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

Last Updated: April 7 2017
Article by Brian Milne

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.

Background

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.


About Norton Rose Fulbright Canada LLP

Norton Rose Fulbright is a global law firm. We provide the world's preeminent corporations and financial institutions with a full business law service. We have 3800 lawyers and other legal staff based in more than 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.

Recognized for our industry focus, we are strong across all the key industry sectors: financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and life sciences and healthcare.

Wherever we are, we operate in accordance with our global business principles of quality, unity and integrity. We aim to provide the highest possible standard of legal service in each of our offices and to maintain that level of quality at every point of contact.

For more information about Norton Rose Fulbright, see nortonrosefulbright.com/legal-notices.

Law around the world
nortonrosefulbright.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions