2017-0735431E5 CEE for Discovery Wells

Principal Issues: Will the costs incurred for the completion of a discovery well qualify as CEE in a given situation?

Position: It depends on the particular facts.

Reasons: Amendments announced as part of Budget 2017.

Author: Christov, Boriana
Section: -

                                                                                                                April 9, 2018

XXXXXXXXXX                                                                                        HEADQUARTERS
                                                                                                                Income Tax Rulings Directorate
                                                                                                                Boriana Christov

                                                                                                                2017-073543

Classification of Costs for Drilling and Completing a Discovery Well

Dear XXXXXXXXXX:

This is in response to your email of December 6, 2017 inquiring about the classification of expenses incurred by a taxpayer in 2020 in connection with drilling and completing an oil or gas well in Canada (including expenses incurred to build a temporary access road to such well and expenses to prepare a site in respect of such well) that resulted in the discovery that a natural underground reservoir contains petroleum or natural gas (referred to as a “discovery well”). In particular, you would like to know whether these expenses will be classified as Canadian exploration expense (“CEE”) as that term is defined in subsection 66.1(6) of the Income Tax Act (footnote 1) or as Canadian development expense (“CDE”) as that term is defined in subsection 66.2(5) of the Act.

You describe the following situation:

1.    in 2020, the taxpayer starts drilling an oil or gas exploration well in a reservoir where no person or partnership has previously discovered either petroleum or natural gas and the exploration well results in a discovery of petroleum or natural gas in that reservoir (i.e., a discovery well);

2.    the discovery well is completed in 2020 (for the present purposes, it is assumed that the drilling of the well is completed on June 1, 2020);

3.    the taxpayer continues through the regulatory assessment process and obtains an approval for a development plan of the discovered hydrocarbons at the end of 2022;

4.    the construction of the project facility for the discovery well is anticipated to continue for four years and it is expected that the construction will end sometime in 2026;

5.    the commissioning and hook-up of the production facility is expected to be sometime in 2027; and

6.    the production from the discovery well is expected to occur in April 2028.

OUR COMMENTS

Written confirmation of the income tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request as described in Information Circular 70-6R7 dated April 22, 2016 issued by the Canada Revenue Agency (“CRA”). A fee is charged for this service. Although we are unable to provide any comments with respect to a particular fact situation otherwise than in the form of an advance income tax ruling, the following general comments may be of assistance.

Unless otherwise indicated, all references herein are to the Act.

Historically, expenditures related to drilling or completing a discovery well (or building a temporary access road to, or preparing a site in respect of, such well) were generally classified as CEE. However, as a result of amendments introduced in Budget 2017 (which came into force on December 14, 2017), any such expenditures incurred after 2018 will now generally be classified as CDE, subject to coming-into-force rules and other potentially applicable provisions, as outlined below.

Following the amendments described above, pursuant to paragraph (d) of the definition of CEE in subsection 66.1(6), expenditures for drilling or completing an oil or gas well will generally continue to be classified as CEE, or reclassified as CEE pursuant to paragraph (e) under circumstances described in subsection 66.1(9), in the following four alternative situations:

1.    the drilling or completing of the well resulted in a discovery and either:

a.    the expenditures are incurred before 2021 (other than expenditures deemed to have been incurred on December 31, 2020 pursuant to the look-back rule for flow-through shares in subsection 66(12.66)) in connection with an obligation that was committed to in writing (including a commitment to a government under the terms of a license or permit) by the taxpayer before March 22, 2017, or

b.    before 2019 (other than expenditures deemed to have been incurred on December 31, 2018 pursuant to the look-back rule for flow-through shares in subsection 66(12.66)) in any other case;

2.    the well has been abandoned in the year or within 6 months after the end of the year without ever having produced otherwise than for “specified purposes” as defined in subsection 66.1(6);

3.    the well has not produced within 24 months (the “24-month Period”) from the completion of the drilling of the well otherwise than for “specified purposes;” or

4.    the Minister of Natural Resources has issued a certificate (referred to as an “NRCan Certificate”) which has not ceased to be valid under subsection 66.1(10) certifying that: (i) the total of expenses incurred and to be incurred in drilling and completing the well, building a temporary access road to the well and preparing the site of the well will exceed $5,000,000 and (ii) the well will not produce (other than for a specified purpose) within the period of 24 months starting from the date on which the drilling of the well was completed.

The classification of any particular expenditures for the drilling and completing of a discovery well (including building a temporary access road to the well and preparing the site of the well) as CEE or CDE will depend on the specific facts and circumstances of each case.

In the situation outlined in your query, it is important to determine:

1.    whether any expenses to be incurred before 2021 will be incurred in connection with an obligation that was committed to in writing by the taxpayer before March 22, 2017;

2.    whether the discovery well is abandoned in the year or within 6 months thereafter without ever having produced otherwise than for specified purposes;

3.    the exact date of the completion of the drilling and whether there is any production from the well (other than for specified purposes) within the 24-month Period after the drilling is completed; or

4.    whether the taxpayer has obtained and duly filed an NRCan Certificate.

In your example, where the expenses incurred in 2020 for the drilling and completing of the discovery well were incurred pursuant to a written obligation entered into by the taxpayer before March 22, 2017, such expenses would generally qualify as CEE by virtue of clause C of subparagraph (d)(i) of the definition of that term in subsection 66.1(6) of the Act.

If there were no written obligation entered into by the taxpayer before March 22, 2017, the expenses may nevertheless qualify as CEE under paragraph (d)(iii) and (e) of the definition of that term in subsection 66.1(6) if there is no production from the well (other than for specified purposes) within the 24-month Period after the drilling is completed (footnote 2) (in this example, June 1, 2020 to May 31, 2022) and all of the other requirements are met. In particular, in such circumstances the expenses could potentially qualify as CEE as follows:

•     under subparagraph (d)(iii) of the definition of CEE for expenses incurred during the taxation year in which the 24-month Period ends (i.e., the 2022 taxation year) and prior to the end of that 24-month Period. In this case, since there are no expenses for the drilling or completion of the well in the 2022 taxation year, this subparagraph would not be applicable.

•     under paragraph (e) of the definition of CEE for expenses that are incurred in taxation years preceding the 2022 taxation year which are deemed to be CEE pursuant to subsection 66.1(9), often referred to as “reclassified CEE.” Based on the above assumptions, this would cover expenses for the drilling and the completion of the well incurred in 2020 which would be reclassified as CEE in the 2022 taxation year and could then be deductible in the 2022 taxation year.

Where the taxpayer has obtained an NRCan Certificate and it has not ceased to be valid, the expenses incurred for drilling and completing the discovery well would generally qualify as CEE under subparagraph (d)(iv) of the definition of CEE in subsection 66.1(6). In this case, the expenses would be included in CEE in the taxation year in which they are incurred and could be deductible in the same taxation year (i.e., the 2020 taxation year in the example above). The NRCan Certificate must be filed with the Minister of National Revenue within 6 months after the end of the taxation year of the taxpayer in which the drilling of the well was commenced.

Lastly, if the discovery well were abandoned, the expenses of drilling and completing the well would generally qualify as CEE under subparagraph (d)(ii) of the definition of CEE in subsection 66.1(6). However, the determination of whether a discovery well has been abandoned is a factual determination that depends on the particular circumstances of each case. Typically, there are industry standards as well as provincial regulatory requirements for an oil or gas well to be considered abandoned.

We note that the above discussion is based on the current provisions of the Act. If the Act were amended, some or all of the above alternatives that are currently available to allow expenses for drilling or completing a discovery well to qualify as CEE may no longer be applicable.

Expenses of drilling or completing a well that do not qualify as CEE will generally qualify as CDE if they meet the conditions of the definition of CDE in subsection 66.2(5). Other expenses relating to the project described above that do not qualify as CEE or CDE may be characterized as the cost of depreciable property and be included in the appropriate class of depreciable properties listed in Schedule II of the Income Tax Regulations; (footnote 3) or they could be treated as general operating business expenditures and deducted under the general rules for business expenditures in the Act. The characterization of any particular expense for purposes of the Act would depend on the specific facts and circumstances relating to that particular expense.

For more information concerning the amendments of the definition of CEE introduced with the 2017 Budget, refer to the Tax Measures: Supplementary Information which can be found at https://www.budget.gc.ca/2017/docs/tm-mf/si-rs-en.html#_Toc476839178.

We hope that these comments will be of assistance.

Yours truly,

Kimberley Wharram
Acting Manager
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  R.S.C. 1985, c. 1 (5th suppl.) as amended; hereinafter (the “Act”).
2  This would generally occur on the drilling completion date or the rig release date.
3  C.R.C, c. 945, as amended.

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