6 December 1989 External T.I. 58955 F - Flow-through Shares

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.

December 6, 1989

Dear Sirs:

Re:  Request for Technical Interpretation Flow-through Shares under paragraph 66.1(6)(a)(v)

We are writing in reply to your letter dated October 13, 1989, in which you requested our interpretation of the flow-through share provisions of the Income Tax Act (the "Act") viz. subparagraph 66.1(6)(a)(v) and paragraph 66(15)(d.1) thereof.

24(1)

As expressed at paragraph 3 of Information Circular 70-6R, dated December 18, 1978, the Department will not express opinions on definite transactions that are being proposed other than by way of an advanced income tax ruling, nor will the Department provide rulings on completed transactions.

Nevertheless, the following general comments concerning hypothetical circumstances similar to those described in your letter are being provided for your assistance.

ASSUMED FACTS

To facilitate our comments, we will assume the ensuing facts:

1.     Pursuant to a mutual prospectus dated May 15, 1986, companies X, Y and Z, collectively "the Companies" raised initial funds by the sale of Class "A" Units and Class "B" Units to investors (the "Subscribers").

2.     Each Class "A" Unit consisted of one common share and two warrants of each of the Companies.

3.     Each Class "B" Unit consisted of one non-transferable Deposit Receipt and two warrants of each of the Companies.  The Deposit Receipt represented the right to earn, on a flow-through basis, one common share ("Earned Share") of X, Y and Z for 40¢, 25¢ and 25¢ respectively expended by the Companies on behalf of the Subscribers of Class "B" Units to incur CEE.

4.     Each X warrant entitled the holder to purchase one common share at a price of 80¢ per share or to one non-transferable Deposit Receipt entitling the holder to earn one Earned Share of X by making expenditures of 80¢ on CEE.  Each Y warrant entitled the holder to purchase one common share at a price of 50¢ per share or to one non-transferable Deposit Receipt entitling the holder to earn one Earned Share of Y by making expenditures of 50¢ on CEE.  Each Z warrant entitled the holder to purchase one common share at a price of 50¢ or to one non-transferable Deposit Receipt entitling the holder to earn one Earned Share of Z by making expenditures of 50¢ on CEE.

5.     All warrants were exercisable on or before May 15, 1987 at which time they expired.

6     The Subscriber of Earned Shares is entitled to grants available under the Ontario Mineral Exploration Program ("OMEP"). The grants were assigned by Subscribers to the Companies in order for the Companies to incur expenses on behalf of the Subscribers for the purpose of earning further Earned Shares.

7.     X, Y and Z have incurred CEE in approximate amounts of $515,000, $92,500 and $94,000 respectively in respect of grants received for the latter part of 1987 and grants receivable for 1988 under the OMEP.

8.     The Companies follow the "old rules", i.e. subparagraph 66.1(6)(a)(v) of the Act, governing flow-through shares which existed at the issuance of the prospectus, i.e. May 15, 1986.

YOUR OPINION

Your submission pertains to the CEE incurred in 1987 and 1988 by the Companies on behalf of the Subscriber of the Class "A" and Class "B" Units as follows:

1.     The CEE should continue to be treated under the old rules and should qualify as eligible CEE to the Subscriber after the CEE program has been completed and the shares are issued to the Subscriber.

2.     The prospectus of May 15, 1986 is an agreement consisting of a number of other agreements (presumably the flow-through share agreements).

3.     If the "new rules", i.e. paragraph 66(15)(d.1) of the Act, apply and as a consequence thereof a two year limitation is imposed on the incurrence of CEE, then the limitation should apply in segments, i.e. two years to spend the original deposit receipt received in May of 1986, two years to spend the deposit receipts from the exercise of the warrants in May of 1987 and two years from the receipt of each grant received and to be received under the OMEP.

COMMENTARY

Prior to December 19, 1986, the term "flow-through share" was not defined in the Act.  A flow-through share was generally understood to mean a share of the capital stock of a corporation issued by the corporation to a taxpayer in a situation where, pursuant to an agreement in writing entered into before 1987 between the taxpayer and the corporation, the taxpayer agreed to incur CEE described in any of subparagraphs (i) to (iii.1) of paragraph 66.1(6)(a) of the Act solely in consideration for the share or a right thereto or an interest therein.  This was enunciated in subparagraph 66.1(6)(a)(v) of the Act which, among other things, is now generally referred to as the "old rules" pertaining to flow-through shares.

Effective December 19, 1986, "flow-through share" is specifically defined in new paragraph 66(15)(d.1) of the Act.  This definition, among other things, constitutes the "new rules" governing flow-through shares.  The new definition is applicable to (a) shares issued pursuant to an agreement in writing entered into after 1986; and (b) shares issued pursuant to an agreement in writing entered into by a corporation after February 1986 and before 1987 where the corporation has elected in prescribed form within a specified time to have paragraph 66(15)(d.1) apply.

The assumed facts indicate that the Companies followed the old rules governing their issue of flow-through shares, hence no election was made to have paragraph 66(15)(d.1) apply to the agreements entered into during 1986.  Consequently, paragraph 66(15)(d.1), the new rules, would have application to those flow-through share agreements entered into by the Companies after 1986, whereas paragraph 66.1(6)(a)(v), the old rules, would apply to those agreements entered into before 1987.

A taxpayer's CEE is defined in paragraph 66.1(6)(a) of the Act.  With respect to CEE incurred after December 18, 1986 under a flow-through share mechanism, subparagraph 66.1(6)(a)(v) is relevant to a taxpayer who purchases the flow-through share.  It provides that a taxpayer may include in his CEE, expenses which qualify for treatment as CEE for purposes of the Act which were incurred by him pursuant to an agreement in writing with a corporation, entered into before 1987, under which he incurred the expenses solely as consideration for shares, other than prescribed shares, of the capital stock of the corporation which are issued to him; or any interest in such shares or right thereto.

With respect to CEE incurred prior to December 19, 1986, there was no requirement that the expenses be incurred pursuant to an agreement in writing with a corporation, entered into before 1987; the requirement was that the incurrence be pursuant to an agreement with a corporation.  Since, however, the CEE described in the facts were incurred in 1987 and 1988, they would be eligible CEE of the Subscribers for purposes of subparagraph 66.1(6)(a)(v) of the Act only if, among other things, they were incurred pursuant to an agreement in writing, entered into before 1987; otherwise such CEE will not qualify as CEE of the subscribers as they will be expenses incurred in consideration for shares (subparagraph 66.1(6)(a)(vi)) and will not be excepted from the application of subparagraph 66.1(6)(a)(vi) by subparagraph 66.1(6)(a)(v) of the Act.

In our view the agreement referred to in subparagraph 66.1(6)(a)(v) of the Act is the flow-through share agreement entered into between the Subscribers and the Companies.  It is also our view that an "agreement in writing" is precisely that, i.e. a "written agreement" and nothing less.  Subparagraph 66.1(6)(a)(v) of the Act requires that this written agreement exist between a subscriber of a flow-through share and the corporation.  In our view, this written agreement must not only reflect the intention of the parties but must be legally binding upon both of them.  A prospectus is a document prepared by a Company which describes the nature and objects of an issue of shares or other securities created by the Company and invites the public to subscribe to the issue of the securities.  A prospectus is not itself an agreement between two parties.  We therefore do not share your view that the prospectus of May 15, 1986 is an agreement consisting of a number of other agreements.

Based on the assumed facts, it would appear that a "right" to a share which would qualify as a flow-through share would include the warrants and Deposit Receipts (collectively, the "Rights") of the Companies provided that these are options granted to a Subscriber to acquire flow-through shares within the meaning of subparagraph 66.1(6)(a)(v) of the Act.  The CEE incurred in 1987 and 1988 by the Companies on behalf of the Subscribers of such Rights would thus fall within the ambit of subparagraph 66.1(6)(a)(v) and would be eligible CEE of the Subscribers; provided that the said CEE was incurred pursuant to an agreement in writing entered into before 1987 under which it was incurred solely as consideration for acquiring the Rights; and provided that the Companies have complied with the various conditions set out in the Act concerning the incurrence of CEE.

With respect to the shares, i.e. the Earned Shares, issued by the Companies upon exercise of the Rights, it is our view that a new agreement is entered into on the date that the Rights are exercised.  Thus, the CEE incurred in 1987 and 1988 would be available to Subscribers under the old rules only in respect of Earned Shares issued upon exercises of Rights that took place during 1986, this being the time that the new agreement in writing would be considered to have been entered into.

In order for Rights or Earned Shares issued to Subscribers pursuant to agreements in writing entered into during 1987, i.e. warrants and Deposit Receipts issued or exercised during 1987, to be eligible for treatment as flow-through shares under the new rules, and as a consequence thereof, CEE incurred in 1987 and 1988 could be renounced thereon, all of the conditions in the definition of flow-through share in paragraph 66(15)(d.1) of the Act would have to be fulfilled.  One of the conditions is that pursuant to the flow-through share agreement, the corporation must agree to incur the CEE.

According to the assumed facts, however, the Companies have followed the old rules governing flow-through shares whereby the Subscriber and the Companies agreed that the Companies would incur CEE on behalf of the Subscriber.  In this case, it is the subscriber, not the corporation, that incurs the CEE.

It appears therefore that the shares and rights thereto described in the assumed facts would not qualify for treatment as flow-through shares under paragraph 66(15)(d.1) of the Act.

Regarding your submission on the application of the two year limitation in segments under the new rules, our response is that if paragraph 66(5)(d.1) were to apply and, as a consequence thereof, the Companies were required to incur CEE within a two year period, subparagraph 66(15)(d.1)(i) states that the CEE must be incurred during the period commencing on the day the agreement was entered into and ending 24 months after the end of the month that includes that day.  Consequently, we do not agree with your contention that the 24 month period should be applied in segments.

CONCLUSION

Based on the above assumed facts and commentary and provided that:

(1)     the Companies have complied with the various conditions set out in the Act concerning the incurrence of CEE on behalf of the Subscribers,

(2)     the shares qualify as flow-through shares within the meaning of subparagraph 66.1(6)(a)(v) of the Act, and

(3)     the expenses are incurred pursuant to agreements in writing with the Companies,

     our interpretation is that the CEE incurred in 1987 and 1988 by the Companies on behalf of the Subscribers would be eligible CEE of the Subscribers pursuant to subparagraph 66.1(6)(a)(v) of the Act to the extent that the CEE may be incurred in respect of

(1)     Earned Shares issued upon the exercise of Warrants and Deposit Receipts before 1987,

(2)     Deposit Receipts issued before 1987 which have not been exercised prior to the incurrence of the CEE.

We would add that it is our view that the OMEP grants which the Subscribers have received or are entitled to receive would reduce their cumulative CEE pursuant to subparagraph 66.1(6)(b)(ix) of the Act, which provides for the reduction of cumulative CEE for assistance received or entitled to be received in respect of any CEE incurred after 1980 or that can reasonably be related to Canadian exploration activities after 1980.

For greater certainty and to avoid any possible misunderstanding, we are not expressing any opinion on whether the amounts in the assumed facts are CEE for purposes of the Act.  Whether or not the said amounts or portions thereof are properly classified as CEE under subparagraphs 66.1(6)(a)(i) to (iii.1) of the Act are questions of fact that can only be determined after examination of all of the relevant facts of the particular situation.

The above comments are only expressions of opinion and as such should not be construed as advance income tax rulings, nor are they binding on the Department.

Yours truly,

J.T. GauvreauSection ChiefResource Industries SectionBilingual Services and ResourceIndustries DivisionRulings Directorate