7 June 1991 Income Tax Severed Letter - Amounts Paid for Undertaking Future Obligations - Take-or-pay Agreements

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.

Subject: Take-or-pay amounts, subsection 116(5.2)

This is in reply to your "fax" of June 24, 1991, addressed to Ollie Laurikainen of the Foreign Section of Rulings requesting an opinion regarding the implications of a take-or-pay agreement, and an election pursuant to subsection 20(24) of the Income Tax Act (the "Act") with respect thereto in determining taxes payable under subsection 116(5.2) of the Act.

In more details, the facts are:

XXX

• 3. The vendor's representative, XXX if of the view that the proceeds of disposition on the sale of the property for the purposes of section 116 of the Act include the consideration represented by the purchaser's assumption of the take-or-pay obligation, and that the deduction available to the vendor pursuant to subsection 20(24) of the Act may be deducted in the computation of the proceeds of disposition of the property in determining the taxes payable as described in paragraph 116(5.2)(a) of the Act.

In our opinion, XXX is correct on the first matter, but not on the second. As take-or-pay agreements seems unique to oil and gas operations, it is probably worthwhile to discuss them in general terms before giving the reasons for our conclusions.

Under a take-or-pay arrangement, a user of extracted gas, wishing to ensure that it will have a supply of gas available to it, pays a producer an agreed upon amount per annum in exchange for the producer undertaking to make available to the user a given amount of gas. In the event less than the agreed upon amount of gas in taken by the user in a particular year, typically, its right to delivery of the gas as yet undelivered carries forward for the balance of the term of the contract. Normally, where the contract expires, and delivery of all of the gas contracted for has not been requested, the producer may retain all amounts paid to it. Although it may be possible in law to make the requirement to deliver gas an encumbrance on the property itself, we are not aware of any instance in which this has been done. Often, where a producer sells a property, the location of the user and of any remaining producing properties of the producer make it logical for the producer to negotiate with the purchaser of the property to assume the producer's responsibilities under the take-or-pay contract.

Where a property worth, say $200, is sold, and the purchaser undertakes to assume the obligations of the vendor under an existing take-or-pay contract, the purchaser will not pay the vendor $200 for the property. Rather, the purchaser will pay the $200 less the take-or-pay obligation, of, say, $25. The result, insofar as determining the sale proceeds of the property is concerned is no different than if the purchaser had agreed to assume a bank loan of the vendor's of $25 in the course of buying a property worth $200. In both cases, the cash consideration would be $175, although, in both cases, the total paid for the property would be $200.

Where the parties transfer the unearned income under the take-or-pay agreement, and elect pursuant to subsection 20(24) of the Act, they are, in effect, putting the purchaser in the shoes of the vendor insofar as the unearned income is concerned. The vendor will have an income inclusion for the year of sale under paragraph 12(1)(e) of the Act, representing the reserve claimed by it under paragraph 20(1)(m) for the preceding year, and a deduction for the amount paid to the purchaser pursuant to subsection 2(24) of the Act. The purchaser will be deemed by subsection 20(24) to have received the amount from the vendor under paragraph 12(1)(a) of the Act, and may be entitled to a reserve under paragraph 20(1)(m) at year end.

We cannot conclude that the transfer of the unearned income in any way reflects an adjustment of the amount paid for the property, which, in our example, remains $200, notwithstanding the election under subsection 20(24) of the Act. So far, our views coincide with XXX as, incidentally, both do with David Ross, a tax lawyer specializing in oil and gas matters, on page 7 of his article "Tax Considerations Relevant to the Purchase of Assets and the Purchase of Shares" in the Canadian Petroleum Tax Journal, Vol. 1, No. 1.

We have, however, some difficulty with the suggestion that the deduction available to the vendor under subsection 20(24) of the Act has any effect on the amount of tax payable in respect of the disposition of the property. It seems to us that, firstly, the deduction is not in respect of the disposition of the property, but in respect of the transfer of the unearned income. Secondly, it seems to us that, if the deduction might be considered logically to offset any income amount, that amount would be the income inclusion under paragraph 12(1)(e) with respect to the reserve under paragraph 20(1)(m) claimed for the preceding year. As such, we cannot agree that the proceeds on the sale of the property are altered by the subsection 20(24) election. In our example, they remain $200.