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Ottawa, March 6, 1996
1996-016
Draft Amendments Relating to the Resource Allowance and Other Matters
Related documents:
Finance Minister Paul Martin today released draft legislation and revised draft regulations dealing with the resource allowance and related matters.
The draft amendments include new measures designed to provide for a more stable interim resource allowance structure until further changes come into effect after 1996, as outlined in the Budget. There are also new rules providing for depreciable property treatment in connection with certain assets built by taxpayers. New rules also clarify the treatment of refund interest for corporations that engage in resource activities and the determination of Canadian exploration expenses, Canadian development expenses and foreign exploration and development expenses.
Most of the draft amendments relate directly to the resource allowance, which is provided to taxpayers instead of allowing for the deduction of provincial Crown royalties and mining taxes in computing income. These amendments clarify original draft regulations issued in July 1992 and further draft regulations, issued in March 1993, dealing with the calculation of the resource allowance for members of partnerships.
The 1992 draft regulations were issued in response to a court case (The Queen v. Gulf Canada Limited) which has resulted in substantial tax refunds, together with interest, becoming payable in the mining and oil and gas sectors. The Government took steps to reduce its future risks with respect to the adverse interpretation of the law by passing legislation in June 1995 which requires all large corporations to specify and quantify their outstanding tax issues.
The draft regulations will be processed as soon as possible. The draft amendments to the Act will be included as part of the package of income tax amendments needed to implement the proposals in the Budget.
The draft amendments, together with an overview and detailed explanatory notes, are attached. References in the notes and draft amendments to "Budget Day" and "Budget Day - 1" should be read as references to today's date and yesterday's date, respectively.
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For further information:
Simon Thompson
Tax Legislation Division
(613) 992-0049
Overview
The draft amendments released today cover a number of issues, but primarily affect taxpayers in the mining and oil and gas sectors. The issues of most interest to taxpayers outside these sectors are the draft amendments affecting the tax treatment of certain roads and other properties funded, but not owned, by taxpayers. An overview of the proposed amendments is provided below. These amendments are described in detail in the accompanying explanatory notes.
1. Terminology: "Gross Resource Profits", "Resource Profits" and "Adjusted Resource Profits"
Under the existing Income Tax Regulations, "resource profits" are determined under subsection 1204(1) of the Regulations. 25 per cent of "resource profits" (after a number of adjustments) may be deducted under paragraph 20(1)(v.1) of the Act in computing income. The deduction is known as the "resource allowance". The determination of resource profits is also relevant in computing the special depletion deductions available to taxpayers under section 65 of the Act.
Under the amendments, "resource profits" will be determined under subsection 1204(1.1) of the Regulations, rather than subsection 1204(1). Instead, the amount determined under subsection 1204(1) will be referred to as "gross resource profits" in recognition of the fact that the Courts determined in the Gulf case that the existing regulations were not sufficiently broad to require the allocation of certain deductions (specifically, certain capital cost allowance claims and scientific research expenditures). The resource allowance will be determined with reference to 25 per cent of "adjusted resource profits", which is defined in subsection 1210(2) of the Regulations.
2. Allocation of Deductions to "Resource Profits" and "Adjusted Resource Profits"
Every amount that is deducted in computing a taxpayer's income for a taxation year will also be required to be deducted in computing the taxpayer's "resource profits" and "adjusted resource profits" for the year unless there is an exemption provided.
The exemptions are designed to preserve the existing treatment of a number of specified deductions (including depletion deductions, exploration and development expenditures, deductions in respect of resource properties and interest deductions) and to allow for the reasonable allocation of deductions to profit-earning activities that fall outside the scope of activities covered by the "resource profits" and "adjusted resource profits" definitions.
The revised amendments in this regard clarify the draft amendments released in July 1992 in response to the Gulf case and apply to taxation years that end after July 23, 1992.
3. Resource Allowance and Partnerships
The Act no longer allows the resource allowance to be used to increase the loss or reduce the income that is allocated by a partnership to its members. Instead, a partnership's adjusted resource profits or losses will be allocated under the draft amendments to partners for the purpose of determining each partner's own resource allowance. These rules are designed to prevent partnerships from being used to maximize the resource allowance through the isolation of profit-earning and loss-producing resource properties.
The current draft amendments clarify those released in March 1993 to deal with the resource allowance and partnerships.
4. Treatment of Net Profit Interests
Under the existing resource allowance rules, royalty payments made by a taxpayer with a working interest in a resource property to a taxpayer who holds a net profit interest in that property do not result in any reduction of the payer's resource allowance. Conversely, royalties received on net profits interests are not allowed to increase resource allowance.
This treatment has given rise to a number of financing arrangements under which net profit interests are used to significantly increase the overall resource allowance that is available. By carving out a net profit interest from a working interest, the holder of the working interest can substantially decrease the amount paid for depreciable properties associated with the working interest. As a consequence, the amount of the resource profits that qualify for the resource allowance can be inappropriately increased.
To address this issue in a manner which minimizes complexity, it is proposed to make a further adjustment in the way in which adjusted resource profits are computed. A royalty on a net profit interest -- referred to in the law as a "specified net royalty" -- paid by the holder of a working interest will now be required to be deducted in computing the payer's adjusted resource profits. However, the recipient will be allowed to include 1/2 of the royalty in computing the recipient's adjusted resource profits. This adjustment is to apply to royalties paid on net profit interests created after [Budget Day - 1].
5. Treatment of Service Income
The draft amendments clarify that, in general, income from services rendered is not treated as resource profits for the purposes of the resource allowance and the capital cost allowance rules. This recognizes that the providers of services are not required to bear the cost of Crown royalties or mining taxes. These amendments are contained in draft paragraphs 1102(1)(a) and 1204(3)(c) of the Regulations.
6. Anti-Avoidance
The draft amendments contain an anti-avoidance rule that is designed to prevent taxpayers from entering into arrangements with non-arm's length parties in order to minimize the costs that are allocated to resource profits and adjusted resource profits. In these circumstances, the draft amendments generally require the reduction of a taxpayer's resource profits and adjusted resource profits to the extent that the amount charged is less than the fair market value of any property or services provided to the taxpayer. For further details, see amended paragraph 1204(1.1)(c) and new subsection 1204(1.2) of the Regulations.
7. Refund Interest
The draft amendments ensure that corporations in the mining and oil and gas sectors will not be entitled to increase their entitlement to the manufacturing and processing tax credit because of the receipt of refund interest. These amendments should not be construed as implying that the receipt of refund interest previously had the result of increasing such entitlement. Refund interest is defined in draft subsection 5203(4) of the Regulations as interest arising from the overpayment of income and mining taxes, Crown royalties and similar amounts.
8. Canadian Exploration Expense, Canadian Development Expense and Foreign Exploration and Development Expenses
The definitions of these expressions in sections 66 to 66.2 of the Act will be amended to clarify that they do not reflect the capital cost of depreciable property. These definitions are relevant for the purpose of the resource allowance rules because such resource expenditures generally do not result in a reduction of adjusted resource profits.
9. Special Rules for Roads and Other Properties not Owned by a Taxpayer
In a number of cases, taxpayers may incur costs or make expenditures relating to the building or use of roads or similar properties where the taxpayer does not actually acquire ownership of the property. New subsection 13(7.5) of the Act generally will provide for depreciable property treatment in these circumstances. This amendment is linked to the changes to the resource allowance rules because capital cost allowance deducted in respect of depreciable property is required to reduce resource profits and adjusted resource profits.
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