22 August 1989 Income Tax Severed Letter RCT-004

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.

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

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

Position Paper # 1 - Dual purpose Canadian Exploration Expenses (CEE) Subparagraphs 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)(a0(iii.1) as 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 if 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 a 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 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 as CEE but must be added to the appropriate Schedule 11 category 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 that 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 a 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 otherwise 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 not 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 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 be renounced pursuant to the flowthrough 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 flowthrough share at paragraph 66(15)(d.1) which requires that a "written agreement" exist between the principal-business corporation and the purchaser of the flowthrough 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 GEE, 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 expenses 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.1) 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 "i 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" for 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 to the 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 of the "all or substantially all" test would result in a rental paid for property used less than 90, for purposes of exploration or development activities being treated entirely as CEDOE, it is our view, a rental paid for property used in part for exploration or development activities and in part for some other activity cannot be all located in part to CEDOE and in part to "non-CEDOE". Paragraph (c) describes the use of the property being rented, which, in our view, is the entire property subject to the rental agreement. - Paragraph (c) clearly results in treating all of the rental paid as CEDOE in the situation described.

However, where a rented property is used 90, or more for part of the year for exploration or development activities and for part of the year does not meet this test, the portion of the rental expense incurred for the period for which the property is used when 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 direct exploration expenses, administrative expenses and markup fees charged by a connected corporation are treated any differently for CEDOE pusposes than if they had been charged by a non-connected corporation, we are of the view that whether a person is connected with a taxpayer has no effect on whether or to what extent an expense of the taxpayer is CEDOE.

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

The sole purpose of the "connected rules" is to eliminate the profit element, i.e. markup fees, from being treated as anything other than CEDOE in situations where a connected corporation charges a taxpayer in respect of Resource Expenses incurred by it.

In example 4, we would note the error in your reference to subparagraph 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 flowthrough 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 the 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 expenditures incurred in the mining industry should be classified, i.e. whether as a cost of depreciable property or GEE, we agree with your position that the cost of property described in Schedule II to the Regulations should be classified as depreciable property provided such cost Is not otherwise precluded from inclusion therein by reason of subsection 1102(1) of the Regulations.

Position Paper fill - 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 Canadian exploration expense (CEE), we agree with your position to disallow such classification except in those situations where the study has a secondary purpose which is not very minor and would meet one of the purpose tests set out in subparagraph 66.1(6)(a)(iii) or (iii.1).

In order for the cost of a feasibility study to qualify as CEE under subparagraph 66.1(6)(a)(iii), it must be incurred for the purpose of determining the existence, location, extent or quality of a mineral resource in Canada. However, it is our view that a feasibility study is too remote from these purposes since it is undertaken in order to determine whether the explorer should proceed to the development of a mine. The feasibility study also falls to qualify for CEE under subparagraph 66.1(6)(a)(iii.1) because it is undertaken for the purpose of making a determination whether or not to bring a mine into production, and not for the required purpose (under the subparagraph) of actually bringing a new mine into production.

Regarding other studies which are required by governments to obtain and maintain mining claims (i.e. environmental and ecological studies), we are of the same conviction that they are not for the purpose of determining the existence, location, extent or quality of a mineral resource in Canada but rather for the purpose of satisfying government concerns prior to the conduct 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 which is binding between them, the contents of that 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.