12 June 1992 Income Tax Severed Letter 9216605 - Resource industry farmout transactions

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

SUBJECT: RESOURCE INDUSTRY FARMOUT TRANSACTIONS SECTION: 66.1(6)(a), 66.2(5)(b), 66(12.1)]

1992 CPTS ROUNDTABLE

QUESTION

• In February, 1991 Revenue Canada announced to the Canadian Petroleum Tax Society that it was reviewing the income tax treatment of farmouts. Has Revenue Canada completed that review and if so, what is its position regarding farmouts?

ANSWER

• Revenue Canada's review of farmouts is now completed and Interpretation Bulletin IT-125R3 is being updated. Revenue Canada's position regarding farmouts is as follows:
• Simple Farmout - In a simple farmout arrangement, the owner (the farmor) of unproven resource property transfers an interest in that property to another person (the farmee) who conducts exploration and development on the property. Revenue Canada will continue the administrative position at paragraph 11 of IT-125R3 to treat the simple farmout as not giving rise to proceeds of disposition.
• Typical Farmout - In a typical farmout, the farmor transfers all of the working interest to the farmee and takes back a percentage royalty in the unproven resource property transferred. The farmee agrees to incur the exploration and development costs and equipping costs. "Equipping costs" refer solely to the cost of equipment acquired to be used at the wellsite primarily for the purpose of producing petroleum substances from a completed well. Subsequently, upon payout of the farmee, a percentage of the working interest reverts to the farmor together with a pro rata ownership interest in the depreciable property that was acquired to equip and complete the well. Revenue Canada will treat the ownership transfer of the percentage interest in the resource property and the completed wells as not giving rise to proceeds of disposition.
• Widespread Farmout - In a widespread farmout, the farmee agrees to conduct exploration and development on the farmor's unproven resource property in exchange for an interest in some other property of the farmor. Revenue Canada will treat widespread farmouts in which the farmee receives unproven resource property of the farmor as not giving rise to proceeds of disposition irrespective of whether or not the unproven resource property is contiguous to the property being explored or developed by the farmee. Widespread farmouts in which the farmor transfers property other than unproven resource property will be treated as a disposition by the farmor for proceeds equal to fair market value of the property transferred; the farmee's cost of the transferred property will equate the proceeds of the farmor; and subsection 66(12.1) will apply to reduce exploration and development expenses incurred by the farmee for the transferred property.

Prepared by: John Chan
957-8975
June 5, 1992

ISSUE SHEET

1992 CPTS Roundtable John Chan
Farmout 5-921660
June 12, 1992

This question is Rulings' announcement of its position on farmouts following the indepth review of farmouts by the Rulings and Audit Program Directorates.

The review was precipated by a letter dated February 7, 1990 to the Deputy Minister from the 24(1) Therein 24(1) stated is discontent with what it believed was a change in Revenue Canada's position on farmouts involving depreciables, i.e., the "typical farmout". The Deputy Minister replied in a December 27, 1990 letter to 24(1) that the matter was being subjected to an indepth review.

This review entailed obtaining written comments from the Department of Finance, the Department of Justice, 24(1) and meetings with same. A study of the tax treatment of farmout transactions in the United States was also conducted.

This review culminated in a discussion paper by Rulings entitled "Farmout Transactions" on April 9, 1992.

The matter was referred to the Technical Subcommittee of the Policy Committee which accepted the positions on farmouts as stated in the announcement.

The question and answer was prepared by Rulings in order to announce Revenue Canada's position on farmouts and that IT-125R3 will be revised to reflect the position. The Deputy Minister was briefed accordingly by memorandum dated June 4, 1992.

John Chan discussed the question and answer with Mr. John Bentley at his office on June 10, 1992 and he does not have any concerns about the question and answer.

In summary, the favourable tax treatment would be extended in the following situations:

• (a) where the farmee explores and develops an unproven resource property of the farmor and the farmee receives an interest in that unproven resource property;
• (b) where the farmee explores and develops an unproven resource property of the farmor and the farmee receives an interest in another unproven resource property of the farmor.

These positions reflect the tenet that the farmee is performing services in exchange for a property which cannot be valued.

A copy of the question and answer together with the issue sheet was sent by fax to Simon Thompson, Dept. of Finance on June 9, 1992 and John Chan spoke to Mr Thompson on June 10. Mr. Thompson said that Finance does not have any concerns about the question and answer.

The question and answer was reviewed by John Kurrant, Oil & Gas Specialist on June 12 and he said that he does not have any concerns.