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 certain expenses can be renounced to flow-through shareholders.
Position: An expense that qualifies as a Canadian exploration expense and that also meets the definition of CEDOE in Regulations 1206 is not eligible for renunciation to flow-through shareholders.
Reasons: Requirements of the law.
XXXXXXXXXX 2007-024692
Fiona Harrison
September 12, 2007
Dear XXXXXXXXXX:
Re: Flow through shares
This is in reply to your letter of July 24, 2007, wherein you requested our comments with respect to the treatment of certain expenses incurred on an exploration project funded with flow-through shares.
In particular, you have advised that you are the sole shareholder of a corporation that conducts mining exploration for clients on a contractual basis. Your clients use their employees to design the exploration program and to perform certain administrative duties, whereas your company performs the engineering duties. Your clients issue flow-through shares to finance the exploration project. You note that these are short-term exploration projects that generally take a month to complete. Your specific question relates to the renunciation of expenses to flow-through shareholders.
The particular situation outlined in your letter appears to relate to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R5 dated May 17, 2002, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. However, we are prepared to offer the following general comments that may be of assistance.
All statutory references herein are references to the Income Tax Act.
Whether any expenditure qualifies for treatment as a Canadian exploration expense ("CEE") is a question of fact to be determined from all of the relevant facts and circumstances. In this regard, the requirements of paragraph (f) and (g) of the definition of CEE in subsection 66.1(6) would have to be satisfied in order for these particular expenditures to be treated as CEE. In order to qualify as CEE under paragraph (f), an expense has to be incurred for the purpose of determining the existence, location, extent or quality of a mineral resource in Canada. It is our view that expenses that do not meet the purpose test in paragraph (f) of the definition will only be eligible to be included in paragraph (g) of that definition if they are incurred for the purpose of bringing a mine in a mineral resource in Canada into production in reasonable commercial quantities. In other words, the expenses must be incurred after the decision has been made to proceed with bringing a new mine into production in reasonable commercial quantities.
Subsection 66(12.6) permits a "principal-business corporation", which is defined in subsection 66(15), to renounce CEE to its flow-through shareholders; however the amount of CEE which may be renounced would have to be reduced, under paragraph 66(12.6)(b), by any of those CEE expenses that are prescribed Canadian exploration and development overhead expenses ("CEDOE") as defined in subsection 1206(4.2) of the Income Tax Regulations (the "Regulations"). In general terms, the effect of paragraph 66(12.6)(b) is that expenditures which qualify for treatment as CEE but which also fall within the ambit of the definition of prescribed CEDOE would not be eligible for flow-through share renunciation.
Pursuant to subsection 1206(4.2) of the Regulations, "prescribed CEDOE" includes any expenses that fall within CEDOE, as well as the profit element of any payments made by the taxpayer for goods, services or rights to use property made to a person, or a person who is connected to a person, to whom the expense is renounced pursuant to the flow-through share provisions.
CEDOE, which is defined in subsection 1206(1) of the Regulations, includes:
(a) costs in respect of administration, management or financing, such as:
(i) activities directed towards the establishment of organizational policies and objectives,
(ii) planning, directing and controlling the activities of an organization,
(iii) administering and controlling the financial resources of an organization;
(b) salary, wages or other remuneration of an employee whose duties are not all or substantially all directed to exploration or development activities. For these purposes, the remuneration of an employee engaged in exploration activities are considered all or substantially all directed to exploration or development activities if 90% or more of this employee's time is devoted to those activities. For example, if a geologist is paid on a salary basis with a company and spends 60% of the time on geological work, and 40% on administration, the full amount of the geologist's salary would not be eligible;
(c) payments for taxes, insurance, maintenance, rental or leasing of property that is not all or substantially all used in exploration or development activities. A property will be considered to be all or substantially all used in exploration or development activities where the property is used at least 90% of the time in such activities; and
(d) amounts paid to a person with whom the taxpayer is connected for goods, services or rights to use property to the extent that the amount charged exceeds the cost to the connected person of providing the goods, services or rights to use the property. In general, persons are connected if they do not deal at arm's length, or, where one of the persons is a corporation, the other has an equity percentage of at least 10% in the corporation (subsection 1206(5) of the Regulations). Generally, a person's equity percentage is the aggregate of the person's direct equity percentage in the particular corporation and the aggregate of all percentages each of which is the product obtained when the person's equity percentage at that time in any corporation is multiplied by that corporation's direct equity percentage at that time in the particular corporation.
Generally, administrative expenses would fall into the ambit of paragraph (a) of the definition of CEDOE and would, therefore, not be eligible for flow-through share renunciation. It is noteworthy that there is no "all or substantially all" test in paragraph (a). Some companies rely heavily on consultants to perform exploration, financing and management functions. The payments to the consultants could cover a variety of services. For example, where a consultant engineer prepares a reservoir report primarily to determine the viability of drilling a well but with the secondary intention that the reports would also be used to prepare reserve reports for the annual report of the corporation, the expense would be considered "in respect of" administration, management or financing. Consequently, the entire payment to the consultant for this work would be CEDOE.
With respect to salaries of employees, pursuant to paragraph (b) of the definition, the salary of an employee whose duties are not all or substantially all (i.e. less than 90%) directed to exploration or development activities would not be eligible for renunciation. For example, if a technologist's salary is accepted for inclusion in CEE, it may still be considered CEDOE if the duties of the technologist are not all or substantially all directed towards exploration or development activities. In addition, salaries of geologists, geophysicists, engineers and technicians involved in certain activities, such as preparing information for the investment community, may not meet the 90% test and should be considered for inclusion in the CEDOE calculation.
We trust the above comments are of assistance to you.
Yours truly,
for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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