ADJUSTMENTS TO THE CANADIAN RESOURCE ALLOWANCE ARE COMING, AND WHILE THEY MAY NOT BE FAVOURABLE, THE HOPE IS THEY WILL BE FAIR

Mining and oil and gas activity in Canada is considered significant as Canada is the world's 11th largest petroleum producer, the third-largest natural gas producer and among the top five world producers of 15 mineral commodities. Yet, until now, there have been relatively few comprehensive changes to the federal Income Tax Act related to taxation of the energy sector. Changes are looming and they could leave the sector with a great uncertainty about its fiscal regime. Adjustments to the resource allowance regime are coming and they won't be favourable, but the hope is they will at least be fair. To date, developments have been to tighten the rules and restrict incentives available to the mining and oil and gas industry.

Although the energy sector is thought of as mining, oil and gas and electrical generation, this article focuses on mining and oil and gas as these are nonrenewable resources and are given different tax treatment compared with electrical generation.

Electrical generation is typically considered a part of the utilities sector, although many fully integrated companies in the energy sector also have significant investments in electrical generation. The taxation of electrical generation is similar to that of manufacturing and processing in that it is eligible for a similar credit: 5% for 2001 and 7% after 2001. Effective January 1, 2001, the federal tax rate on electrical generation is 23%, and 21% on manufacturing and processing. The federal tax rate on oil and gas and mining activities remains at 28%. The federal tax rate reduction that increases to 7% by 2004 does not apply to income earned by oil and gas companies on upstream activities and on income earned by mining companies on production and initial processing activities.

Within the energy sector, there are significant differences between taxation of the mining and the oil and gas sectors. For example, preproduction development expenses in oil and gas are deductible at a rate of 30% on the declining balance; for a mining operation, these expenses can be written off at 100%. The cost of a mineral resource property can be written off at 30%, and for an oil and gas property, at 10%, both on the declining balance.

There are also significant differences between the higher amounts of such expenditures for a mine compared with a conventional oil and gas well. However, this distinction is not as prevalent as it used to be when one considers the significant capital required for an oil and gas play in the Atlantic or the tar sands projects in Alberta.

Except for mining and oil and gas equipment, which is generally written off for income tax purposes at a rate of 25% on declining balance, the early expenditures associated with a mining or an oil and gas play would generally be classified as Canadian exploration expense (CEE), Canadian development expense (CDE) or Canadian oil and gas property expense (COGPE).

If the play is situated in a foreign jurisdiction, these expenditures were grouped into a category called foreign exploration and development expenses (FEDE).

The rates of writeoff for these are generally 100%, 30%, 10% and 10% respectively. Expenditures in these categories are pooled so the unclaimed balance of each pool is carried forward indefinitely and claimed in the future.

Resource allowance
The energy sector is subject to provincial taxation in the form of mining taxes, royalties and other provincial levies that are not deductible for income tax purposes. The resource allowance, generally 25% of resource profit, is provided in lieu of deductibility of these provincial charges. One of the looming changes is elimination of the resource allowance. It is not yet known whether there will be complete elimination of the resource allowance and replacement of this deduction with full or partial deductibility of provincial taxes and levies, but the issue is under consideration by the Department of Finance.

The sector awaits the fate of the resource allowance with bated breath, as the expectation is that Finance will eliminate it and permit full or partial deductibility of provincial taxes and levies. The federal tax reduction should then be applicable to mining and oil and gas operations.

Provincial taxes and levies on the mining sector as a whole are lower than the resource allowance that is intended to compensate for the nondeductibility of such provincial charges. There is considerably less difference between nondeductible provincial charges and resource allowance in the oil and gas sector as a whole. The resource allowance should be continued for the mining sector, or alternatively, some other form of assistance for the sector could replace it. The mining industry has made submissions to the government for general income tax reduction.

Provincial taxation
Recent announcements by the provinces to reduce corporate income tax rates have created disparity between the effective provincial tax rates among provinces. In view of the economic downturn, it remains to be seen if the provinces will proceed with previously announced tax rate reductions.

Needless to say, the disparity in tax rates has made tax practitioners pay attention to tax planning for recognizing income in lower tax rate provinces.

Mining incentives
The governments of Quebec, British Columbia and the Yukon have recognized the need that junior mining companies have for assistance in obtaining financing for mining exploration, and have initiated programs to provide an exploration tax credit (up to 20% in some cases) with respect to grassroots CEE in conjunction with flow-through shares. The federal government provided a similar tax credit for individuals (not trusts) who invest in flow-through shares of corporations that incur grassroots CEE after October 17, 2000, and before 2004. This new mining exploration tax credit provides an individual with a 15% investment tax credit on mining exploration expenditures renounced to the individual by a corporation under a flow-through share agreement. Unfortunately, a similar credit has not been extended to the oil and gas sector.

CEE/CDE
The act was amended to clarify that a taxpayer's CEE, CDE and FEDE don't include the cost of depreciable property. These amendments received royal assent in 2001 and are applicable retroactively to property acquired after 1987. The definition of CEE was also amended in 2001 to clarify that drilling and completion costs for an oil and gas well would qualify as CEE only if the drilling or completion of the well resulted in the initial discovery that a natural underground reservoir contains petroleum or natural gas.

FEDE
For a foreign oil and gas or mining play, there have been changes to the rate of writeoff for FEDE and the foreign tax credit claim related to a foreign resource property. After February 27, 2000, expenses that would have qualified as FEDE are called foreign resource expenses. Unlike FEDE, FRE of a taxpayer must be related to a foreign resource property that is owned or will be owned by the taxpayer. FRE can still be claimed at a rate of 10% on the declining balance when there is no income from the foreign resource property. However, whereas FEDE can be claimed at 100% to the extent of income in the taxation year from the foreign resource property, the claim for FRE is limited to a maximum 30% deduction to the extent of income in the taxation year from the foreign resource property. In addition to this, in order to calculate the foreign tax credit, a separate FRE pool must be kept for each country and the FRE deduction has to be sourced to the relevant country so as to determine the business income in respect of that particular country.

Production tax amount
In relation to exploration, development and production in a foreign country, there is a new regime that provides for a production tax amount in production sharing contracts to be treated as an amount that would give rise to a foreign tax credit against Canadian income taxes payable. This is a favourable legislative amendment; but as many would say, it merely provides a level playing field with other taxpayers in foreign jurisdictions that already had a similar mechanism in place.

Mergers and acquisitions
In 2001, there were several significant acquisitions of Canadian oil and gas companies by US investors. These were facilitated by the favourable currency exchange rate for the US acquirer and double-dipping structures that provide interest deductions in both Canada and the United States and do not limit the amount of debt borne by the Canadian operations. Different types of inbound financing structures and particular variations exist within each structure, depending on individual client needs. The synthetic NRO structures are usually used when the US parent is providing related party financing. However, the synthetic NRO structure has a 10% withholding tax cost arising on interest and is subject to Canada's thin capitalization restrictions. The hybrid bond structure utilizes US source long-term third party financing and, as a result, has no withholding tax or thin capitalization restrictions.

Joint ventures, partnerships and trusts
Exploration, development and production activities in the energy sector require significant financing but are also very risky ventures. Different business structures are used to facilitate sharing risk, to pool capital and to bring exploration and development expertise to the resource property. Joint ventures and partnerships are commonly used to structure these projects. Since a joint venture is not a separate entity, the joint ventures share the revenue and expenses associated with exploration, development and production. A partnership achieves a similar result by the net profit or net loss of the partnership being shared by the partners.

The royalty trust is popular and the use of a business trust to carry out production operations is receiving more attention. There is some apprehension with business trusts due to the lack of tax-deferred rollovers into and out of the trust. Since resource assets are depleting assets, a tax-deferred rollout at the end of the life of the resource property may not be an important issue. Nevertheless, it can be addressed with creative tax planning. Losses in a business trust cannot flow through to beneficiaries, but trust income can be allocated to beneficiaries and claimed as a deduction by the trust. The tax advantages to a business trust include that they are not subject to large corporations tax and provincial capital tax; income earned by the trust can be flowed out to investors on a pre-tax basis, unlike resource income earned by a corporation that is taxed in the corporation before distributions to shareholders.

Flow-through shares
Corporations in the oil and gas sector with no more than $15 million of taxable capital are permitted to incur up to $1 million in Canadian development expenses and renounce these expenses to flow-through share investors as Canadian exploration expense.

The investor can claim the CEE at the more favourable rate of 100% compared with the 30% rate of writeoff for CDE. The limit of $1 million on eligible CDE and the cap of $15 million are too low and would have to be expanded in order for sufficient capital to be available for oil and gas exploration.

A frequently asked question is whether seismic costs can be renounced to flow-through share investors. Costs to shoot and create seismic data in the course of exploring for oil and gas or minerals can be renounced. Seismic costs related to off-the-shelf seismic data cannot be renounced. (Off-the-shelf seismic refers to data purchased from a vendor that did not shoot the seismic and create the data, seismic data that other persons had a right to use, and seismic data where more than 90% of the work to create the data was performed more than a year before being purchased.)

Any significant changes regarding the resource allowance will affect the effective tax rate for the mining and oil and gas sector. Hopefully, these changes will be mitigated by a reduction in the tax rate applicable to the energy sector. The mining and oil and gas industry is lobbying the government for reduction of the tax rate applicable to the energy sector. In the meantime, the general tax planning strategy is to defer income to future years as much as possible.