Principal Issues: What are the income tax consequences with respect to an agreement where a purchaser agrees to expend money in exploration expenses in consideration for the acquisition of an undivided interest in an unproven resource property of the seller and the granting by the seller of warrants to acquire shares of the capital stock of the seller?
Position: Part of the exploration expenses incurred should constitute a consideration for a right to a share of the seller. The value of such consideration would reduce the Canadian exploration expenses of the purchaser pursuant to paragraph (j) of the definition of "Canadian exploration expense" (CEE) in subsection 66.1(6) of the Act. However, if it was demonstrated that no consideration was given by the purchaser for the warrants, subsection 15(1) would apply to include in the purchaser's income the value of the benefit. Alternatively, the warrants could be found to constitute assistance, as defined in subsection 66(15) of the Act, in respect of a portion of the CEE. This would reduce the cumulative CEE pursuant to item J of the definition of such term in subsection 66.1(6). The amount that would reduce the CEE or cumulative CEE, or the amount added in income pursuant to subsection 15(1), would constitute the acquisition cost of the warrants which would be added, pursuant to subsection 49(3), to the cost of the shares acquired at the time of the exercise of the warrants.
The administrative position stated in Interpretation Bulletin IT-125R4 with respect to the simple farm-out would apply with respect to the acquisition of the interest in the unproven resource property in consideration for the CEE that are not part of the consideration for the warrants. The property would not have an acquisition cost for the purchaser and the consideration for that part of the deal would be considered CEE if the expenses otherwise qualify. The seller would not include in its income any proceeds of disposition with respect to the disposition of the unproven resource property.
Raisons: Wording of the Act and previous positions.
January 24, 2011
XXXXXXXXXX Team Leader Income Tax Rulings Directorate Audit Division XXXXXXXXXX Tax Services Office Sylvie Labarre, CA
2010-038925
Farmout Transaction and Warrants
This is in response to your e-mail of December 2, 2010 in which you asked our opinion on the tax consequences arising from a contract, for the acquisition of a mining property, which also includes the granting of warrants ("warrants").
Background
On XXXXXXXXXX, a mining exploration corporation, XXXXXXXXXX (the "Purchaser"), signed an agreement with another mining exploration corporation, XXXXXXXXXX (the "Vendor") to acquire a XXXXXXXXXX% interest in the Vendor's properties identified as the XXXXXXXXXX properties (the "Properties"). In order to earn its interest, the Purchaser had to incur exploration expenses of XXXXXXXXXX. The Purchaser did not give any other consideration.
As part of this agreement, the Vendor also agreed to issue warrants to the Purchaser, which allowed the Purchaser to acquire XXXXXXXX shares of the capital stock of the Vendor, allocated as follows:
XXXXXXXXXX
XXXXXXXXXX
Paragraph XXXXXXXXXX of a letter dated XXXXXXXXXX between the two parties setting out the terms and conditions of the agreement to be entered into between the Buyer and the Seller reads as follows:
XXXXXXXXXX
In the final agreement signed by the parties on XXXXXXXXXX, the terms and conditions of the letter of XXXXXXXXXX were largely repeated. Thus, the introductory paragraphs of the final agreement indicate that the Vendor grants to the Purchaser the exclusive right to acquire an undivided interest of XXXXXXXXXX% in the Properties. These Properties are described in paragraphs XXXXXXXXXX and XXXXXXXX of the final agreement. Paragraph XXXXXXXXXX of the final agreement stipulates that in order to be entitled to the undivided interest in the Properties, the Purchaser agrees to incur $XXXXXXXXXX of exploration expenditures on the Properties, under the terms more fully described in the said paragraph XXXXXXXXXX. Paragraph XXXXXXXXXX of the final agreement stipulates that upon completion of the exploration program, the Purchaser will have fully acquired the undivided interest in the Properties. Finally, under the terms of paragraph XXXXXXXXXX of the final agreement, the Vendor undertakes, upon execution of the agreement, to grant the Purchaser a number of XXXXXXXXXX warrants to acquire shares in the capital stock of the Vendor, the whole in accordance with the terms more fully described in that paragraph of the final agreement.
Furthermore, the Purchaser exercised its XXXXXXXXXX warrants in the year ending XXXXXXXXXX for an amount of $ XXXXXXXXXX that it paid to the Vendor. The Purchaser thus received XXXXXXXXXX shares of the capital stock of Vendor.
The Purchaser has disposed of the shares of the capital stock of Vendor, acquired through the warrants, on the following dates and in the following numbers: XXXXXXXXXX .
XXXXXXXXXX
Question
What are the tax consequences of the agreement signed by the Vendor and the Purchaser on XXXXXXXXXXXXXX that provides for the grant of warrants by the Vendor to the Purchaser, the transfer of the Properties by the Vendor to the Purchaser and the commitment by the Purchaser to incur exploration expenses in respect of those Properties?
Our Comments
Subject to paragraph (j) of the definition of "Canadian exploration expense" in subsection 66.1(6) of the Income Tax Act (the "Act") (the "Definition"), we have assumed that the expenses incurred by the Purchaser in the amount of $XXXXXXXXXX otherwise qualify as "Canadian exploration expense" under the Definition. We also assume that for the purposes of Interpretation Bulletin IT-125R4, the Properties are unproven resource properties.
Paragraph (j) of the definition provides that the term "Canadian exploration expense" does not include any consideration given by the taxpayer for any share or any interest therein or right thereto, except as provided by paragraph (i)
Although paragraph XXXXXXXXXX of the final agreement does not expressly link the grant by the Vendor of warrants to the Purchaser to the commitment by the Purchaser to incur exploration expenses on the Properties, we are of the view, taking into account, among other things, the letter of intent and considering the final agreement as a whole, that there would be good arguments for concluding that a portion of the $XXXXXX expenses incurred by the Purchaser constituted consideration given by the taxpayer for a right in respect of a share of the Vendor. Since paragraph (i) of the Definition does not apply, that consideration should be deducted by virtue of paragraph (j) of the Definition from Canadian exploration expenses otherwise computed. That portion of the costs incurred by the Purchaser would, however, be the cost to the Purchaser of the warrants and would form part of the adjusted cost base to the Purchaser of the warrants.
With respect to the above, it is interesting to note that in Daishowa-Marubeni International Ltd. v. The Queen, 2010 TCC 317, the Tax Court of Canada held that even though the purchase price of property under the contract did not include the amount of an assumption of a liability and even though the assumption was not technically part of the consideration paid to acquire the property as set out in the contract, the fact remains that the assumption was in fact part of the consideration given to acquire the property from a legal standpoint. The Canadian Court made the following comments at paragraph [27]:
Does the fact that the final agreement between the Parties specifically excluded the assumption of liability from the purchase price have the legal effect of removing it from the consideration for the forest tenures and consequently from the proceeds of disposition? Further, does the fact that the Parties, in that agreement, only allocated the cash purchase price amongst the assets, likewise have the legal effect of removing the assumption of the liability as part of the consideration? I would answer no to both those questions. To answer positively would put form over substance in the interpretation of contracts which is not a supportable approach.
If no consideration had been given for the warrants (which seems a surprising assumption in the context where the corporation granting the warrants is a XXXXXXXXXXXXXX ), it would follow, as stated in Interpretation Bulletin IT-96R6, that a taxable benefit under subsection 15(1) of the Act would apply to ensure that the value of the benefit conferred by the Vendor on the Purchaser is included in computing the Purchaser's income.
In determining the portion of the total consideration for the warrants, we would consider the amount that would have been the benefit under subsection 15(1) if no consideration had been paid for the warrants. According to Interpretation Bulletin IT-96R6, that amount is the greater of the following amounts:
- the trading value of the rights received; and
- the amount by which the fair market value of the shares subject to the option at the time of the option's distribution exceeds the exercise price provided in the option.
As an alternative to the two alternatives stated above, you could argue that the warrants, as you valued them, would represent an amount received as assistance, as defined in subsection 66(15) of the Act. Such an amount of assistance would reduce the "cumulative Canadian exploration expense" as defined in subsection 66.1(6) under element J of that definition.
Thereafter, upon the exercise of the warrants by the Purchaser, paragraph 49(3)(b) applies so that the adjusted cost base to the Purchaser of the warrants that has been determined to be equal to the amount of the reduction in Canadian exploration expense, the inclusion under subsection 15(1) or the reduction in cumulative Canadian exploration expense described above, is added to the price paid for the Shares pursuant to the terms of the warrants.
As stated in paragraph 6 of Interpretation Bulletin IT-96R6, the Vendor is not subject to tax on the proceeds from granting an option to acquire shares of the corporation's own capital stock, bonds, or debentures when the holder exercises the option. Similarly, it is not subject to tax when the warrants are granted because of the exception provided in paragraph 49(1)(b).
Regarding the tax consequences of acquiring the Properties for consideration consisting of incurring Canadian exploration expenses, we are of the view that we could apply the position taken in Interpretation Bulletin IT-125R4 with respect to farm-out transactions. This would be a simple farm-out transaction where the owner (the farmor, in this case, the Vendor) of an unproven resource property transfers part of the owner’s interest in the property to another person (the farmee, in this case, the Purchaser) in exchange for exploration and development work on the transferred property. The farmee agrees to provide farm-out services in respect of the property and to take on the costs of such services in the form of exploration and development expenses.
Thus, the position stated in paragraph 14 of Interpretation Bulletin IT-125R4 is that "[t]o the extent that the disposition by a farmor (in a simple farm-out or a typical farm-out transaction) of an interest in an unproven resource property can be considered an exchange for farm-out services, in the form of exploration or development costs and equipping costs incurred by the farmee, the disposition does not give rise to proceeds of disposition to the farmor that are accounted for in the manner outlined in 2 above. …” Thus, in this case, the disposition of the Properties by the Vendor would not give rise to proceeds of disposition for the Vendor calculated as set out in paragraph 2 of IT-125R4.
Similarly, the CRA's current position with respect to simple farm-out transactions is that there would be no cost to the farmee to acquire a property and that the farmee may consider the expenses incurred by the farmee to be Canadian exploration expenses if the expenses meet the definition of Canadian exploration expense in subsection 66.1(6). In this regard, we refer you to 2005-0119731E5. Consequently, in this case, the Purchaser would have no acquisition cost for the Properties. However, the portion of the exploration expenses incurred by the Purchaser to enable it to acquire the Properties (this portion not including, of course, the portion subject to the reductions described above) would constitute Canadian exploration expenses to the extent that such expenses otherwise qualify as such.
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We hope that our comments will be of assistance.
Best regards,
Stéphane Prud'Homme, Notary, M. Fisc.
Manager
Mergers and Acquisitions Section
Corporate Reorganization and Resource Industry Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.