Tax angles More on the new exploration incentives

On May 3, 1988, Finance Minister Michael Wilson and Minister of Energy, Mines and Resources Marcel Masse announced measures to maintain the effectiveness of flow- through share financing for exploration, (N.M., May 9 and 16/88). These measures are:

(a) the extension of the mining exploration depletion allowance (MEDA) at 33 1/3% of qualifying CEE incurred or deemed incurred to the end of 1988, but only for individuals, and

(b) A new incentive grant program, the Canadian Exploration Incentive Program (CEIP) is to provide grants of 30% of eligible expensives effective Oct 1, 1988, for oil and gas exploration, and effective Jan 1, 1989, for mining exploration.

In our last article, we compared the economic effect of MEDA and the proposed CEIP grants and concluded that the grant system should provide marginally better economics for the flow-through share investor, as long as the grants are flowed through to the investor.

Accordingly, exploration companies and fund organizers should be considering how to structure their financings to make optimum use of the CEIP system after 1988. Only for flow-through

CEIP grants will be available only in respect of eligible expenses that have been financed by issuing flow- through shares. Accordingly, it will benefit the raising of exploration funds by corporations that are not currently taxable. In addition, CEIP grants will only be available where the investor under a flow-through share agreement deals at arm’s length with the corporation issuing the shares.

This requirement is presumably intended to deter self-dealing that could be abusive. Since eligible expenses are to be those renounced under the Income Tax Act, the restrictions applicable to such renounced expenses will apply. For example, indirect expenses and certain connected party expenses that are included in Canadian Exploration and Development Overhead Expense will not be eligible for grants. Only for exploration

Mining exploration expenses eligible for CEIP will be the “grassroots” mining CEE that would be eligible for the MEDA bonus under today’s rules. For oil and gas exploration it is contemplated that expenses relating to activities which are purely exploratory in nature and which would qualify for grants under the present Canadian Exploration and Development Incentive Program (CEDIP) will be eligible for CEIP.

For example, the expenses of drilling a wildcat exploratory well, whether a dry hole or a discovery well, will qualify for CEIP, whereas the expenses of drilling a well into a known accumulation of oil or gas will not qualify.

It might be expected that the special CEDIP rules relating to seismic and other similar surveys will apply for CEIP purposes, and that similar rules will be developed to deal with mineral data base information. Annual limits

CEIP grants are to be available for 30% of eligible expenses (subject to variation after 1990) but eligible expenses are to be subject to an annual expense limit (AEL) of $10 million for each corporation or associated group of corporations.

Accordingly, the maximum annual grant for such corporation or associated group will be $3 million.

Where a corporation elects to flow the CEIP grants to the flow- through share subscribers, the AEL of the corporation will still determine the annual limit. Since the old CEDIP program is to continue until Dec 31, 1989 (with a reduced grant rate after Sept 30, 1988), there is just one $10-million AEL for the combined CEIP and CEDIP eligible expenses.

Expenditures subject to the 60-day claw-back rule are to be applied to the AEL of the year in which the renunciation is deemed effective rather than in the year the expenses are actually incurred.

Subject to this adjustment, the AEL is to be based on expenses incurred in a calendar year. As a transitional measure, the $10-million AEL is to be available for oil and gas expenses incurred or deemed incurred in the period Apr 1-Dec 31, 1988, that are eligible for CEDIP and CEIP. Deductions interaction

A taxpayer who receives or is entitled to receive a CEIP grant will be required to deduct the amount of the grant from his cumulative CEE account, either reducing the available claim for the year or giving a recapitulated CEE amount. The time of “entitlement” would appear to be the time the grant application is approved. Where a corporation has elected to flow the grant to the flow-through share subscriber, it is the subscriber who will account for the grant in this manner.

The MEDA bonus deduction at 33 1/3% of eligible expenses is to be available to individuals for expense incurred or deemed incurred in all of 1988. Other taxpayers will earn MEDA at the rate of 33 1/3% for expenses incurred prior to July 1 and at the rate of 16 2/3% for expenses incurred after June 30. For 1989, the MEDA bonus deduction at the 16 2/3% rate will be available to all taxpayers in respect of qualifying expenses — and qualifying expenses will not include expenses eligible for CEIP. Administration

Except for the effect on the cumulative CEE account, the CEIP grants are outside the Income Tax Act. CEIP will be administered by the Department of Energy, Mines and Resources from its existing offices in Calgary and Weyburn and new offices to be established in Vancouver, Kirkland Lake, Val d’Or, Saint John, and St. John’s.

There will clearly be more paperwork involved. In addition to all the income tax forms required for a flow-through share issue, there will be separate applications for the CEIP grants.

There is the specter of overlapping audits — by Revenue Canada on the income tax amounts and by EMR on CEIP grant applications. However, based on experience with the present CEDIP program, the system can be made to work reasonably well.

There is to be no discretion as such in approving the applications. There is no pre-program clearance contemplated. If the expenses qualify and are within the AEL, the grant will be paid. Conclusion

It would clearly be preferable to have an incentive system for exploration that did not involve a separate administration and some delay factor in realizing on the incentive.

However, the proposed CEIP system is a reasonable solution to the issue faced by the government — to provide much-needed incentives to attract high-risk exploration funding while maintaining the basic thrust of tax reform.

It’s up to us all, the companies, promoters, advisors and administrators, to make CEIP work. Playfair and Dent are tax partners with Clarkson Gordon, Toronto.