2008 Ruling 2007-0262881R3 - Flow through shares - farm-out agreement

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.

Principal Issues: Whether proposed Canadian exploration expenses to be incurred by a holding corporation carrying out business in Canada pursuant to a "farm-out agreement" can be renounced to flow-through shareholders.

Position: Yes.

Reasons: The "farm-out agreement" satisfies the administrative position in Interpretation Bulletin IT-125R4. By virtue thereof, the holding corporation will carry out business XXXXXXXXXX . Therefore, subsection 66(12.71) will not preclude the holding corporation from renouncing such CEE to flow-through shareholders. In this situation, the Property is "Canadian resource property" and the flow-through shareholders will be residents of Canada. The flow-through shares will be listed on the XXXXXXXXXX .

XXXXXXXXXX 							2007-026288

XXXXXXXXXX , 2008

Dear. XXXXXXXXXX :

Re: XXXXXXXXXX
Advance Income Tax Ruling

This is in reply to your letter of XXXXXXXXXX , wherein you requested an advance income tax ruling on behalf of the above-noted taxpayers. We acknowledge the various electronic messages received in respect of this ruling.

You have advised that to the best of your knowledge and that of the taxpayers above, none of the issues contained herein:

a) is in an earlier return of the taxpayers or a related person;

b) is being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayers or a related person;

c) is under objection by the taxpayers or a related person;

d) is before the courts; or

e) is the subject of a ruling previously issued by the Income Tax Rulings Directorate.

Definitions

In this letter the following terms or expressions have the meanings specified:

"Act" means the Income Tax Act, R.S.C. 1985 (5th Supp.) c.1, as amended from time to time and consolidated to the date of this letter;

"Aco" means XXXXXXXXXX , a wholly-owned subsidiary of Bco;

"AZone" has the meaning ascribed in paragraph 16 below;

"Bco" means XXXXXXXXXX , a private company incorporated under the laws of XXXXXXXXXX and a wholly-owned subsidiary of Cco;

"BZone" has the meaning ascribed in paragraph 17 below;

"Cco" means XXXXXXXXXX , a company incorporated under the laws of XXXXXXXXXX whose shares are listed on the XXXXXXXXXX ;

"Canadian development expense" has the meaning assigned to that expression by subsection 66.2(5);

"Canadian exploration expense" ("CEE") has the meaning assigned to that expression by subsection 66.1(6);

"Canadian resource property" has the meaning assigned to that expression by subsection 66(15);

"depreciable property" has the meaning assigned to that term by subsection 13(21);

"flow-through share" has the meaning assigned to that expression by subsection 66(15);

"Former Mines" means collectively the XXXXXXXXXX ;

"mineral resource" has the meaning assigned to that term by subsection 248(1);

"Other Zones" means collectively the XXXXXXXXXX described in paragraphs 8 and 9 below;

"principal-business corporation" has the meaning assigned to that term by subsection 66(15);

"Property" means the XXXXXXXXXX property located in XXXXXXXXXX , Canada consisting of approximately XXXXXXXXXX ; and

"taxable Canadian corporation" has the meaning assigned to that expression by subsection 89(1).

Our understanding of the facts, proposed transactions, purposes of the proposed transactions and additional information is as follows:

Facts

1. Cco is a company incorporated under the laws of XXXXXXXXXX , whose shares are listed on the XXXXXXXXXX . Its business office is located at: XXXXXXXXXX .

2. Cco has a fiscal year end of XXXXXXXXXX . Cco XXXXXXXXXX is not currently taxable in Canada.

3. Cco is a principal business corporation. Currently, the only assets of Cco are the shares of Bco, and the only assets of Bco are the shares of Aco.

4. Aco is a taxable Canadian corporation and a private corporation. Its business office is located at: XXXXXXXXXX .

5. Aco is incorporated under the laws of XXXXXXXXXX .

6. Aco has a fiscal year end of XXXXXXXXXX .

7. Aco's principal business is mining and exploring for minerals and it is a principal business corporation for the purposes of the Act.

8. XXXXXXXXXX (a corporation which deals at arm's length with Aco) carried on mining operations in the XXXXXXXXXX on the Property from XXXXXXXXXX until XXXXXXXXXX . Total production during this period was XXXXXXXXXX . The XXXXXXXXXX was discovered in XXXXXXXXXX but ceased operating in XXXXXXXXXX due to XXXXXXXXXX .

9. XXXXXXXXXX

10. XXXXXXXXXX

11. Other than for the brief period from XXXXXXXXXX to XXXXXXXXXX there has been no commercial mineral production from the Property since XXXXXXXXXX .

12. At the time the Former Mines ceased operations and were abandoned, all mining related equipment and moveable infrastructure was dismantled or removed from the Property. No infrastructure from the Former Mines which could support any underground or surface mining operation remains on the Property. The hoist, underground crusher, surface and underground electrical sub-stations were all removed upon closure of the Former Mines. XXXXXXXXXX .

13. Upon cessation of operations, the Former Mines were not subject to a care and maintenance program and were allowed to flood. There is approximately XXXXXXXXXX US gallons of water in the Former Mines that must be pumped from the Former Mines before any underground exploration drilling can commence. Dewatering operations began on the XXXXXXXXXX and to date XXXXXXXXXX gallons have been removed from the mine with the water table now situated at the XXXXXXXXXX L. The underground exploration drilling subsequently began on the XXXXXXXXXX from the XXXXXXXXXX L where it continues from today.

14. XXXXXXXXXX ("Xco") entered into an agreement to acquire the mineral rights to the Property from XXXXXXXXXX . in XXXXXXXXXX and conducted exploration work on the Property from XXXXXXXXXX to XXXXXXXXXX .

15. In XXXXXXXXXX , Aco acquired the mineral rights to the Property from Xco. Xco currently owns approximately XXXXXXXXXX % of the outstanding shares of Cco.

16. XXXXXXXXXX had estimated that a reserve of XXXXXXXXXX is present on the Property in a zone known as the XXXXXXXXXX (the "AZone"). This estimate, completed in XXXXXXXXXX , is historical in nature and not NI-43-101-compliant. Surface drilling by Aco has successfully repeated some of the key intersections attained by the former operators and has considerably extended the plunge-length of the AZone mineralization.

17. Approximately $ XXXXXXXXXX has been spent by Aco on surface exploration of the Property since XXXXXXXXXX and two promising zones (the AZone and the XXXXXXXXXX ("the BZone") of mineralization have been identified and partially delineated at depths ranging from XXXXXXXXXX metres to XXXXXXXXXX metres below surface. The program has reached a resource definition stage and independent consultants have advised that XXXXXXXXXX -metre drill intercepts will be required for a resource calculation. Subsequently, on XXXXXXXXXX , Aco issued its first N143-101 compliant resource. Given the depths, Aco has determined that dewatering of the abandoned Former Mines and drilling from underground is both more efficient and technically superior to drilling deep definition holes from the surface. Accordingly, a plan to dewater the Former Mines and undertake partial rehabilitation of the underground infrastructure has been designed in order to facilitate drilling from underground. To date approximately $ XXXXXXXXXX has been spent on underground exploration drilling. The water table currently resides at the XXXXXXXXXX L with services, air, water and electrical power installed down to the XXXXXXXXXX L. Aco expects to have the Mine fully dewatered shortly whereupon pre-development work will commence. This pre-development work will set up the exploration drifts that will allow the underground drills to further explore the property.

18. The newly discovered mineralization in the AZone is present in the footwall and lies approximately XXXXXXXXXX metres below the previously mined massive sulphide horizon in the Other Zones. Considering the large volumes of relatively low grade mineralization, an underground bulk tonnage mining method will be appropriate, as opposed to the former, smaller-scale, selective extraction used in the Former Mines. Accordingly, if a new mine were to be developed, it is expected that the mining techniques that would be used would be different than the techniques used in the Former Mines. Different skill sets, technical expertise and equipment will be required. The former underground infrastructure is not suitable to mine the new mineralization although limited use of the dewatered ramp may be considered. Entirely new infrastructure would have to be put in place to excavate bulk tonnages from the underground mine, including a new ramp system. Furthermore, the existing derelict shaft is not capable of supporting a bulk tonnage operation and would have to be substantially re-configured or perhaps left abandoned with a new shaft being sunk. Aco has assembled a team of key staff including management, geologists and engineers that are not Former Mine employees. XXXXXXXXXX who have been hired as an independent consultant by Aco to perform a scoping study level report, have confirmed that an entirely new mining method and infrastructure will be required to support any new bulk tonnage mine. The Property is an "unproven resource property" and at such a stage in its development that expenses incurred thereon, would still qualify as CEE.

Proposed Transactions

19. In order to advance the project, it is necessary to increase confidence levels in grade, geometry and continuity of the AZone and new resource estimates. This will be accomplished through additional surface drilling, but given the depths and costs involved, it is also proposed to conduct the delineation and definition drilling from underground with access through the dewatered ramp used by the Former Mines. The underground exploration drilling has started although to date only XXXXXXXXXX m have been drilled within a minimum XXXXXXXXXX m drill program.

20. Cco proposes to issue some of its common shares as "flow-through shares" in a public offering to investors for proceeds of approximately, but not limited to, $ XXXXXXXXXX . Cco intends to offer these flow-through shares on the XXXXXXXXXX to members of the public that are residents of Canada. Cco will use a broker or dealer resident in Canada to facilitate the issuance of this offering. Cco may use a private placement. In the case of private placements, Cco will provide the CRA with the name, address, social insurance number of, and number of shares acquired by each investor. The net proceeds of this offering will be used to finance the exploration program on the Property. Cco will file a T100A with the Canada Revenue Agency and will apply for a Selling Instrument T100 Identification Number.

21. Aco and Cco will enter into an option agreement (the "Agreement") whereunder Aco will grant Cco an exclusive option to acquire an undivided working interest in the Property (the "Option"), currently estimated at between XXXXXXXXXX % to XXXXXXXXXX % for an investment of between $ XXXXXXXXXX and $ XXXXXXXXXX . The undivided working interest has been determined on the basis of normal commercial terms between parties dealing at arm's length. Under section XXXXXXXXXX of the Agreement, Cco must fund and incur a specified amount of expenditures (the "Expenditures") on the Property. The specified amount of the Expenditures will be equal to the aggregate amount of qualifying exploration expenses that Cco has committed to expend pursuant to the flow-share agreements relating to the offering described in paragraph 20 above. If Cco has made the Expenditures in accordance with this provision, Cco will be required to provide a written notice of exercise of the Option to Aco and Cco will be deemed to have exercised the Option. The amount of the working interest that will be the subject of the Option will be equal to the specified amount of the Expenditures divided by the fair market value of the Property, which has recently been appraised at $XXXXXXXXXX .

Cco intends to incur the Expenditures on the Property in the course of:

(a) prospecting,
(b) carrying out geological, geophysical, or geochemical surveys,
(c) drilling by rotary, diamond, percussion, or other methods, and
(d) trenching, digging test pits, and preliminary sampling.

Other than its obligation to incur the Expenditures, Cco will not give any additional consideration to Aco to acquire its working interest in the Property on the exercise of the Option. You have advised that only CEE will be incurred by Cco on the Property and that no depreciable properties or other amounts will be acquired or incurred by it in order to earn its applicable interest in the Property. Cco will act as Operator during this period.

Cco will use arm's length contractors to conduct the work described herein. As noted in paragraph 20 above, Cco will use the proceeds from the flow-through share offering to pay the contractors. The contractors intend to use their own specialized drilling equipment. Cco will not acquire an interest in Aco's depreciable property.

The Agreement will specify that Cco will not be acting as agent for Aco and that the Agreement does not create a partnership or joint venture arrangement.

This arrangement will constitute a "simple farm-out transaction" as described in Interpretation Bulletin IT-125R4. By virtue of carrying on the exploration activities, Cco will be carrying on business in Canada and will file the required income tax returns in Canada.

22. Following completion of the exploration program, Cco will renounce the CEE, under subsections 66(12.6) and 66(12.66), to the Canadian resident investors to whom the flow-through shares were issued as described in paragraph 20. Cco will file form T101A in respect of this renunciation. The CEE to be renounced to a flow-through share investor will not include any amount incurred in respect of the exploration program described in paragraph 21 before the later of:

a. the date that the flow-through share agreement is entered into with each investor; and

b. the date that the Agreement is executed.

Cco will comply with the provisions of Part XII.6 of the Act in respect of the proposed transactions.

23. Following completion of the exploration program and the renunciation of the CEE, Cco will transfer the working interest in the Property to Aco in return for shares of Aco. Cco and Aco will jointly file an election under section 85 to deem Cco's proceeds of disposition and Aco's cost of the working interest to be the elected amount, which will be a nominal amount. Cco's adjusted cost base of the shares of Aco received as consideration for the working interest will be equal to the elected amount.

24. Following the underground exploration program, the completion of a feasibility study and assuming a positive decision, Aco expects to incur capital costs to develop a new mine on the Property.

Purpose of the Proposed Transaction

25 The proposed expenditures to be incurred to complete the proposed exploration work will allow Aco to gain greater confidence and certainty with respect to the location, nature, extent and quality of the mineralization in the Property. If the exploration program is successful, and assuming a positive production decision can be made and a mine development financed then Aco intends to take the project to production.

26 The purpose for using this particular structure is because it will be easier for Cco to issue the flow-through shares since it is publicly listed on the XXXXXXXXXX. However, it is intended that the flow-through shares will be issued only to residents of Canada. The purpose of issuing flow-through shares is to provide financing for the CEE that will be conducted on the Property, which is a Canadian resource property.

Rulings

Provided that the preceding statements constitute a complete and accurate disclosure of all the relevant facts, proposed transactions and purpose of the proposed transactions, and provided further that the proposed transactions are carried out as described above, our rulings are as follows:

A. An expense incurred by Co, after the date of this letter, and in respect of the exploration program (referred to in paragraph 21 above), which is incurred for the purpose of determining the existence, location, extent or quality of a mineral resource in the AZone and BZone, including any expense incurred in the course of:

(i) prospecting,

(ii) carrying out geological, geophysical, or geochemical surveys,

(iii) drilling by rotary, diamond, percussion, or other methods, or

(iv) trenching, digging test pits, and preliminary sampling,

but not including any Canadian development expense, will qualify as Canadian exploration expense of Cco pursuant to paragraph (f) of the definition thereof contained in subsection 66.1(6) provided:

(a) the expense does not constitute the cost, or any part of the cost, to Cco of any depreciable property; and

(b) the expense is incurred before a mine comes into production in reasonable commercial quantities in respect of any mineralization that may be found in the AZone pursuant to the exploration program (described in paragraph 21 above).

B. Provided that XXXXXXXXXX , subsection 66(12.71) will not apply to prevent Cco from renouncing the CEE to an investor that acquires flow-through shares as described in paragraph 20.

COMMENTS

Except as expressly stated, our rulings do no imply acceptance, approval or confirmation of any income tax implications relating to the facts or proposed transactions. In particular, nothing in this letter should be interpreted as confirming, either expressly or implicitly:

a) the determination of the fair market value or adjusted cost base of any property referred to herein;
b) whether any particular expense incurred by Cco in respect of the exploration program referred to in paragraph 21 above will qualify as a Canadian exploration expense of Cco. Expenses incurred in order to determine the economic feasibility of whether or not to proceed with developing a new mine, or that are related to the processing or sale of the mineral do not, in our view, satisfy the purpose test in either paragraph (f) or (g) of the definition of Canadian exploration expense; and
c) whether any share in the capital stock of Cco which is issued as contemplated in paragraph 20 above will be a flow-through share.

The above rulings are given subject to the limitations and qualifications set forth in Information Circular 70-6R5 issued by the Canada Revenue Agency on May 17, 2002, and are binding provided that the proposed exploration program described in paragraph 21 above commences before XXXXXXXXXX .

These rulings are based on the Act in its present form and do not take into account the effect of any proposed amendments thereto.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislation Policy Regulatory and Affairs Branch