8 June 1990 Income Tax Severed Letter ACC9599 - Deduction of Provincial Drilling Penalties

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.

June 8, 1990

Special Audit Division Resource Industries
Section
E.N. Gauthier John Chan
Director (613) 952-9019

Specialized Industries Section
S. Kapur (Calgary D.O.)

• SUBJECT: OBJET: Request for Technical Interpretation - Payments under Section 16 of the Petroleum and Natural Gas Agreements Regulation of Alberta ("Drilling Penalties")

We are writing in reply to your request, dated April 25, 1990, for a technical interpretation in relation to the nature of drilling penalties and whether the payment of these penalties could be permitted as deductions in computing income under the Income Tax Act (the "Act").

FACTS

Our understanding is that petroleum and natural gas leases ("PNG leases") are entered into with the Province of Alberta pursuant to the Petroleum and Natural Gas Agreements Regulation ("PNGAR") of Alberta. The relevant sections of the PNGAR are as follows:

• 2. This regulation applies to petroleum and natural gas rights that are the property of the Crown in right of Alberta.
• 3. (1) The annual rental for a petroleum and natural gas lease or a licence is $2.50 per hectare payable yearly in advance.
• 15. A lessee of a 10-year lease shall commence drilling operations on the location of his lease on or before the first day of the 7th year of the term, and shall continue drilling operations diligently and continuously to the satisfaction of the Minister, for the purpose of evaluating the petroleum or natural gas, the rights to which are granted by the lease.
• 16. (1) The Minister may, during the term of a 10-year lease, extend the time for the commencement of drilling operations under section 15 from year to year until the expiry date of the term of the lease upon payment to the Minister of a penalty determined in accordance with subsection (2).
(2) The penalty payable under subsection (1) is
• (a) $2.50 per hectare for the first year,
• (b) $7.50 per hectare for the 2nd year,
• (c) $12.50 per hectare for the 3rd year, and
• (d) $22.50 per hectare for the 4th year, for each hectare contained in the location.
17. (1) A lessee is not required to commence drilling operations on the location, of a 10-year lease if
• (a) the Minister considers the location to be capable of producing petroleum or natural gas in paying quantity.
• (b) the location is subject to a unit operation, or
• (c) the Minister waives the requirement to commence drilling operations.
25. If a lessee
• (a) fails to comply with section 15 with respect to part of the location of his lease and fails to pay any penalty under section 16 with respect to that part of his location, ... the Minister may cancel the lease or licence, as the case may be, as to that part of the location."

YOUR VIEWS

Specialized Industries Section has opined that the drilling penalties, ie. payments under section 16 of the PNGAR, do not fall within the ambit of paragraph 18(1)(m) of the Act and are therefore deductible business expenses under paragraph 18(1)(a) of the Act.

Paragraph 18(3)(m) of the Act prohibits the deduction of any amount paid or payable by virtue of an obligation imposed by statute, or a contractual obligation substituted for an obligation imposed by statute, to a province as a royalty, tax, lease rental or bonus, or as an amount, however described, that may reasonably be regarded as being in lieu of any such amount, and that may reasonably be regarded as being in relation to, inter alia, the acquisition, development or ownership of a Canadian resource property.

Specialized Industries Section noted that the drilling penalties are not in the nature of a royalty, tax, lease rental or bonus, or an amount, however described, that may reasonably be regarded as being in lieu of any such amount. Thus, they concluded that the drilling penalties do not fall within the ambit of paragraph 18(1)(m) of the Act.

Rather, in their view, the payments meet the definition of a "penalty" and since penalties are not prohibited from deduction by paragraph 18(1)(m), the inference was made that the drilling penalties must be deductible under paragraph 18(1)(a) of the Act.

OUR COMMENTS

Nature of the Payments As provided in section 15 of the PNGAR, a lessee in a petroleum and natural gas lease with the Province of Alberta (the "Crown") is required to commence drilling within 6 years of commencement of the lease. If no drilling has commenced within that period, the Crown may terminate or cancel the lease under section 25 of the PNGAR.

The lessee may however extend the 6 year period, within which commencement of drilling is required, by paying the amount specified in subsection 16(2) of the PNGAR to the Crown, thereby ensuring continuance of the lease. It is the nature of these payments that are in question and which have been referred to as drilling penalties.

The drilling penalties are analogous to the payments considered in Francis D. Sparrow vs MNR, [18 Tax A.B.C. 11] 57 DTC 453, T.A.B.. Therein, the taxpayer and an associate granted to an oil company an oil and gas lease on a tract of land they owned jointly. Under the terms of the lease, the company agreed to start drilling a well within 90 days. When drilling was delayed due to legal difficulties, the company sought and obtained an extension of the time limit for the commencement of drilling operations and in return agreed to pay the lessors $500 monthly until the matter was settled. The payments were held to have been received on account of capital.

With respect to whether the payments for deferral of commencement of drilling are "penalties", R.S.W. Fordham, Q.C. had this to say in the Sparrow case at page 455 "Just how a witness describes a particular payment, when giving evidence, is of no significance. He may refer to it as "deferred rental" or a "penalty", as, if I remember correctly, occurred in the present case, or by some other name. In any event, it matters not, as it is the true legal designation that must govern in the final analysis. This may not always be easy to determine, but is there to be found, nevertheless."

In an opinion to the Calgary District Office dated March 7, 1979, Mr. M. A. Hiltz of Corporate Rulings wrote regarding delay rentals

• "Delay rentals are payments made under certain petroleum and natural gas leases in order to
• (a) extend the time in which drilling must begin, or
(b) keep the lease in existence
• (i) after drilling has begun but has been halted, or
• (ii) after drilling has ended and a well capable of production has been brought into existence but is not producing."

Other descriptions of delay rental are as follows:

• 1. Oil and Gas terms, Seventh Edition, page 230
• "A sum of money payable to the lessor by the lessee for the privilege of deferring the commencement of drilling operations or the commencement of production during the primary term of the lease."
• 2. The Oil and Gas Lease in Canada, Second Edition, page 125
• "The annual payment made to defer the commencement of drilling operations is normally referred to as a delay rental, the reference to `delay' recognizing that by such payment the commencement of drilling operations may be postponed or delayed. The courts have also pointed out on many occasions that the payment is not a rent. This sum was not paid as rent but was paid for the privilege of postponing the obligation to drill, ... obviously, the sum of money paid each year by the oil company to the appellants was not rent but was the purchase price of an extension of the time fixed for drilling. The payments bad none of the characteristics of rent.' (Duncan vs. Joslin (1965) 51 W.W.R. 346)."
• 3. Delay Rental Payments Under Petroleum & Natural Gas Leases, M. Arthur Mears, Canadian Bar Review, 1960, page 264
• "Delay rental has been defined as a sum of money payable by the lessee to the lessor for the privilege of deferring the commencement of drilling operations or the commencement of production during the primary term of the lease."

In our view, the drilling penalties which are provided for under section 16 of the PNGAR are delay rentals in the context of the above meanings.

Black's Law Dictionary, Fifth Edition defines "penalty" as "An elastic term with many different shades of meaning; it involves the idea of punishment, corporeal or pecuniary, or civil or criminal, although its meaning is generally confined to pecuniary punishment".

This definition is followed by a statement at the same place that "A penalty provision operates to compel performance of act and usually becomes effective only in event of default on which a forfeiture is compelled without regard to actual damages sustained by party aggrieved by breach." On the basis of this description of the operation of a penalty provision, coupled with the belief that the relevant sections of the PNGAR are penalty provisions to compel performance, Specialized Industries Section adopted the position that the drilling penalties are "penalties" for purposes of determining how they should be treated under the Act.

Since the lessee is not compelled to pay the drilling penalties, ie. the drilling penalties may be paid at the option of the lessee depending on whether the lessee wishes to obviate cancellation of the lease, the payment does not embody the idea of punishment.

Consequently, it is our view that the payments would not constitute a "penalty" but rather a "delay rental".

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For reasons for maintaining that the drilling penalties are delay rentals and not penalties will be evident in the ensuing discussion.

Paragraphs 18(l)(a) and (b)

Since the decision in the Sparrow case, the Department has taken the position that payments such as the drilling penalties, which are made under petroleum and natural gas leases in order to extend the period within which commencement of drilling is required, are payments on account of capital.

Consequently the drilling penalties would not be deductible business expenses under paragraph 18(l)(a) because they are prohibited from deduction by virtue of paragraph 18(l)(b) of the Act.

Paragraph 18(l)(m)

Paragraph 18(l)(m) of the Act denies deduction of certain payments to the Crown which would otherwise be deductible business expenses under paragraph 18(l)(a) of the Act.

Since the drilling penalties are not considered as deductible business expenses under paragraph 18(l)(a), but rather as payments on account of capital under paragraph 18(l)(b), paragraph 18(l)(m) is not relevant to determining the income tax treatment of the drilling penalties.

Although for different reasons, we concur with Specialized Industries Section that paragraph 18(1)(m) does not apply to the drilling penalties.

Paragraph 66.4(5)(b)

Petroleum and natural gas leases are generally considered to be Canadian resource properties by virtue of subparagraph 66(15)(c)(i) of the Act, ie. property that is any right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada.

The Department's position has been that delay rentals under petroleum and natural gas leases, ie. payments made to defer commencement of drilling, are payments for the cost of Canadian resource property.

Paragraph 66.4(5)(b) of the Act defines Canadian oil and gas property expense ("COGPE") and provides at subparagraph (i) thereof, for inclusion therein, of the cost of any property described in subparagraph 66(15)(c)(i),(iii) or (iv) or a right to or interest in such property, but not including any payment made to any of the persons referred to in any of subparagraphs 18(1)(m)(i) to (iii), such as the Crown, for the preservation of a taxpayer's rights in respect of a Canadian resource property.

Thus, a drilling penalty would otherwise be included in COGPE as a cost of property described in subparagraph 66(15)(c)(i), but is specifically excluded therefrom as a payment to the Crown for the preservation of rights in respect of a Canadian resource property, ie. a payment for continued existence of the PNG lease.

Paragraph 14(5)(b)

Paragraph 14(5)(b)of the Act defines eligible capital expenditure ("ECE") as an outlay or expense made or incurred by a taxpayer on account of capital for the purpose of gaining or producing income from the business.

The cost of tangible property and the cost of an interest in tangible property are excluded from ECE by virtue of clauses 14(5)(b)(iii)(A) and (D) of the Act, respectively. Petroleum and natural gas leases are generally considered to be in the nature of an interest in land - see Berkheiser v. Berkheiser, 57 S.C.R. 387, wherein Rand J. wrote at page 392 that the petroleum and natural gas lease in question was either a profit à prendre or an irrevocable licence to search for and to win the substances named. He also wrote at the same place that the lessor's liability for payment of taxes with respect to the ownership of mineral rights "treats the legal title to the substances as remaining in the lessor and the interest of the lessee as analogous to that of an ordinary lessee of land, that is, as having only an interest in relation to them."

The drilling penalties which would thus be considered as the cost of an interest in land, would therefore fall within the ambit of an interest in tangible property, thereby being excluded from ECE under clause 14(5)(b)(iii)(D) of the Act.

Regulation 1211

Section 1211 of the Income Tax Regulations (the "Regulations") prescribes amounts for the purposes of paragraphs 12(1)(o) and 18(1)(m) of the Act and provides, inter alia, generally for the deductibility of lease rentals paid to the Crown under PNG leases of up to $2.50 per year per hectare of land covered by the lease.

As discussed previously, paragraph 18(1)(m) of the Act is not relevant to the treatment of the drilling penalties under the Act and, as a consequence, section 1211 of the Regulations is not applicable to the drilling penalties.

Other

In the answer to question 20 of the Revenue Canada Round Table, page 319, Canadian Petroleum Tax Journal, Fall 1988, it was stated that -"Delay rental payments to the Crown would therefore appear to be non-deductible. However, we have been allowing deductions for such amounts to the extent prescribed by Regulation 1211. We have taken this position because the Department of Finance has stated that it was always intended that payments to the Crown to the extent permitted by Regulation 1211 be deductible."

As indicated in the foregoing discussion, deduction of the drilling penalties under Regulation 1211 would not be technically supportable.

We note also that the amount of deduction permitted under Regulation 1211 is limited to rentals of $2.50 per year per hectare. Since the annual rental under PNG leases with the Crown is $2.50 per year per hectare under subsection 3(1) of the PNGAR, it is a moot pont whether the drilling penalties are precluded from deduction under Regulation 1211.

Conclusion

Drilling penalties paid to the Crown are not deductible in computing income under the Act. They are true "nothings".

Our comments, as stated above, have been discussed and confirmed
informally with 23 and with Mr.
Simon Thompson, Tax Policy Office of the Department of Finance.

Director
Bilingual Services & Resource
Industries Division
Rulings Directorate

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