Section 66.2

Can revenues earned while a mine is in the development phase and before the mine comes into production in reasonable commercial quantities (“Pre-Production Revenues”) be netted against expenses included in a taxpayer’s Canadian development expenses under para. (c.2) of the definition thereof, rather than being included in income under s. 9?

In responding negatively, CRA noted inter alia that the purpose of moving what now was para. (c.2) from the CEE to the CDE definition was “to better align the tax treatment of pre-production mining expenditures with the tax treatment of pre-production oil and gas expenditures,” and inferred that no such netting was permitted for the latter type of expenditure, stating that:

Paragraph (a) of the definition of CDE, which addresses pre-production oil and gas expenditures, does not contemplate the netting of any Pre-Production Revenues against expenses included in CDE.

A shale gas well will generally qualify under subparagraph (a)(ii) of the definition of "oil and gas well" in s. 248(1), and consequently expenses to drill and complete the well, including building temporary access roads and preparing a site in respect of the well, "may" be classified as Canadian development expenses. However, the drilling of the well may qualify instead as Canadian exploration expense "where the drilling of a well results in the discovery that a natural underground reservoir contains petroleum or natural gas, a dry hole, or the well is shut in or abandoned within specified time limits and without having produced." Finally, the drilling may qualify for scientific research and experimental development credits if done for "experimental development of a new technology."

Can revenues earned while a mine is in the development phase and before the mine comes into production in reasonable commercial quantities (“Pre-Production Revenues”) be netted against expenses included in a taxpayer’s Canadian development expenses under para. (c.2) of the definition thereof, rather than being included in income under s. 9?

In responding negatively, CRA noted that there was a telling contrast with the permitted netting of Pre-Production Revenues in s. (f)(v.1) and (former) s. (g) of the definition of Canadian exploration expense. CRA also noted that the purpose of moving what now was para. (c.2) from the CEE to the CDE definition was “to better align the tax treatment of pre-production mining expenditures with the tax treatment of pre-production oil and gas expenditures,” and stated:

Paragraph (a) of the definition of CDE, which addresses pre-production oil and gas expenditures, does not contemplate the netting of any Pre-Production Revenues against expenses included in CDE. Therefore, permitting the netting of Pre-Production Revenues against expenses included in CDE under the CDE Provision would not be consistent with the purpose of better aligning the tax treatment of pre-production mining expenditures with the tax treatment of pre-production oil and gas expenditures.

Costs of mineral claims and exploration permits (both of which are Canadian resource properties) are CDE under para. (e).

Existing structure

Pubco, a CBCA public corporation, and Subco, its wholly-owned CBCA corporation, are partners, along with GPCo (also wholly-owned by Pubco), of Partnership D. Partnership D has a royalty which represents an interest in XX% of the net profits from the production from a specified property of two other partnerships (Partnership E and LP) and from other cash flows generated in Partnership E (the "Royalty"). The net profits are computed by reference to XX% of the interest that Partnership E owns in a specified property and by reference to XX% of the interest in LP of Partnership E.

Proposed transactions

1. All the issued shares of Subco will be exchanged by Pubco under s. 86 for one new common share and one new preferred share.
2. Pubco will acquire an undivided percentage interest in the Royalty from Partnership D in consideration for the issuance of a demand promissory note (the "Royalty Purchase Note"), with the proceeds being allocated by Partnership D to its partners (Subco and Pubco.)
3. Subco will transfer its interest in Partnership D and other "Distributed Assets" to a newly-incorporated subsidiary of Pubco (Newco 1) in consideration for redeemable preferred shares of Newco 1 with a price adjustment clause and with a s. 85(1) election made.
4. Newco 1 will redeem such preferred shares for the Newco 1 Note (also subject to a price adjustment clause), and with a contemporaneous notice that the deemed dividend is an eligible dividend.
5. Subco will redeem the preferred share issued to Pubco in 1 in consideration for transferring the Newco 1 Note and for issuing a further Note, with a contemporaneous eligible dividend notice.
6. Newco 1 will then be wound-up into Pubco. Pubco will elect to have s. 80.01(4) apply to the resulting settlement of the Newco 1 Note.
7. Pubco will transfer its undivided interest in the Royalty to Partnership D as a contribution to its capital, with a s. 97(2) election being made.

Purposes

The reorganization, by bringing principal revenue sources together in Pubco (which incurs head office and financing costs), will match operating income with related expenses, and will help Pubco to effect an income tax consolidation within Canada and move some of Subco's CCDE balances to it.

Rulings

Include: Provided that the Royalty is a Canadian resource property, Pubco pursuant to s. 98(2), and (e) of the CDE definition will incur an addition to its CCDE account equal to the fair market value of the interest in the Royalty acquired by it, and the partners of Partnership D (including Pubco) will have their CCDE reduced by their share of the FMV proceeds to Partnership D.

See more detailed summary under s. 55(3)(a).

Corporation A entered into an option agreement with Corporation B under which it obtained the right to acquire the subject claims (representing unproven resource properties) after paying stipulated sums, issuing shares and performing stipulated work in specified amounts over an 18 month period, and with the right to abandon its option at any time. What are the consequences to it?

CRA indicated that it was not prepared to extend its policy on farm-in arrangements to this situation (given that “carrying out the work on the claims does not give a right in the claims but potentially only an option to acquire them”), stating:

Consequently … the amounts paid to carry out the work on the claims of Corporation B would be added to the cash payments provided for in the agreement and would be considered part of the overall consideration given by Corporation A to acquire a property. The sums paid to carry out the work on the claims of Corporation B would therefore not constitute "Canadian exploration expenses" to Corporation A.

Therefore, assuming that Corporation A actually acquired an option to acquire the claims for the purpose of exploration or development of the claims and assuming the claims were described in paras. (b), (e) or (f) of the definition of "Canadian resource property" in s. 66(15):

[T]he amounts paid by Corporation A to Corporation B or to perform the work would be included in paragraph (e) of the definition "Canadian development expense" in subsection 66.2(5), and element A of the definition "cumulative Canadian development expense" in subsection 66.2(5.

Corporation B should add those amounts to Element F of the definition of "cumulative Canadian development expense" in subsection 66.2(5).

Consequently, taking into account the acquisition of the resource property that occurred at the time of the outlays, Corporation A could continue to deduct the deductible portion of its cumulative Canadian development expense account if it does not exercise the option. On the other hand, taking into account the acquisition of the resource property that took place at the time of the outlays, the exercise of the option would not entail any additional tax consequences to Corporation A or Corporation B.

The questioner stated that in 9406335, CRA stated that it would not extend its position in IT-125R4, para. 14 respecting farm-out arrangments that did not give rise to a disposition, to the acquisition of a royalty in exchange for exploration and drilling activities performed by the farmee on unproven Canadian resource properties of the farmor. When asked whether it would extend its policy in IT-125R4 to a situation where the interest transferred by the farmor to the farmee is a royalty, CRA stated that, as stated in 9406335, it

is prepared to consider, on an individual basis in the context of an advance income tax ruling application, whether such farmout treatment will be applied to a proposed transaction wherein a farmee is to obtain a royalty interest in exchange for exploration and drilling activities that it will perform on an unproven property of the farmor.

The Vendor sold a percentage of its interest in unproven resource properties (the “Mining Properties”) in consideration for cash paid on signing and for stipulated cash sums and shares of the Purchaser (also a public corporation) which, in each case, were to be paid over a four-year period on the four anniversaries of the effective date of the agreement. The agreement was subject to specified conditions precedent.

After noting that the Mining Properties appeared to be property described in (f) of the Canadian resource property definition, that their disposition date was “the effective date and the date on which the conditions … were satisfied,” that the sale agreement did not specify a sale price, and that in F of the CCDE definition the “the expression ‘became receivable’ should have the same meaning as for the purposes of paragraph 12(1)(b),” the Directorate first turned to the cash component of the deferred consideration and stated that, having regard to jurisprudence indicating that where proceeds included note receivable, the value of such notes was not to be discounted:

this is even more the case when it comes to monetary consideration. Thus, for the purposes of F in the definition of CCDE in subsection 66.2(5), the amount of $XXXXXXXXXX should be part of the proceeds of disposition that became receivable by the Vendor in respect of the Mining Properties on the effective date of the agreement.

Turning to the deferred share issuance consideration portion of the sale consideration, the Directorate noted that over the four-year deferred payment period, the shares’ market price could “fluctuate greatly,” and stated that the TSO accordingly might:

conclude that such portion of the proceeds of disposition for the Mining Properties by the Vendor is not determinable prior to the date of issuance of the shares by the Purchaser and that such portion of the proceeds of disposition would be recognized for tax purposes at the times of their issuance … .

The Directorate also stated that it was prepared to extend the position in IT-125R4, para. 14 respecting farmouts to this situation, so that:

an amount equal to the exploration expenses [required to be incurred by the Purchaser] would not result in proceeds of disposition to the Vendor for purposes of element F … .