Memo to File
7-902877
Subject: Surface Rights Rentals
In this memorandum, we address the issue of whether a surface rights rental paid to the Crown is deductible in computing income of a taxpayer. We also address other related issues as described in details below under the heading of "Issues".
Background
In order to carry out mineral exploration and development operations it is necessary to obtain appropriate rights not only in the underlying minerals, but in the surface of the land as well. Historically, grants of mineral rights normally carried with them surface rights to the extent reasonably necessary to permit the mineral owner to enter, win, work and remove the minerals. However, the western provinces have by statute removed these surface rights from of the mineral estate. The surface rights statutes require that, where surface and mineral rights are vested in the same owner, any person acquiring the mineral rights must provide separate compensation for the surface rights. The surface rights may be viewed as special statutory property rights vested in the surface owners and occupants of mineral lands. The surface rights statutes do not deal only with those surface rights associated with the mineral estate. They go further and create new surface rights that did not exist at common law. These are the rights that may be acquired by operators to construct pipelines, power lines and roads that are not directly associated with a particular mineral interest. At common law such "easements in gross" did not exist as property rights and could be no higher than matters of contract. The surface rights statutes, along with the relevant land titles legislation, establish these rights and authorize, if necessary, the compulsory taking of such rights and compensation of their owners. There is no explicit distinction in the statutes between those surface rights that derive from the mineral estate and the new statutory easements. The distinction is still important since surface rights agencies (i.e. land agents) tend to consider the residual common law rights to be of a higher order and this may be reflected in compensation decisions.
The basic method of obtaining surface rights necessary for carrying out oil and gas operations is negotiation and agreement with the surface landowner. The operator's objective is to obtain the owner's consent to the operations and reach agreement on compensation. The agreement resulting from these negotiations is normally in the form of a surface lease. Only if negotiations are unsuccessful and agreement cannot be reached is it necessary to consider the right of entry and compensation procedure under the surface rights legislation. The lease describes the lands to be used and occupied and specifies the period of occupation. "Operations" are normally defined generally as all activities necessary or incidental to drilling and producing a well. The operator covenants to use only such area as is necessary for its operations, to fence the area, to compensate the owner for use of this area and for any actual damage or disturbance of the area, as well as for any off-site damage, and to restore the area to its original condition when operations are abandoned. Normally, operators will attempt to secure as long a term as possible - in the order of 25 or 30 years. Normally, the compensation includes two parts: first, a lump sum first year payment for the value of the surface rights taken and an award for general disturbance, and second, an award of annual payments for loss of use, adverse effect, and damage to land, since these effects continue through the period of use by the operator.
Audit's Position
Based mainly on paragraph (3) of TOM 14(19)2.7, Audit has taken the following position with respect to surface rights rental payments:
Both freehold and Crown surface lease rentals are operating costs if incurred on producing properties. When incurred on non-producing properties (this does not include previously producing shut-in- wells), they are eligible additions to either the Canadian development expense ("CDE") or Canadian exploration expense ("CEE") pool depending upon the status of the well.
Issues
1. Is a surface right considered to be a Canadian resource property pursuant to paragraph 66(15)(c)?
2. Is paragraph 18(1)(m) applicable to a surface rights rental paid to the Crown?
3. Is a surface rights rental on account of capital or current expense?
4. If the requirements in both paragraphs 14(5)(b) and 66.1(6)(a) or 66.2(5)(a) are met, which provision should be applied first?
Analysis and Positions Taken
1. In the western provinces, a surface right cannot be regarded as a right, licence or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons because a separate right, licence or privilege (e.g. a mineral right) must be obtained for such activities. The surface right does not meet the requirements of paragraph 66(15)(c). We concluded that the surface right is not a Canadian resource property within the meaning of paragraph 66(15)(c).
21(1)(b)
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Howard R. Williams and Charles J. Mayers define the term "lease" in The Manual of Oil and Gas Term (7th edition) at pages 503 and 504 as follows:
The conveyance of a nonfreehold interest in land. The instrument by which a leasehold or working interest is created in minerals.
They further commented as follows:
The very name "lease" is unfortunate as it tends to give the impression to the uninformed that the "oil and gas lease" is of the same genus as the common law "lease" of land... .
A mineral rights rental is sometimes referred to as "lease rental", "oil and gas lease rental" or "mineral lease rental". A surface rights rental is sometimes referred to as "surface lease rental"
21(1)(b)
3. As discussed in 1 above, a surface right is not a Canadian resource property. It is also not a tangible property, nor is it a depreciable intangible property (i.e. by virtue of subsection 1102(2) of the Income Tax Regulations, a surface right of land is not a class 13 asset). We concluded that a surface rights rental may be regarded as an eligible capital expenditure pursuant to paragraph 14(5)(b) (ie only to the extent of the lump sum payment relating to the value of the surface rights taken and any award for general disturbance). The annual surface rights rentals are recurring expenses with respect to loss of use, adverse effect, and damage to land and are fully deductible in the year incurred.
21(1)(b)
Prior to any relevant production, these annual surface rights rentals may at the taxpayer's discretion be considered as CEE or CDE pursuant to paragraph 66.1(6) (a) or 66.2(5) (a), respectively, depending upon the status of the relevant resource property.
4. The wordings of paragraphs 66.1(6)(a) and 66.2(5)(a) are very broad, any expense incurred by a taxpayer may be a CEE or a CDE pursuant to paragraph 66.1(6)(a) or 66.2(5)(a), respectively, provided the requirements under the respective paragraph are met. In a memorandum, dated March 22, 1989,
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During the meeting between Peter Lee and John Bentley on March 13, 1991.
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Conclusion
We agree with Audit's Position,
21(1)(b)