NO.: IT-438R2
DATE: April 21, 1995
SUBJECT: INCOME TAX ACT
Crown Charges – Resource Properties in Canada
REFERENCE: Paragraphs 12(1)(o) and 18(1)(m) (also section 80.2, subsections 66.2(2), 66.4(2), 69(6) to (10) and 214(1), paragraph 212(1)(d), the definition “Canadian development expense” in subsection 66.2(5) and the definition “Canadian oil and gas property expense” in subsection 66.4(5) of the Income Tax Act, and sections 805 and 1211 of the Income Tax Regulations)
Application
This bulletin cancels and replaces Interpretation Bulletin IT-438R, Income From Oil or Gas Wells or Mineral Resources þ Crown Charges and Provincial Incentive Programs dated September 4, 1984. The comments in this bulletin apply after July 1990.
Summary
This bulletin describes certain income tax implications arising from amounts to which the Crown is entitled in relation to the acquisition, development or ownership of a Canadian resource property or in relation to the production in Canada from certain resource properties, referred to as “Crown charges.” Generally, a Crown charge is included in income, or is denied as a deduction, when determining income. However, certain Crown charges may qualify as a Canadian development expense or as a Canadian oil and gas property expense. This bulletin also outlines certain income tax consequences for acquisitions from and dispositions to the Crown of production from a Canadian resource property at other than fair market value.
Discussion and Interpretation
Crown charge
1. In this bulletin, the word “Crown” refers to:
(a) Her Majesty in right of Canada or a province;
(b) an agent of Her Majesty in right of Canada or a province; or
(c) a corporation, commission or association controlled by (a) or (b).
The expression “Crown charge” is used in this bulletin to mean an amount to which the Crown is entitled and which is (or may reasonably be regarded as being a substitute for) a royalty, tax, lease rental or bonus in relation to the acquisition, development or ownership of a Canadian resource property or in relation to the production in Canada from certain resource properties (see 3 below). A Crown charge does not include a tax or any portion of tax that may reasonably be considered to be a municipal or school tax or any amount prescribed in section 1211 of the Regulations. For example, under paragraph (d) of section 1211 of the Regulations, an amount of $2.50 a hectare for lease rentals paid on non-producing property is prescribed. Such an amount is, therefore, not a Crown charge and would be deductible when determining income.
2. Since there are various methods by which the Crown may impose an amount as a Crown charge, the following provisions of the Act may be involved:
(a) If any amount is paid or payable by the taxpayer to the Crown as a Crown charge in relation to the acquisition, development or ownership of a Canadian resource property or in relation to the production in Canada from certain resource properties, paragraph 18(1)(m) denies a deduction when determining the taxpayer’s income for the amount of this Crown charge (see 3 and 4 below).
(b) If any amount is receivable by the Crown as a Crown charge in relation to the acquisition, development or ownership of a Canadian resource property or in relation to the production in Canada from certain resource properties, paragraph 12(1)(o) requires the amount to be included in computing the taxpayer’s income (see 5 below).
(c) If an operator of a Canadian resource property acquires production from that operation from the Crown for an amount that exceeds its fair market value, subsection 69(7) applies to deem the acquisition to be at fair market value (see 11 and 15 below).
(d) If an operator of a Canadian resource property disposes of production from that operation to the Crown for an amount less than its fair market value, subsections 69(6), 69(8) and 69(10) apply to deem the disposition to be at fair market value (see 11 to 14 below).
(e) If an operator of a Canadian resource property disposes of production from that operation to the Crown, and simultaneously or subsequently acquires production from that operation from the Crown for an amount that exceeds its fair market value, subsection 69(7) applies to deem the acquisition to be at fair market value as determined under subsection 69(9) (see 11 and 16 below), and if the disposition to the Crown was made at less than fair market value, subsections 69(6), 69(8) and 69(10) are not considered to apply to that disposition.
Non-deductible Crown charges
3. Under paragraph 18(1)(m), a Crown charge that is paid or payable under an obligation imposed by statute, or a contractual obligation substituted for it, is not deductible when determining income if it may reasonably be regarded as being in relation to:
(a) the acquisition, development or ownership of a “Canadian resource property” (as defined in subsection 66(15)); or
(b) the production in Canada of:
(i) petroleum, natural gas or related hydrocarbons from a natural accumulation of petroleum or natural gas in Canada (other than a mineral resource) or from an oil or gas well in Canada;
(ii) metal, minerals (other than iron or petroleum or related hydrocarbons) or coal from a mineral resource in Canada to any stage that is not beyond the prime metal stage or its equivalent;
(iii) iron from a mineral resource in Canada to any stage that is not beyond the pellet stage or its equivalent; or
(iv) petroleum or related hydrocarbons from tar sands from a mineral resource in Canada to any stage that is not beyond the crude oil stage or its equivalent.
4. Paragraph 18(1)(m) refers to Crown charges paid or payable. The words “paid or payable” indicate that either the cash method or the accrual method may be used to determine the amount of a Crown charge in a taxation year for purposes of this provision provided that the method so used is consistent with the taxpayer’s established method of calculating income for tax purposes. However, only taxpayers engaged in a farming or fishing business are entitled to use the cash method when determining income. If income is calculated using the accrual method for a taxation year that does not coincide with the period for which a Crown charge is calculated, the amount of the Crown charge which applies to the taxation year should be determined using the same basis as that used to calculate the Crown charge, which, for example, may be gross sales, units of production or number of days in the relevant period.
Crown charges included in income
5. Under paragraph 12(1)(o), a Crown charge (other than one to which paragraph 18(1)(m) applies, as described in 3 above) that became receivable by the Crown under an obligation imposed by statute, or a contractual obligation substituted for it, and that may reasonably be regarded as being in relation to a taxpayer’s activities referred to in 3(a), or to production described in 3(b) in which the taxpayer has an interest, is included when determining the taxpayer’s income for the taxation year in which the amount became receivable.
Crown charges reimbursed
6. If, under the terms of a contract, a Crown charge denied as a deduction or included in income under paragraph 18(1)(m) or 12(1)(o), respectively, is reimbursed by a taxpayer who was resident in Canada or carrying on business in Canada at the time of the reimbursement, section 80.2 provides that:
(a) the taxpayer who makes the reimbursement is deemed to have paid an amount described in paragraph 18(1)(m) equal to the amount of the reimbursement; and
(b) the taxpayer who is reimbursed for the Crown charge is deemed not to have received the reimbursement.
Thus, when a taxpayer (lessor) leases an interest in a Canadian resource property to an operator (lessee), and under the terms of the agreement the lessee reimburses the lessor for the Crown charges incurred by the lessor, the lessee is deemed to have paid the Crown charges and is denied a deduction by paragraph 18(1)(m) (provided the lessee is resident in Canada or carrying on business in Canada at the time of the reimbursement). The lessor is deemed not to have received or to have become entitled to receive the reimbursement.
Crown as partner or joint venturer
7. To prevent the Crown’s share of production or profits, receivable in its capacity as a participant, from being included in the income of the other participants in those cases when the Crown is a partner or joint venturer under an agreement, paragraphs 12(1)(o) and 18(1)(m) apply only to amounts which become receivable by, or paid or payable to, the Crown under an obligation imposed by statute or a contractual obligation substituted for it. For example, assume that in the case of a Canadian resource property, the Crown, as well as being lessor of the property, is one of two equal participants under a joint venture agreement. Under the agreement, the Crown substitutes its right, as lessor, to impose a Crown charge under statute for a right to 40% of the total production. The remaining production is to be shared equally by the two participants. Paragraph 12(1)(o) would apply to the other participant for one half of the 40% of the production receivable by the Crown in place of the royalty but it would not apply to the 30% of the production receivable by the Crown in its capacity as a participant in the joint venture. For the same reason, subsection 69(6) only applies if the taxpayer makes the disposition to the Crown under an obligation imposed by statute or a contractual obligation substituted for it.
Canadian development expense and Canadian oil and gas property expense
8. A Crown charge that may reasonably be regarded as being in relation to the activities referred to in 3(a) above, other than a charge incurred to preserve a taxpayer’s rights in a Canadian resource property, may qualify as a Canadian development expense (CDE) under paragraph (e) of the definition of “Canadian development expense” in subsection 66.2(5) or as a Canadian oil and gas property expense (COGPE) under paragraph (a) of the definition of “Canadian oil and gas property expense” in subsection 66.4(5). If a Crown charge does so qualify, it is deductible when determining income, under subsection 66.2(2) or 66.4(2), as the case may be, notwithstanding paragraph 18(1)(m).
9. A Crown charge incurred to preserve a taxpayer’s rights in a Canadian resource property is not deductible when determining a taxpayer’s income because of paragraph 18(1)(m) (see 3 above), and no other provision of the Act permits a deduction. Such Crown charges are specifically excluded from the definitions of CDE and COGPE and, as a result, are not deductible under subsections 66.2(2) and 66.4(2).
Government assistance
10. Any government assistance that a taxpayer has received or is entitled to receive with respect to Crown charges will not reduce the amount of a Crown charge subject to the provisions of paragraphs 18(1)(m) or 12(1)(o).
Deemed fair market value – dispositions or acquisitions
11. In 12 to 16 below:
(a) “producer” means a taxpayer who is an operator with respect to a natural accumulation of petroleum or natural gas in Canada, an oil or gas well in Canada or a mineral resource in Canada; and
(b) “production” means any petroleum, natural gas or related hydrocarbons or metal or minerals produced in an operation referred to in (a) above.
12. Subsection 69(6) provides that when a producer disposes of production, under an obligation imposed by statute or a contractual obligation substituted for it, to the Crown for proceeds of disposition less than its fair market value at the time of disposition, the producer is deemed to have received proceeds of disposition equal to that fair market value determined without regard to the relevant statute or contract.
13. For purposes of subsection 69(6), the fair market value at the time of disposition of a unit of any particular quantity of production is deemed by subsection 69(8) to be the amount by which:
(a) the average proceeds of disposition for like units that became receivable by the Crown from persons (other than a Crown body) during the month in which the disposition occurred; exceeds the total of:
(b) the Crown’s average aggregate of certain expenses incurred during that same month for each such unit; and
(c) the amount, for the unit disposed of, that may reasonably be attributed as being an amount paid to, an amount that became payable to, or an amount that became receivable by, Her Majesty in right of Canada for the use and benefit of a band or bands as defined in the Indian Act.
The expenses referred to in (b) above are those, including depreciation, that may reasonably be attributed to transmitting, transporting, marketing or processing each such unit to the extent that such expenses are reasonable and necessary but they do not include the cost of acquiring each such unit of production.
14. For purposes of subsection 69(8), subsection 69(10) provides that when the Crown disposes of a unit of any particular quantity of production to another Crown body, they are deemed to be the same person. Thus, in these circumstances, it is the final price received by the Crown(s) that is used to determine the deemed fair market value received by the producer in 13(a) above. Similarly, it is the total of the expenses and amounts, referred to in 13(b) and 13(c) above, of the Crown which has to be used in the deemed fair market value calculation.
15. Subsection 69(7) provides that when a producer acquires production, in circumstances where the taxpayer is required by a law or contract to so acquire the production, from the Crown for an amount in excess of its fair market value, the producer is deemed to have acquired that production at its fair market value determined without regard to the relevant statute or contract.
16. When subsection 69(7) applies, and the production was originally disposed of to the Crown by the producer, subsection 69(9) deems the fair market value of such production, for purposes of subsection 69(7), to be equal to the total of:
(a) the amount, if any, paid or payable by the Crown to the producer for the production; and
(b) the amount, if any, paid or payable to Her Majesty in right of Canada for the use and benefit of a band or bands (as defined in the Indian Act) of the production.
When the specific conditions in subsection 69(9) exist, that is, when there is a disposition to and a buy back from the Crown of a particular quantity of production by the producer, subsections 69(6), 69(8) and 69(10) are considered not to apply to the disposition to the Crown if that disposition was made at less than fair market value. The example below illustrates the foregoing comments.
Example
Crown C and producer P enter into a joint venture in which each party is to participate equally. In lieu of a royalty to the Crown, C and P make the following contractual arrangements:
- C will receive the first 20% of production, and the remaining 80% is to be shared equally between C and P.
- P will sell its 40% participatory share of production to C at $11 a unit, which is $1 a unit less than fair market value.
- P will purchase 100% of the production from C at $13 a unit, which is $1 a unit more than fair market value.
Fair market value is $12 a unit, and production is 100 units.
Calculation of P’s Crown charges
The Crown charges obtained from P are $260, calculated as follows:
(a) P’s one-half contribution to C’s 20% non-participating share at fair market value: 10 units at $12 a unit (paragraph 12(1)(o)); $120
(b) ordinarily subsection 69(6) would apply to this transaction but it is not applied when subsection 69(9) is applied to the same production (see (c) and Note 1 below);
(c) the 100 units purchased by P from C are divided into two groups:
(i) P’s 40% participatory share first sold to C at less than fair market value (Note 1): 40 units at $2 a unit (subsections 69(7) and (9)); 80
(ii) C’s 40% participatory share plus 20% non-participatory share, purchased by P in excess of fair market value (Note 2): 60 units at $1 a unit (subsection 69(7)); 60
Total Crown charges $260
Note 1: The $2 per unit charge for P’s participating share that was sold to and reacquired from C, represents the excess of P’s reacquisition price of $13 a unit over the fair market value, which, under subsection 69(9), is deemed to be the price paid by C to P for the same production, $11 a unit.
Note 2: The $1 per unit charge for C’s participatory share represents the excess of P’s acquisition price of $13 a unit over the fair market value of $12 a unit.
Calculation of P’s gross profit
P’s gross profit (after selling all the production at $12 a unit) will be $340, calculated as follows:
Sales:
Disposition to C 40 units at $11 = $440
Disposition on the market 100 units at $12 = $1,200
Total sales $1,640
Cost of sales:
Purchase from C 100 units at $13 = $1,300
Gross profit $340
For tax purposes, P’s gross income would be $600 (gross profit of $340 plus the Crown charges of $260).
Crown charges of a non-resident
17. Under paragraph 212(1)(d) and subsection 214(1), it is the gross amount of a royalty or similar amount paid or credited by a person resident in Canada (or deemed to be resident in Canada by subsection 212(13.2)) to a non- resident, before any deduction for the Crown charges which are required to be borne by the non-resident, that is subject to tax under Part XIII of the Act. However, if the non-resident royalty owner is not required to bear a share of Crown charges, as, for example, when a royalty is based on net profits (after deducting Crown charges), the amount subject to the provisions of Part XIII is the amount of the royalty so calculated and paid or credited to the non- resident owner. On the other hand, tax under Part XIII will not be exigible on amounts which are required to be included, under Part I, when determining the income from a business carried on by a non-resident person in Canada. In this regard, reference should be made to section 805 of the Regulations.
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Explanation of Changes for Interpretation Bulletin IT-438R2 Crown Charges – Resource Properties in Canada
Introduction
The purpose of the Explanation of Changes is to give the reasons for the revisions to an interpretation bulletin. It outlines revisions we have made as a result of changes to the law, as well as changes reflecting new or revised departmental interpretations.
Overview
This bulletin explains the term “Crown charge” and outlines certain income tax implications arising therefrom. We revised the bulletin to reflect amendments to the Income Tax Act by S.C. 1985, c. 45 (formerly Bill C-72), S.C. 1986, c. 6 (formerly Bill C-84) and S.C. 1991, c. 49 (formerly Bill C-18).
The contents of this bulletin are not affected by any draft legislation released prior to April 21, 1995.
Legislative and other changes
To be more concise, we have changed the title of the bulletin from Income From Oil or Gas Wells or Mineral Resources þ Crown Charges and Provincial Incentive Programs to Crown Charges þ Resource Properties in Canada.
We have revised paragraph 3 to reflect the Bill C-72 and Bill C-18 amendments to paragraphs 12(1)(o) and 18(1)(m). These changes serve to further differentiate those activities that are resource activities (the Crown charges of which are not deductible) from manufacturing and processing activities (the Crown charges of which, if any, are deductible). The activities identified as resource activities are the processing of iron ore to the pellet stage (rather than to the prime metal stage) and the processing of tar sands to the crude oil stage. In addition, coal royalties are specifically identified as being within the scope of paragraphs 12(1)(o) and 18(1)(m).
We have revised paragraph 10 (former paragraph 12) to highlight that government assistance in respect of Crown charges does not reduce the amount of the Crown charge subject to the provisions of paragraphs 12(1)(o) and 18(1)(m).
Paragraph 11 (former paragraph 13) now reflects the Bill C-84 amendment to the preamble to subsections 69(6) and 69(7). This change was consequential to an expansion of the definition “Canadian exploration expense” to include operators of “a natural accumulation of petroleum or natural gas in Canada.”
Paragraphs 13 and 16 (former paragraph 15 and part of former paragraph 17) reflect the Bill C-72 amendments to subsections 69(8) and 69(9). These changes affect the deemed fair market value calculation for dispositions to or acquisitions from the Crown at other than fair market value. The deemed fair market value rules were amended to exclude amounts paid or payable for the use and benefit of an Indian band. Under Section 1211 of the Regulations, these amounts are specifically excluded from being Crown charges for purposes of paragraphs 18(1)(m) and 12(1)(o).
We have deleted former paragraph 6, which dealt with 1974 transitional law.
We have made a number of other changes to improve the overall clarity and readability of the bulletin.