SUBSECTION 111(5) SAME OR SIMILAR BUSINESS CONSIDERATIONS IN AN OIL AND GAS CONTEXT Prepared for: 2014 CPTS FALL LECTURE SERIES October 16, 2014 Matthew Kraemer Felesky Flynn LLP
SUBSECTION 111(5) Why This Is Topical Review of Subsection 111(5) Basic Test Two Examples Applying Subsection 111(5) That Demonstrate Interpretive Challenges Considerations re Combination of Entities Post Acquisition of Control Takeaways Page 2
INTRODUCTION: LOSS RESTRICTION EVENT Concept of loss restriction event introduced in 2013 budget. Used to be the case that loss streaming rules applied where there was an acquisition of control. Now loss streaming rules apply to an expanded set of circumstances beyond where there is a de jure acquisition of control. Introduced rules for trusts and corporations controlled by trusts. LRE when a person becomes a majority interest beneficiary of a trust. Burghardt and Chiu, Loss As a Four Letter Word, 2013 CTF Annual Conference Good place to start to understand rules More planning may rely on interpretations of 111(5). Page 3
POLICY BACKGROUND TO 111(5) Discussion of policy background to 111(5): Policy is important to understand ambiguity in text demands a purposive interpretation Government shares in income - it should share equally in losses But loss trading is restricted Nothing inherently wrong with utilizing losses before or after an acquisition of control provided legislative requirements met The examples in this presentation involve generically similar businesses (oil and gas exploration and production businesses). Page 4
SUBSECTION 111(5) BASIC TEST No non-capital loss carry forward after an LRE unless: Loss business was carried on by the taxpayer throughout the particular year for profit or with a reasonable expectation of profit Only to the extent of income from that business or If properties were sold, leased, rented or developed or services rendered in the course of carrying on that business before that time, any other business substantially all the income of which was derived from the sale, lease, rent or development of similar properties or the rendering of similar services Page 5
SUBSECTION 111(5) BASIC TEST A similar test is included in 88(1.1)(e) after a winding up and 111(5) applies after amalgamations by virtue of 87(2.1). Threshold test: Was the loss business carried on for profit or REOP throughout the particular year in which the loss is being applied? Quantum Test: to the extent of income from the same business or a similar business. Colloquially referred to as same or similar business test. Language of the provision is not actually a similar business test - significant interpretive challenges lurk. Page 6
QUANTUM TEST Once the threshold test has been met: To the extent of income from that business ; or if properties were sold, leased, rented or developed by the loss business, then to the extent of income from a business substantially all the income of which is derived from the sale, lease, rental or development of similar properties. Page 7
QUANTUM TEST Key words for interpretation highlighted: if properties were sold, leased, rented or developed in the loss business, then to the extent of income from a business substantially all the income of which is derived from the sale, lease, rental or development of similar properties. Page 8
FACT SPECIFIC DETERMINATIONS Laden with fact driven determinations - no two situations alike. Is the loss business carried on in the year? - Fact driven determination Is the loss business carried on with a reasonable expectation of profit in the year? - Fact driven determination Is the income against which the losses will be used from the same business? - Fact driven determination Are two types of properties similar? - Fact driven determination Does the profit business earn substantially all its income from the sale/lease/rental/development of a similar property? - Fact driven determination Does the profit entity carry on one or more than one business? - Fact driven determination Page 9
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. OffShore ExploreCo: a private company has operated exclusively in offshore Canadian east coast describes itself as an oil and gas exploration and development company but as of yet has not produced its assets has never earned any revenue has acquired primarily natural gas assets assets are promising, however the horizon for production is still in the future has 20 employees and a head office in St. John s Newfoundland has accumulated $25 million of non-capital losses Page 10
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. Alberta Oil and Gas Co.: is a public oil and gas company with its head offices in Calgary an oil and gas exploration and production company producing conventional natural gas and oil assets in Alberta, B.C. and Saskatchewan approximately 50% of its revenue is from the development and sale of crude oil and 50% from the development and sale of natural gas Alberta Oil and Gas Co. purchases all of the shares of Offshore ExploreCo Page 11
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. After acquisition of control Alberta Oil and Gas Co.: shuts the Newfoundland head office of Offshore ExploreCo offers 5 employees positions in Calgary (full time positions entirely related to the Offshore ExploreCo assets) lets the other 15 employees go retains all the assets of Offshore ExploreCo and continues the operations of Offshore ExploreCo, albeit at a reduced activity level. Alberta Oil and Gas Co. amalgamates with Offshore ExploreCo. The amalgamated corporation is called Alberta Oil and Gas Co. Page 12
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. Can Alberta Oil and Gas Co. apply the pre-lre non-capital losses of Offshore ExploreCo against its income from production of conventional natural gas from its Alberta properties? Oil? Page 13
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. Threshold Test Is the loss business being carried on in the particular year for profit or with a reasonable expectation of profit? CRA Rulings - substantial reduction is a change in the nature of the business such that there is a new business Canadian Dredge and Dock NRT Technologies Moldowan Page 14
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. To the extent of income from the same business Is Alberta Oil and Gas Co. s business the same business as Offshore ExploreCo s business? CRA Technical Interpretation 9234795 STB Holdings Gaz Metropolitan Dupont Page 15
EXAMPLE #1 OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. To the extent of income from a business substantially all the income of which was derived from the sale, lease, rental or development of properties similar to those properties sold, leased, rented or developed by Offshore ExploreCo. Accept that substantially all is 90% How do we characterize property? Is it the hydrocarbon or is it the Canadian resource property? A hydrocarbon is a hydrocarbon - CRA Rulings verbal comfort Rulings and interpretations re minerals Page 16
EXAMPLE OFFSHORE EXPLORECO ACQUIRED BY ALBERTA OIL AND GAS CO. Two possibilities: Alberta Oil and Gas Co. is an oil and gas company that is carrying on an oil and gas business that is the same as the oil and gas business carried on by Offshore ExploreCo so that all income is from the same business; or Property means the hydrocarbons or CRP and the natural gas developed by Offshore ExploreCo is similar to the natural gas and oil developed by Aberta Oil and Gas Co. so that substantially all the income of Alberta Oil and Gas Co is derived from the development of properties similar to those developed by Offshore ExploreCo. Page 17
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Shale Gas Co.: is a private company involved in natural gas exploration and development focussed its exploration activity on shale gas in Alberta and B.C. incurred significant losses but has some revenue from the production and sale of gas. Page 18
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Diversified Oil and Gas Company is a public oil and gas company with operations across Canada and, through subsidiaries, internationally. It has revenue from: the production and sale of oil and natural gas (40% of revenue) production and sale of natural gas liquids and other petrochemicals (19% of revenue) hedging (3% of revenue) production and sale of industrial lubricants (11% of revenue); investment revenue (15% of revenue) franchising of retail outlets (12%) Page 19
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Diversified Oil and Gas Co. buys all the shares of Shale Gas Co. and amalgamates with Shale Gas Co. Amalco makes few or no changes to the business operations of Shale Gas Co. After amalgamation, the Shale Gas Co. assets do not produce any income, but Amalco s income is similar to prior years of Diversified Oil and Gas Co. Page 20
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Can Amalco apply pre-lre losses from Shale Gas Co. business against income? Is the same business carried on? To the extent of income from the same business? Technical Interpretation 9234795 Canadian Dredge and Dock Co. STB Holdings Gaz Metropolitan Page 21
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY To the extent of income from a business substantially all the income of which was derived from the sale, lease, rental or development of properties similar to those properties sold, leased, rented or developed by Shale Gas Co. Page 22
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Revenue Sources 12% 14% 40% 11% Production of sale of oil and natural gas Processing of natural gas liquids and other petrochemicals Hedging Production and sale of industrial lubricants Investment revenue 3% 20% Franchising of retail outlets Page 23
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY One business or many businesses? Degree of interconnectedness/interdependence. Dupont Canada Inc. - one income producing unit If separate businesses? If one business? Page 24
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Not a revenue test Gross Income/Net Income/Taxable Income? Division B, Subdivision b - Income from a business, start with profit, apply subdivision b. But see Ludco uncertainty Practically difficult test to apply to a corporation that does not track its net income from each different type of activity Overhead and general administrative expenses might need to be allocated to the revenue generated from each type of property Against which source does Diversified deduct interest expense? What should Diversified do with its resource pool claims in determining its income? Disregard them? Should the pool claims be applied to only reduce income from the production and sale of natural gas and oil? Or should the pool claims be applied to reduce income from all activities? Page 25
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY 14% 11% 12% Income 40% Production of sale of oil and natural gas Processing of natural gas liquids and other petrochemicals Hedging Production and sale of industrial lubricants Investment income 3% 20% Franchising of retail outlets Page 26
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Reasonable answer might be: Oil and gas business is oil and gas business that derives income from the development, production and sale of hydrocarbons or Canadian resource properties - i.e., income is from the same business as the loss business; However, if not the same business: Properties could be characterized as hydrocarbons or CRP; Hydrocarbons or CRP were developed by loss business in the course of carrying on the loss business; Industrial lubricants are similar properties to the gas resources developed by Shale Gas Co. or the industrial lubricants operation is a separate business; Page 27
EXAMPLE #2 SHALE GAS CO. ACQUIRED BY DIVERSIFIED OIL AND GAS COMPANY Investment income is income from property and need not be considered in determining whether substantially all of Diversified s business income is derived from the sale/lease/rental/development of similar properties; Franchising of retail outlets may be separate business (not interdependent and interlaced); Substantially all of Diversified s income is derived from the development of Canadian resource properties (similar CRP to those developed by loss business): the production and sale of oil and natural gas is derived from the development of hydrocarbons or CRP; the production and sale of natural gas liquids and other petrochemicals is derived from the development of hydrocarbons or CRP; the production and sale of industrial lubricants is derived from the development of hydrocarbons or CRP; hedging made up such a small part of the income that it does not upset the substantially all test. Page 28
OTHER ALTERNATIVES TO AMALGAMATING There are alternatives to amalgamating/winding-up. The acquired corporation could be left to exist separately and steps could be taken to make it profitable. It could acquire an interest in other producing properties. It could acquire a partnership interest. Carrying on business directly or through a partnership may not compromise the carrying on the business test. This may simplify some of the analysis necessary in applying the Quantum Test. This isn t to say amalgamating isn t the best option, but consideration could be given to which alternative provides the strongest arguments regarding the utilization of losses under 111(5). Page 29
TAKEAWAYS Because of the introduction of the concept of loss restriction event the circumstances in which 111(5) will apply are broader. More planning will rely on interpretations of 111(5). Same or similar business test is a misnomer. Actual test has significant interpretative challenges. Careful consideration should be given to whether and how corporations are combined post-lre. The ability to utilize the losses post-lre may depend on it. Page 30
QUESTIONS? Matthew Kraemer mkraemer@felesky.com 403-260-3304 Page 31