Canada: New Rules Affecting Treatment Of Oil And Gas Resource Expenses

Last Updated: April 7 2017
Article by Brian Milne

Most Read Contributor in Canada, December 2017

The 2017 federal budget (Budget 2017) introduced on March 22 included proposals to amend the Income Tax Act (Canada) (the Tax Act) that will have a meaningful impact on the Canadian oil and gas industry. The proposals:

  • restrict the types of expenses that oil and gas companies may treat as "Canadian exploration expense" (CEE); and
  • eliminate the ability for certain junior companies to renounce expenses incurred as "Canadian development expense" (CDE) to flow-through share subscribers as CEE.

These proposals are generally applicable to expenses incurred after 2018, though grandfathering is available for certain expenses incurred pursuant to an agreement made in writing before March 22, 2017.

This update provides background on these proposals and discusses their potential impact to the oil and gas industry, including for flow-through share financings.


While these proposals (described in greater detail below) are an unwelcome development for many in the oil and gas industry, they do not necessarily come as a surprise. These proposals generally accord with the platform on which the Liberal Party campaigned prior to the 2015 federal election.

The campaign platform indicated the government would seek to phase out fossil fuel subsidies, which would increase tax revenue by $125 million in 2017/2018, $250 million in 2018/2019 and $250 million in 2019/2020. Of note, Budget 2017 indicates the proposals concerning resource expenses announced in Budget 2017 are projected to generate combined revenue of $47 million in 2017/2018, $57 million in 2018/2019, and $46 million in 2019/2020. The budget materials suggest these proposals are motivated by policy rather than financial considerations, and the relatively small revenue increases attributable to these changes appear to support this position.

The proposals included in Budget 2017 that limit or restrict the availability of resource expenses are generally targeted at the oil and gas industry and generally do not affect other resource-based industries, notably mining. In addition, Budget 2017 included a number of proposals to enhance the availability of certain resource expenses in the context of renewable energy, generally in accordance with the policy positions being promoted by the government.

Restriction of CEE

The most significant of the two proposals affecting the oil and gas industry concerns the type of expenses that qualify as CEE.

Expenses incurred by a taxpayer that qualify as CEE are generally eligible for a 100% deduction against income earned by a taxpayer in the year incurred. In contrast, the other categories of Canadian resource expenses, being CDE and Canadian oil and gas property expense (COGPE), are deductible at 30% annually and 10% annually, respectively.

In the oil and gas context, CEE has generally included:

  • expenses incurred for determining the "existence, location extent or quality" of oil and gas resources (excluding costs of drilling a well);
  • expenses incurred for bringing an oil and gas resource into production prior to the commencement of production (excluding costs of drilling a well); and
  • expenses incurred for the drilling or completion of wells, and in building access roads to and preparing sites in respect of such wells, that either result in either the discovery of a new oil and gas reservoir or result in a non-producing well or abandoned well.

Budget 2017 proposes to amend the definition of "Canadian exploration expense," found in subsection 66.1(6) of the Tax Act, to exclude costs in respect of drilling or completing a well that results in discovering a new oil and gas reserve. If this proposal is enacted, expenses incurred in drilling or completing wells that result in discovering a new oil and gas reservoir (together with the costs of temporary roads to and site preparation for such wells) will generally be treated as CDE, deductible at 30% annually, while costs of drilling and completing an unsuccessful or a non-producing well will generally continue to qualify as CEE.

Budget 2017 states that deductibility of expenses incurred for successful wells at the rate of 30% (as CDE), rather than 100% (as CEE), is more consistent with the enduring nature of a successful well.

The costs of drilling new discovery wells (and associated site preparation costs) generally represent a significant portion of the expenses that would ordinarily qualify as CEE in the oil and gas context, and by reclassifying expenses for successful discovery wells as CDE, Budget 2017 shifts a significant amount of expenses from CEE to CDE. This affects the taxability of oil and gas companies, but also affects the ability of such companies to raise capital through flow-through share financings.

Impact on Flow-through Shares

Flow-through shares, which allow a resource company to renounce certain types of resource expenses to investors, for deduction by such investors against their own income, are a meaningful tool for resource companies to finance their capital-intensive businesses.

While the flow-through share rules found in the Tax Act allow companies to renounce either CEE or CDE, the majority of flow-through share offerings are in respect of CEE as investors are generally willing to pay a greater premium to the company for the accelerated deductions associated with CEE. In addition, CEE may be renounced to investors under the so-called look-back rule, which allows CEE incurred in one year, to be renounced to investors effective as of the prior year. The look-back rule is not generally applicable to renunciations of CDE.

By restricting the types of oil and gas-related expenses that qualify as CEE, oil and gas companies will face greater challenges with incurring sufficient CEE to meet commitments made to flow-through share subscribers under flow-through share financings. This will negatively affect the number of oil and gas flow-through share financings, and accordingly oil and gas companies may experience greater difficulty accessing sufficient capital.

Of note, while CEE will continue to include expenses incurred for unsuccessful discovery wells, and certain other wells that are abandoned, these expenses are unlikely to assist oil and gas companies in the context of a flow-through share financing as such companies are required to commit to a level of expense at the time flow-through shares are issued and before expenses are actually incurred. At such time, it will not generally be possible to determine which wells will be successful (the costs for which may be CDE) and which will be unsuccessful (the costs for which may be CEE), making it very difficult for an oil and gas company to provide flow-through share investors with certainty as to the specific amounts of CEE or CDE that are to be renounced. Effectively, drilling must be unsuccessful to incur drilling expenses that qualify as CEE for renunciation to flow-through investors, which is not generally the anticipated result at the time exploratory drilling is undertaken.

Elimination of CDE to CEE on flow-through renunciations by junior companies

As noted above, there is a general preference among investors to invest in flow-through shares that offer renunciation of CEE, rather than CDE. This is on the basis that CEE allows for an immediate deduction against income and may be renounced under the look-back rule. This preference allows resource companies to obtain a greater premium on flow-through shares that entitle investors to CEE, as opposed to CDE.

The flow-through share rules currently allow certain small oil and gas companies (generally those with capital under $15 million) to incur expenses that qualify as CDE, but to renounce such expenses to flow-through shares investors as CEE (the Conversion Rule). This rule has generally offered those oil and gas companies that qualify for this special treatment an enhanced ability to raise capital.

Budget 2017 proposes to repeal the Conversion Rule.

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