20 November 1981 Income Tax Severed Letter

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.

CALGARY DISTRICT OFFICE

HEAD OFFICE Corporate Rulings Directorate G.R. White 593-6201

J.C. Walker Basic Files

Clarification of Practice Requested by XXXX

NOV 20 1981

This is in reply to your memorandum of March 10, 1981 in which you requested clarification of our practice with respect to 1) the proper classification of the cost of an "in situ" pilot plant of the above-noted taxpayer and 2) the impact of such costs on the computation of resource profits in Regulation 1204.

Our understanding of the facts is as follows:

XXXX

1. In connection with the classification of the cost of the in XXXX pilot project, the taxpayer has suggested three alternatives:

(a) Research and development,

(b) Oil and gas well rules,

(c) Mining rules.

Research and development

Interpretation Bulletin 439, entitled The Meaning of Scientific Research, issued on September 17, 1979, and Interpretation Bulletin 151R2, entitled Scientific Research Expenditures and Allowance, issued December 16, 1980, contain all the basic information required on this subject.

As you know, our practice was and still is that if a taxpayer is entitled to claim a deduction under section 65, 66.1 or 66.2 of the Act as a result of so-called "pilot plant" operations, there is a strong presumption that he is not engaged in scientific research but that he is engaged in an excluded activity described in Regulation 2900(g) i.e. "prospecting, exploring or drilling for or producing minerals, petroleum or natural gas". This is what is meant in paragraph 17 of IT439.

The issue that must be decided in a particular case is therefore whether the taxpayer's activities are, in fact, with respect to "prospecting, exploring or drilling " or with respect to basic research, applied research or development of new or improved materials, devices, products or processes. In this context, the Minister of Finance advised the Canadian Petroleum Association on October 6, 1980 that "the costs of a pilot plant to establish whether possibilities proven theoretically on a laboratory basis can be implemented practically on a commercial basis and not constructed on a scale that could be used for continuing production will be treated as scientific research expenditures". This is consistent with paragraph 11 of IT439. Paragraph 12 of IT439 elaborates on this statement by explaining that if a pilot plant switches to operating as a normal commercial production unit, the activity can no longer be considered scientific research.

We would suggest that wherever possible, in connection with this determination, taxpayers be encouraged to request advance rulings, as described in paragraphs 19 and 20 of IT439. We can request assistance from Energy, Mines and Resources, The National Research Council, or Industry, Trade and Commerce in order to establish whether, in the view of their engineers and scientists, what the taxpayer maintains is a scientific research pilot plant is such a plant. In this context, where the taxpayer has received a scientific research grant from another Department of the Federal Government under essentially the same criteria as Regulation 2900, for a specific project, we would normally agree that the specific costs represent scientific research costs.

Oil and gas vs. mining rules

Income Tax Regulations 1104(5), (6), (7) and 1206(1) were amended on June 5, 1980, effective as of April 11, 1978. As a result, the definition of a mine for certain specific purposes no longer includes "a well for the extraction of material from a deposit of bituminous sand, oil sand or oil shale", and the meaning of income from a mine for certain specific purposes no longer includes "income reasonably attributable to the production of crude oil from bituminous sand, oil sand or oil shale". The definition of a mineral resource (section 248 of the Act), however, remains the same. Thus, a mineral resource includes a bituminous sands deposit, oil sands deposit or oil shale deposit. Accordingly, the income tax treatment of the cost of "in situ" projects is as follows:

(a) The drilling of wells in an "in situ" project does not constitute the "bringing of a mineral resource into production" but does constitute an expense incurred in "drilling an oil or gas well" (as defined effective January 1, 1981 in paragraph 66(15)(g.1) of the Act). The cost of such wells may constitute Canadian exploration expense or Canadian development expense.

(b) The expense of determining the existence, location, extent or quality of the "bituminous sands deposit, oil sands deposit or oil shale deposit", (mineral resource) is an expense referred to in subparagraph 66.1(6)(a)(iii).

(c) Machinery and equipment used in the "in situ" project constitutes gas or oil well equipment (Class 10(j) which is defined under Regulation 1104(2) and accordingly qualifies as "enhanced recovery equipment" which is defined under Regulation 1206(1). We realize the definition of gas or oil well equipment may appear anomalous because it refers to equipment acquired to be used in a gas or oil field. However, a gas or oil field is not defined in the Act, and there is no reason why that type of a mineral resource may not be in a gas or oil field.

"Preproduction revenue" of an "in situ" project (other than a pilot plant) would be treated as normal production income from an oil well. In other words, there is no special treatment available to "in situ" projects similar to the provisions applicable in respect of mining pre-commercial production costs. The mining provisions are applicable to the Syncrude type of development, on the basis that such project is an actual open pit mine located in a bituminous sands deposit. The distinction is supported in the definitions of bituminous sands equipment in Regulation 1206(1) (appropriate for Syncrude) and enhanced recovery equipment (appropriate for "in situ" projects). You will note that bituminous sands equipment refers to one or more mines in a bituminous sands deposit from which material is extracted, while enhanced recovery equipment refers to production of oil from a deposit of bituminous sand which is incremental to the oil that would be recovered using primary recovery techniques. Two different techniques are envisaged.

In connection with "in situ" pilot plant projects, we have generally taken the position that the cost of a pilot plant should be reduced by the revenues derived from its operation. The argument which has been made against this position is that such income should flow into resource profits in order to provide a resource allowance to compensate the operator for the undeductible crown charges. As a practical matter, this issue is normally resolved when one looks to what expenses are reasonably attributable to such income from production (Regulation 1204(l)(f)) and the argument that all current expenses may be so characterized.

Therefore, all of the expenses incurred in an "in situ" pilot plant which is engaged in determining the quality of a mineral resource (other than the cost of depreciable property) would fall into subparagraph 66.1(6)(a)(iii) of the Act. (This is the expense against which any preproduction revenue would be applied). The depreciable property components of such a pilot plant do not fit the definition of gas and oil well equipment which requires that the equipment be used in a gas or oil field in the production therefrom of natural gas or crude oil. A pilot plant is not engaged in production. Accordingly, such assets would not constitute "enhanced recovery equipment since they do not meet the Class 10(j) of Schedule II definition. In our view, such assets are properly described in Class 10(t) of Schedule II as property designed principally for the purpose of determining the quality of accumulations of petroleum provided they were acquired after May 22, 1979.

In the case of an "in situ" pilot plant project which qualifies for scientific research treatment, the related outlays and expenses would fall under sections 37 and 37.1 of the Act. Any incidental revenue would be applied against such outlays and expenses, as described above.

In a case where an "in situ" pilot plant changes from pilot plant status to commercial production status (see paragraph 12 of IT439) it would constitute a change in use of the assets and the rules in subsection 13(5) of the Act would apply. These rules are discussed in IT190R.

2. We have recently advised the Toronto D.O. that, in our opinion, deductions claimed under sections 37 and 37.1 of the Act do not reduce resource profits. Our opinion is based on the decision of the Supreme Court in The Queen vs The International Nickel Company of Canada Ltd. case (75 DTC 5461). In this decision, the Court examined the decision of the Federal Court of Appeal which had accepted Inco's argument that "scientific research expenditures are not related to the production of prime metal, and thereby are not deductible by virtue of the language of Regulation 1201". The Federal Court of Appeal had cited the decision of the Supreme Court in the MNR vs Imperial Oil Ltd. case (60 DTC 1219) which stated that "the profits or losses of each producing well are determined in the normal manner by ascertaining the difference between the receipts reasonably attributable to the production of oil or gas from the well and the expenses of earning those receipts". In this context the Court of Appeal then stated that profits are to be ascertained in the normal manner of calculating the difference between receipts attributable to production and the expense of earning those receipts. It then stated categorically that "the costs incurred (scientific research) are not expenses of the respondent production of prime metal". The Supreme Court agreed with these statements. We interpret all this to mean that the Supreme Court has said that scientific research is not an expense incurred in the production of petroleum, natural gas or prime metal.

We have been requested by the Toronto D.0., in response to our memorandum in this connection, to reconsider our opinion on this matter. We have agreed to refer this matter to our advisors in the Department of Justice for their opinion. Accordingly, we suggest that any action which you may be considering in this regard be deferred, pending our reconsideration of this issue.

We apologize for our delay in replying to your memorandum. If we can be of further assistance on these matters, please advise.

Chief, Mines, Oil & Forest Industries Specialty Corporation Rulings Division Corporate Rulings Directorate Legislation Branch

c.c. T.A. Sullivan Toronto D.O. Appeals 16th Floor 36 Adelaide Street