreme cases, we would not be surprised if the Courts supported your position.

Position Paper # 2 - Cost of depreciable property claimed as     Canadian Exploration Expense (CEE)                     Paragraphs 66.1(6)(a) and 20(1)(a) and                     Part XI of the Regulations

With the respect to the issue of whether the cost of property described in Schedule II to the Regulations and acquired for the purposes of paragraph 66.1(6)(a) can be classified as CEE, we agree with your position that the cost of such property cannot be claimed an CEE but must be added to the appropriate Schedule IIcategory and claimed as capital cost allowance.

Position Paper # 3 - Costs of eligible capital expenditures (ECE)  claimed as Canadian Exploration Expense                     (CEE)  Paragraphs 66.1(6)(a), 14(5)(b) and 20(1)(b)

With respect to the issue of whether an expense tat would otherwise be classified as ECE can be classified as CEE, we agree with your position that provided one of the purpose tests under paragraph 66.1(6)(a) is met, such an expense should be treated as CEE and as a consequence, would not meet the definition of ECE by virtue of paragraph 14(5)(b)(i).  We acknowledge your administrative policy that the Department would not disallow deduction under 20(1)(b) where a taxpayer has treated such an expense as ECE and has not included such expense in his CEE pool.

Position Paper # 4 - Cost of expenditures claimed as Canadian   

Exploration Expense (CEE) but deductible under another provision of the Act Paragraphs 66.1(a) and 20(1)(ee), etc.

With respect to the issue of whether an expense which meets the purpose test under either subparagraph 66.1(6)(a)(iii) or (iii.1) and is otherwise deductible under another provision of the Act such as paragraph 20(1)(ee) can be claimed as CEE, we affirm your position {only with respect to an expenditure which would other be deductible under paragraph 20(1)(ee)}, provided one of the purpose tests in paragraph 66.1(6)(a) is met, (where that purpose is considered very minor), such an expense may be treated as CEE. Where the purpose described in either of subparagraphs 66.1(6)(a)(iii) and (iii.1) is considered very minor, it is our view that the expense would not qualify as CEE.  Where the expense qualifies as CEE, we agree that a taxpayer has the choice of claiming such an expense as either CEE, we agree that a taxpayer has the choice of claiming such as expense as either CEE or a utility service connection expense under paragraph 20(1)(ee).  We have restricted affirmation of your position to paragraph 20(1)(ee) expenditures since we have not considered any other provisions of the Act which may be applicable in the circumstances.

Position Paper # 5 - Renunciation of resource expenses incurred  prior to entering in an agreement

Paragraph 66(15)(d.1) and subsections       66(12.6), 66(12.62) and 66(12.64).

With respect to the issue of whether resource expenditures incurred prior to the date on which an agreement is entered into can renounce pursuant to the flow-through share provisions of the Act, although we acknowledge your position of permitting the renunciation in circumstances where the only agreement entered into is a letter of intent or some other similar writing, we wish to direct your attention to the definition of a flow-through share at paragraph 66(15)(d.1) which requires that a "written agreement" exist between the principal-business corporation and the purchaser of the flow-through share prior to the date the resource expenditures are incurred.  This written agreement must not only reflect the intention of the parties but must be legally binding upon both of them.  Although letters of intent or other similar writing may depict the parties intentions, in most situations they do not legally bind the parties and, therefore in our view are not contemplated by paragraph 66(15)(d.1).

In addition, with regards to the particular areas of the Act dealing with the "flow through" of CEE, CDE and COGPE, being subsections 66(12.6), (12.62) and (12.64) of the Act respectively, such provisions reiterate the above requirement in order for such expenses to "flow through" to a shareholder.  The aforesaid subsections may be paraphrased as follows in stating the requirement as to when a principal-business corporation has to incur the various expenses so that they qualify for "flow through" purposes:

        "...and, during the period commencing on the day the agreement was entered into and ending 24 months after the end of the month that included that day, the corporation has incurred (the specific expense), the corporation  may..., renounce..., by which those expenses incurred by  it during that period...".

In other words, the Act requires these expense to be incurred by the corporation subsequent to the entering into the agreement which is the written agreement that is legally binding referred to in paragraph 66(15)(d.) by the parties in order for these expenses to be capable of "flowing through" to the holders of the flow-through shares.

Position Paper #6 - "All or substantially all" rule dealing with                     salaries/bonuses

Regulation 1206(1) - Canadian exploration & development overhead  expense (CEDOE) definition, paragraphs (a)                       and (b)

With respect to the issue of whether the "all or substantially all" rule should be strictly interpreted to apply in the situation of a junior resource company with few employees (who perform a multitude of tasks spending less then 90% of their time directly on exploration activities) to classify the salaries of such employees as CEDOE, it is our view, unless all or substantially all (ie. - 90% or more) of the duties of a person employed by a taxpayer, whether or not a junior resource company, are directed toward exploration or development activities, the entire salary,wages or other remuneration paid the person (to the extent the salary, etc. is a Canadian exploration expense (CEE) or a Canadian development expense (CDE) is CEDOE.  Bonuses would be considered "other remuneration "nor the purposes of paragraph (b) of the CEDOE definition.

We would agree that a salary or other amount, including a bonus, which would otherwise be CEE or CDE would not be CEE or CDE tothe extent it was unreasonable.

We would agree that a field supervisor - e.g., a crew foreman - would not normally be considered to be engaged in administration or management of the taxpayer for the purposes of paragraph (a) of the CEDOE definition solely by virtue of his supervision of the field employees.

Position Paper #7 -  "All or substantially all" test dealing with  rents and other leased assets

Regulation 1206(1) -  Canadian exploration & development overhead                       expense (CEDOE) definition, paragraph (c)

With respect to the issue of whether a strict interpretation ofthe "all or substantially all" test would result in a rental paid forproperty used less than 90% for purposes of exploration ordevelopment activities being treated entirely as CEDOE, it is ourview, a rental paid for property used in part for exploration ordevelopment activities and in part for some other activity cannotbe allocated in part to CEDOE and in part to "non-CEDOE". Paragraph (c) describes the use of the property being rentedagreement.  Paragraph (c) clearly results in treating all of therental paid as CEDOE in the situation described.

However, where a rented property is used 90% or more for part ofthe year for exploration or development activities and for partof the year does not meet this test, the portion of the rentalexpense incurred for the period for which the property is usedwhen the test is met is not CEDOE.

Position Paper #8 - Canadian exploration and development overhead                    expense (CEDOE), "Connected Rules"

Regulations 1206(1) and 1206(5)With respect to the issue of whether expenses such as directexploration expenses, administration expenses and mark-up feescharged by a connected corporation are treated any differentlyfor CEDOE purposes than if they had been charged by a non-connected corporation, we are of the view that whether a personis connected with a taxpayer has no effect on whether or to whatextent an expense of the taxpayer is CEDOE.

Paragraph (d) of the definition of CEDOE includes as CEDOE anyamount in respect of a Canadian exploration or Canadiandevelopment expense (Resource Expense) of a taxpayer charged tohim by a person connected with him for goods, services, or rightsto use property to the extent the amount charged exceeds the costto the connected person of providing the goods, services or rightsto use the property.

The sole purpose of the "connected rules" is to eliminate theprofit element, i.e. mark-up fees, from being treated as anythingother than CEDOE in situations where a connected corporationcharges a taxpayer in respect of Resource Expenses incurred byit.

In example 4, we would note the error in your reference tosubparagraph 1206(5)(a)(ii), i.e. should be to (iii) instead.

Position Paper #9 - Equity percentage determination

Regulation 1206(5) and (7), paragraphs 95 (4)(a), and (b)

1.       With respect to the issue of the application of the         "connected rules" in paragraph 1206(5)(a) of the         Regulations to a situation where the percentage         ownership of an existing shareholder changes as a         result of a flow-through share issuance from a         percentage not less than 10% to a percentage which         is less than 10%, we would note that where the         issuance of such shares may affect whether a         taxpayer (existing shareholder) is connected with         issuer for the purposes of paragraph (d) of the         Canadian exploration and development overhead         expense (CEDOE) definition, the effect of such         issuance is not taken into account for this         determination until such time as the shares are         actually issued.  Subsection 1206(5) of the         Regulations, which establishes when a person is         connected with a corporation for purposes of the         CEDOE definition does so by reference to the "equity         percentage" rule in paragraph 95(4)(b) of the Act         which in turn refers to the "direct equity percentage"         rule in paragraph 95(4)(a).          This last rule deals only with issued share capital.  It         should be noted that, even if the flow-through share         issue resulted in the equity percentage of the taxpayer         in the corporation being less than 10%, the parties would         continue to be connected if they did not deal with each         other at arm's length.

2.       With respect to the issue of whether the words "group of         persons" can be substituted for the word "person" in the         connected rules re the CEDOE definition, in our view,         "group of persons" cannot be substituted for "person" in         subsection 1206(5) of the Regulations.  Again, it is         worth noting that the parties may be connected if they do         not deal with each other at arm's length.  In a particular         fact circumstance it may well be worthwhile to examine         paragraph 251(2)(c) of the Act in this regard.

Position Paper #10 - Expenses to be classified as depreciable                         property or as Canadian exploration expense                      (CEE) Paragraphs 18(1)(b) and 20(1)(a); Part                     XI and Schedule II to the Regulations;

With respect to the issue of how certain outlays or expendituresincurred in the mining industry should be classified, i.e.whether as a cost of depreciable property or CEE, we agree withyour position that the cost of property described in Schedule IIto the Regulations should be classified as depreciable propertyprovided such cost is not otherwise precluded from inclusiontherein by reason of subsection 1102(1) of the Regulations.

Position Paper #11 - Classification of costs of studies                     Subparagraphs 66.1(6)(a)(iii) and (iii.1)

With respect to the issue of whether the cost of feasibility,environmental or other studies can be classified as Canadianexploration expense (CEE), we agree with your position todisallow such classification except in those situations wherethe study has a secondary purpose which is not very minor andwould meet one of the purpose tests set out in subparagraph66.1(6)(a)(iii) or (iii.1).

In order for the cost of a feasibility study to qualify as CEEunder subparagraph 66.1(6)(a)(iii), it must be incurred for thepurpose of determining the existence, location, extent or qualityof a mineral resource in Canada.  However, it is our view that afeasibility study is too remote from these purposes since it isundertaken in order to determine whether the explorer shouldproceed to the development of a mine.  The feasibility study alsofails to qualify for CEE under subparagraph 66.1(6)(a)(iii.1)because it is undertaken for the purpose of making adetermination whether or not to bring a mine into production, andnot for the required purpose (under the subparagraph) of actuallybringing a new mine into production.

Regarding other studies which are required by governments toobtain and maintain mining claims (i.e. environmental andecological studies), we are of the same conviction that theyare not for the purpose of determining the existence, location,extent or quality of a mineral resource in Canada but ratherfor the purpose of satisfying government concerns prior to theconduct of any such exploration activities.

Position Paper #12 - Classification of oil and gas wells                     Subparagraphs 66.1(a)(ii.1) and                     66.2(5)(a)(i) and subsection 66.1(9)

1.       With respect to the issue of whether the costs of an oil         or gas well which is classified by the Province of         Alberta as being either "undefined" or "standing" should         be considered a Canadian exploration expense (CEE) or         Canadian development expense (CDE), we are of the view         that it is the status of the well which determines         whether the costs incurred are classified as CEE or         CDE.

         It is our understanding that an undefined well is one         that will be drilled into an undesignated zone or pool         and there is insufficient data available to the Energy         Resources Conservation Board (ERCB) to determine if the         zone/pool is distinct and unique, while a standing well         on the other hand is one that is either under test or the         taxpayer has requested the ERCB to hold the well         information in confidence.

         In either event, the definitions of CEE and CDE used in         the Act do not coincide with the parameters used by the         ERCB for classifying wells which in the case of an         undefined well constitutes at best, an educated guess,         since its classification is approved before the drilling         takes place.

         The Act provides, inter alia, for a classification of         wells after drilling when the status is finally known -         reference to clauses 66.1(6)(a)(ii.1)(A) and (B) which         refer respectively to a well that resulted in a         discovery of a new pool and a well that is abandoned.

2.       With respect to the issue of whether an investor in         flow-through shares would be entitled to deduct CDE         where the flow-through share agreement specifies only         CEE to be renounced, we concur with the position you         intend to take with regards to this issue that an         investor in such circumstances cannot claim CDE.

         Our view is that a legal agreement between parties will         be the law that regulates their conduct with regards to         the particular subject matter contained therein.  Once         parties have concluded an agreement represent what the         parties have agreed to and this is what the Department         will rely on in order to determine how the Act will         apply to them regarding that transaction.  Where an         agreement permits CEE to be renounced and provided that         the expense is CEE according to paragraph 66.1(6)(a) of         the Act, that expense may be renounced and flowed         through.  On the other hand where a flow-through share         agreement permits only CEE to flow through, a CDE expense         cannot be flowed through since this expense cannot be         renounced between the parties.          This procedure is followed so that the Act will be applied         on an equitable basis to all taxpayers.

3.       With respect to the issue of whether costs incurred in a  particular year regarding an oil and gas well should be  reclassified from CEE to CDE when at the time of a tax  audit, it is determined the well qualifies for CEE         treatment notwithstanding within six months after the end of the particular year and prior to the tax audit,         the status of the well was such that the costs should  have been treated as CDE, we acknowledge your         administrative position of not reclassifying the well costs from CEE to CDE when at the time of the audit, it         is established that the well qualifies as CEE in a subsequent year.