9 August 2023 External T.I. 2023-0979431E5 - CEDOE - "costs incurred by a person"

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: 1) Whether a portion of payments from a corporation to another corporation, with a common shareholder that owns at least 10% of the shares of each corporation, for performing XXXXXXXXXX services would be considered CEDOE. 2) If so, what is the meaning of "costs incurred by a person" in respect of the performance of the services in the context of CEDOE?

Position: 1) Question of fact, but likely yes. 2) Requires that the person has a clear legal obligation to pay an amount and that it is incurred in respect of providing the services.

Reasons: See below.

XXXXXXXXXX									2023-097943
M. Sims

August 9, 2023

Dear XXXXXXXXXX:

Re: CEDOE – “costs incurred by a person”

This is in reply to your email dated June 15, 2023, and our telephone conversation with you on June 20, 2023 (Wharram/Sims/XXXXXXXXXX). You described the following hypothetical situation:

• Mr. X owns all the shares of two companies, ACO and BCO.
• ACO provides XXXXXXXXXX geophysical services to its customers.
• BCO is a customer of ACO. ACO also has third party customers.
• BCO stakes claims on properties that it identifies as having potential for further exploration based on the information obtained from ACO’s XXXXXXXXXX services.
• BCO proposes to issue flow-through shares to obtain further funding to pay for its exploration activities.
• After the issuance of flow-through shares by BCO, Mr. X will continue to own at least 10% of a class of shares issued by BCO.

You requested our views on whether any portion of the payments for XXXXXXXXXX services made by BCO to ACO, would be Canadian exploration and development overhead expense (“CEDOE”), with the result that such portion could not be renounced by BCO to its flow-through share investors.

In addition, you stated that you understood that, in the context of a payment for a service, CEDOE does not generally include the costs incurred to perform that service and you enquired whether certain non-insurable risks and liabilities (e.g., losses from crashing) could be considered to be “costs incurred” for this purpose.

Our Comments

This technical interpretation provides general comments about the provisions of the Income Tax Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.

Unless otherwise stated, all references to a statute are to the relevant provision of the Income Tax Act R.S.C. 1985 (5th Supp.), c.1, as amended (the “Act”), or, where appropriate, the Income Tax Regulations, C.R.C., c.945, as amended (the “Regulations”).

I. Payment for XXXXXXXXXX Services as “CEDOE”

CEE and CEDOE - Overview

Subsection 66(12.6) of the Act permits a “principal-business corporation”, which is defined in subsection 66(15), to renounce Canadian exploration expenses (“CEE”) to its flow-through shareholders. (footnote 1) The amount of CEE which may be renounced is required, under paragraph 66(12.6)(b), to be reduced by any of those CEE expenses that are “prescribed CEDOE” as defined in subsection 1206(4.2) of the Regulations.

Pursuant to subsection 1206(4.2) of the Regulations, “prescribed CEDOE” of a corporation includes any expense of the corporation that is a CEDOE. CEDOE is defined in subsection 1206(1) of the Regulations and constitutes certain expenditures that are included in CEE. Included under paragraph (d) of the definition of CEDOE are amounts paid to a person with whom the taxpayer is connected for the use of property, performance of a service, or the acquisition of materials, parts or supplies to the extent that the amount charged exceeds the costs incurred by the connected person in providing the property, service, or materials, parts or supplies (i.e., the profit element).

Connected Person Test

Generally speaking, pursuant to paragraph 1206(5)(a) of the Regulations, a person and a particular corporation are connected with each other if:

(i) they are not dealing at arm’s length with each other,

(ii) the person has an equity percentage (within the meaning of subsection 1206(7) of the Regulations) in the particular corporation that is not less than 10 per cent, or

(iii) the person is a corporation in which another person has an equity percentage that is not less than 10 per cent and that other person has an equity percentage in the particular corporation that is not less than 10 per cent.

Application to Hypothetical Situation Outlined Above

In the situation outlined above, the amounts paid by BCO to ACO will be payments for a service performed by ACO for BCO. In addition, BCO will be connected to ACO because BCO is a corporation in which Mr. X will have an equity percentage of not less than 10 per cent and Mr. X will also have an equity percentage in ACO that is not less than 10 per cent.

As a result, an amount paid for XXXXXXXXXX services performed by ACO for BCO would be considered CEDOE to the extent the amount exceeds the costs incurred by ACO to provide the service.

II. “Costs incurred by a person”

Overview

Although the phrase “costs incurred by a person” is not expressly defined in the Regulations, paragraph 1206(5)(b) of the Regulations provides that “costs incurred by a person” will not include certain outlays and expenses, such as:

(i) Certain expenses that would otherwise be CEDOE of the person providing the service, such as expenses in respect of the management, administration or financing of the service provider;

(ii) An outlay or expense of the service provider to the extent that it is not reasonably attributable to the performance of the service by the service provider; and

(iii) An amount in respect of the capital cost of a property to the service provider, except to the extent of a capital allowance described in subparagraph 1206(5)(b)(iii) and subsection 1206(6) for depreciable property of the service provider.

In addition, the Courts have held that a taxpayer will not be considered to have incurred an expense unless and until the taxpayer has an absolute and unconditional legal obligation to pay an amount. (footnote 2)

Application to Hypothetical Situation Outlined Above

Whether a particular expense incurred by ACO would be reasonably attributable to the performance of a service by ACO to BCO and whether such expense would be considered to be a “cost incurred” by ACO is an issue that could only be determined taking into account all of the relevant facts and circumstances relating to that expense. We note, however, that at the time ACO provides the services to BCO, it seems unlikely that ACO would have a clear legal obligation to pay an amount in respect of contingent and future non-insurable risks or liabilities, in which case no amount in respect of such non-insurable risks or liabilities could be included in determining the “costs incurred by ACO” in providing the XXXXXXXXXX services to BCO.

As a result, the amount of CEE BCO would be entitled to renounce to its flow-through shareholders in respect of the amount paid by BCO to ACO for the XXXXXXXXXX services would be limited to only the actual costs incurred by ACO in providing the XXXXXXXXXX services to BCO.

We trust these comments will be of assistance.

Yours truly,

Kimberley Wharram
Manager, Resources Section
for Division Director
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 Whether any expenditure qualifies for treatment as CEE is a question of fact to be determined from all of the relevant facts and circumstances. For purposes of this letter, we have assumed that payments made by BCO to ACO for the performance of XXXXXXXXXX services would qualify as CEE of BCO.

2 For example, see Canada v. McLarty, 2008 SCC 26 and Wawang Forest Products Ltd. v. The Queen, 2001 FCA 80