Welcome tax change announced for Canadian resource companies

On July 13, 2020, the Canadian federal Department of Finance announced proposed changes to the flow-through share tax rules that will be welcome news to Canadian resource exploration companies. The proposals, which are in response to difficulties that such companies have faced in pursuing their exploration activities in light of the COVID-19 pandemic, extend the period by 12 months during which “Canadian exploration expenditures” (CEE) must be spent.

By way of background, it is common for Canadian resource companies to finance their exploration activities in part through the issuance of flow-through shares that provide tax advantages to their investors. In a flow-through share financing, the resource company agrees to incur expenses that qualify as CEE in an amount equal to the subscription price of the shares and renounce that CEE to the flow-through share investors for Canadian tax purposes. These expenses must be incurred within a defined period of time. The tax benefit for investors is a tax deduction equal to the amount of their investment.

Under the flow-through share rules, a resource company must incur the CEE within one of two defined time periods.

• General Rule. Under the general rule, the expenses must be incurred within 24 months after the end of the month in which the agreement to issue the flow-through shares was entered into. Under this rule, expenses cannot be renounced to investors until they are actually spent by the resource company.
• Look-Back Rule. Under the look-back rule, the expenses must be incurred by the end of the calendar year following the year in which the agreement to issue the flow-through shares was entered into. The benefit of the look-back rule is that it permits the company to renounce the CEE to investors on December 31 of the year that the flow-through share was issued even though the expenses may not be incurred until the following year. It is more common for resource issuers to rely on the “look-back rule” when offering flow-through shares to investors, as there is certainty that investors will obtain the desired tax deduction in the year that the investment is made. When a resource company relies on the “look-back rule”, it is subject to a special tax under Part XII.6 of the Income Tax Act for each month (other than January) of the calendar year following the year in which the flow-through share agreement is entered into based on the amount of renounced CEE that has not yet been expended before the end of that month. In addition, a 10% penalty tax applies to the resource company to the extent that CEE has not been expended by the end of the calendar year and investors can have their tax deductions retroactively denied.

The Department of Finance’s backgrounder statement describes the following proposed changes to the flow-through share rules:

• The period to incur eligible flow-through share expenses under the general rule and the look-back rule will be extended by 12 months.
• The 12 month extension would apply to agreements entered into on or after March 1, 2018 and before 2021, when using the general rule.
• The 12 month extension would apply to agreements entered into in 2019 or 2020, when using the look-back rule.
• Part XII.6 tax will be applied as if expenditures were incurred up to one year earlier than the date they were actually incurred. If amounts are not actually expended by the end of 2021 (where the agreement was entered into in 2019) or 2022 (where the agreement was entered into in 2020), the additional 10% tax under Part XII.6 would apply and the tax payable of investors would be adjusted accordingly.
• The relief in respect of Part XII.6 tax would apply to agreements entered into in 2019 or 2020.

Draft legislation has not yet been released with respect to these proposed changes. Accordingly, there may be additional details to come.

It will be important for resource companies that wish to take advantage of these changes with respect to existing flow-through share offerings to consider whether amendments will be needed to be made to their flow-through share agreements, as these agreements usually specify the dates by which CEE must be spent.

Please contact any member of our National Tax Group or Energy and Natural Resources  Group with any questions you have about these proposals.

This article provides only general information about legal issues and developments, and is not intended to provide specific legal advice. Please see our disclaimer for more details.