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C. Savage (613) 593-6201
October 20, 1982
Dear Sirs:
Re: Regulation 5907(2) and (2.1) Adjustments
This is in response to your letter of April 19, 1982 with respect to the calculation of the earnings of a foreign affiliate (U.S. Co) of a Canadian corporation in the following circumstances:
U.S. Co is resident in and carries on an active business in the United States. It is engaged in the exploration for and production of petroleum and natural gas. The capital expenditures which it incurs in the course of exploring for petroleum and natural gas and bringing successful wells into production fall into three categories for income tax purposes in the United States:
(i) Costs associated with land and lease acquisitions are generally not deductible. These costs form part of the base for cost depletion (discussed below).
(ii) Costs associated with drilling wells and preparing wells for the production of oil and gas, other than those which give rise to tangible assets having a salvage value, are referred to as intangible drilling costs and must be capitalized unless the taxpayer makes an election to have them deducted as incurred. The section in the Internal Revenue Code (the "Code") that permits this deduction is 263(c) and this section limits the deductibility of capital expenditures.
If such casts are capitalized, they form part of the base for calculating cost depletion.
(iii) Expenditures for the purchase of or creation of assets with salvage value are considered depreciable property and are depreciated in accordance with the Code.
In determining taxable income for U.S. purposes, U.S. Co is required to deduct the greater of "percentage depletion" and "cost base depletion" in respect of the current year's production. Percentage depletion is a fixed percentage of gross revenue (currently 18%) and is restricted initially to 50% (and possibly 65%) of taxable income before any deduction for depletion. Cost base depletion is determined on a unit of production basis by dividing the cost depletion, base by the remaining reserves. The current year's depletion claimed, whether percentage or cost base, reduces the cost depletion base until this base becomes nil. Since percentage depletion is not restricted to costs incurred, the accumulated percentage depletion claimed often exceeds the total of such costs.
Regulation 5907(2)(b) to the Act would allow the addition, in computing the earnings of U.S. Co from an active business, of an amount equal to the excess of deductions allowed in determining taxable income for U.S. purposes in respect of expenditures over the amount of the expenditure. You are requesting our opinion as to whether a deduction for U.S. percentage depletion claimed in excess of actual costs incurred would be an allowable addition in accordance with Regulation 5907(2) to the Act.
While we cannot agree that percentage depletion is a deduction in respect of an expenditure since it is determined with reference to gross revenue and taxable income, in the situation which you have described, we would permit the amount of a deduction for percentage depletion in excess of the cost deple- tion base of a property to be added in computing the earnings of the foreign affiliate.
You have also requested our opinion as to whether an adjustment pursuant to Regulation 5907(2.1) to the Act is available with respect to U.S. resource properties.
Regulation 5907(2.1) to the Act allows certain adjustments with respect to a capital property. Capital property is defined for purposes of the Act so as to exclude foreign resource properties from the meaning of that term. This definition of capital property applies both for the purposes of the Act and any regulations thereto unless it is specifically modified. For the purposes of Regulation 5907(2.1) the meaning of capital property is not modified thus it is our view that no adjustment is available with respect to the cost of a foreign resource property since it is not a capital property.
We trust that this will be of some assistance.
Yours truly,
for Director General Corporate Rulings Directorate Legislation Branch