Commentary: Income tax changes for miners in Canada and Quebec

The past months have brought many changes to the taxation of the mining industry in Canada. These new measures generally have the effect of tightening access to certain tax incentives specific to the mining sector, both at the federal and Quebec provincial levels, with the exception of the welcomed extension of the Mineral Exploration Tax Credit (the “Exploration Credit”) by the federal government. These changes have a significant impact on mining operators — especially juniors — as well as flow-through share investors.

Federal level

The recent changes representing the greatest impact for the Canadian mining industry are: the extension of the Exploration Credit; the reclassification of pre-production development expenses, historically “Canadian exploration expenses” (CEE) as “Canadian development expenses” (CDE); and the abolition of the “accelerated” capital cost allowance.

Extension of the exploration credit — The 15% Exploration Credit helps junior exploration corporations raise capital by providing an incentive to individuals who invest in flow-through shares issued to finance mineral exploration, in addition to the deduction provided to investors for exploration expenses “flowed through” by the corporation that issues the shares.

The Exploration Credit was scheduled to expire on March 31, 2014. However, in the context of the Budget Speech delivered by the Minister of Finance on Feb. 11, 2014, the government announced its intention to extend the Exploration Credit for an additional year, more specifically to flow-through share agreements entered into on or before March 31, 2015.

Where the “look-back” rule applies, this means that funds raised by issuing flow-through shares which are eligible to the Exploration Credit can be spent on eligible exploration until the end of 2016.

The Exploration Credit was first introduced by the federal government in 2000 as a “temporary” measure applying to eligible expenses incurred before 2004. It has since been extended several times, the announcement in Budget 2014 being the latest of such extensions.

Several Canadian provinces offer an incentive that is similar to the Exploration Credit. The “super” deductions provided by the Quebec legislation are discussed below.

Pre-production development expenses — As CEE, pre-production development expenses could either be fully deductible in the computation of a mining corporation’s income, or be renounced in favour of investors and be entirely deducted by them.

From now on, the costs of these intangible assets incurred in view of bringing a new mine into production in reasonable commercial quantities, including an expense for cleaning, removing overburden, stripping, sinking a mine shaft or constructing an adit or other underground entry, among others, will move from the CEE regime to the CDE regime which allows only a tax deduction of 30% on a declining-balance basis.

This new measure generally applies to expenses incurred on or after March 21, 2013. However, due to certain transitional relief to “take into account” the development of mining projects, which can be lengthy, and a timetable for transition up to 2017, the new measure will only take full effect as of 2018.

This new tax treatment applicable to certain intangible assets will have a negative impact on the ability of junior mining corporations to finance the development of new mines by way of flow-through shares: the tax treatment of renounced expenses is a decisive factor for the investor.

This measure was included in Bill C-4 which received royal sanction on Dec. 12, 2013. Moreover, the Quebec Department of Finance and the Economy has announced that Quebec’s income tax legislation will be harmonized.

Accelerated capital cost allowance — As for the federal “accelerated” capital cost allowance allowing to deduct up to 100% (rather than 25%) of the cost of certain tangible assets acquired for use in new mines or as part of a major expansion projects, it will be phased out between 2017 and 2020.

However, the government of Quebec has announced that the gradual elimination of the “accelerated” capital cost allowance is not one of the measures that it has retained for harmonization. The Quebec income tax regime will thus continue to allow the deduction of up to 100% of the cost of eligible assets.

Analysis

The extension of the Exploration Credit will certainly help junior exploration corporations raise in the coming year equity to fund exploration activities in Canada. Given that the Exploration Credit has been systematically renewed since its inception in 2000, one may wonder if the federal government should consider making it permanent in order to ensure stability in the mining sector.

On the other hand, the CEE/CDE reclassification and elimination of the federal “accelerated” capital cost allowance mean that tax can’t be deferred until the mine operator has recovered the cost of its assets.

The impact of these measures on the net present value of a new mining project and on the internal rate of return is very real.

The mining operator should follow a maximum systematic deduction policy of its cumulative CDE account and of its undepreciated capital cost to create tax losses during the period prior to production: with the period of tax losses carried over 20 years, the impact of these new rules could therefore, in part, be mitigated, all things being otherwise equal.

However, the impact of CEE/CDE reclassification on the accessibility of flow-through financing during the period of pre-production development will be important and will not be easily alleviated.

Quebec developments

On Dec. 20, 2013, the Quebec Department of Finance and the Economy issued Information Bulletin 2013-14 announcing inter alia changes to various tax measures applicable to the mining industry.

The bulletin is certainly important for mining corporations in respect of the tax credit relating to Mining, Petroleum, Gas or Other Resources (the “Resources Credit”) and the “super” tax ­deductions to which an individual subscribing for flow-through shares is generally entitled when the issuing corporation, directly or indirectly, conducts exploration activities from the surface of the soil in Quebec.

Resources Credit — A qualified mining corporation which incurs certain exploration expenses in Quebec is eligible to a refundable tax credit under the Taxation Act (Quebec).

The Resources Credit may reach, in certain cases, 38.75% of the eligible expenses, particularly where a qualified corporation that does not operate a mineral resource or an oil or gas well in reasonable commercial quantities incurs certain exploration expenses in certain northern areas.

Furthermore, to obtain the highest Resources Credit rate (the “Preferential Rate”), the qualified mining corporation must not be related to a corporation operating a mineral resource or an oil or gas well in such quantities.

The table above (page 34)  shows the Resources Credit rates that currently apply depending on the various applicable parameters.

In the March 20, 2012, Budget Speech, rate reductions respecting the Resources Credit  were announced regarding expenses incurred after Dec. 31, 2013: a 10% reduction for corporations not operating any natural resource and 5% for the other corporations. It was furthermore stated that such corporations could benefit from an increase of the Resources Credit equal to such rate reduction in exchange for an option granted to the Quebec government to acquire an equity stake of 5% or 10% in the development of the resource relating to a claim or an oil and gas exploration permit. However, the te
rms of such option to acquire an equity stake in the development have not to date been unveiled by the Quebec government.

Acknowledging that the international context is less favourable to investments in mining exploration, which may among other things be explained by a decrease in metal prices, the provincial government announced the postponement to Jan. 1, 2015, of the coming into force of these modifications to the Resources Credit.

The bulletin also contains two technical modifications which will restrict the scope of the notion of “qualified corporation that does not operate a mineral resource or an oil or gas well in reasonable commercial quantities” for the purposes of the Resources Credit. First, the notion of “related corporation” used to determine whether there is operation or not of a resource for the purposes of such notion will be replaced with the notion of “associated group”, similar to the notion used in respect of the tax credit for investments relating to manufacturing and processing equipment.

It is also intended to replace the condition that the qualified corporation must not operate a mineral resource or an oil or gas well in reasonable commercial quantities with the requirement that no gross income be earned from the operation in reasonable commercial quantities of such a resource.

Thus, corporations which indirectly earn gross income derived from the operation of a mineral resource, under the form of royalties for example, will henceforth no longer be eligible for the Preferential Rate, even if they don’t operate any natural resource and are not associated with any corporation that operates such a resource.

A corporation which earns gross income of any nature whatsoever (including royalties) from the operation of a mineral resource or an oil or gas well in reasonable commercial quantities will therefore “taint” all the other corporations of its associated group and no corporation of the group will be eligible for the Preferential Rate.

It is intended that the amendments pertaining to the Resources Credit will apply to the taxation years beginning after Dec. 20, 2013. It should be noted that these new rules will also apply mutatis mutandis to partnerships.

Super tax deductions with respect to flow-through shares — The Quebec legislation provides for two additional deductions of 25% each (i.e. the “super” deductions) for individuals who subscribe for flow-through shares, the first one respecting some exploration expenses incurred in Quebec and the second one when the exploration expenses in question are surface exploration expenses.

At the present time, the eligibility for these “super” deductions is among other things conditional upon the issuing corporation not operating or having operated a mineral resource or an oil or gas well in reasonable commercial quantities at the time it incurred the expenses and throughout all of the preceding 12 months. In addition, the eligibility to these “super” deductions is conditional upon the issuer not controlling a corporation that operates such a natural resource or being controlled by such a corporation. It is stated in the bulletin that changes similar to those pertaining to the Resources Credit will be made to the flow-through share regime.

More specifically, the notion of “operation of a mineral resource or oil or gas well” will be replaced with the requirement that no gross income be earned from the operation in reasonable commercial quantities of such a resource. Any royalty from the operation of a mineral resource in reasonable commercial quantities earned by a junior corporation will therefore preclude the issuance of “super” flow-through shares.

Furthermore, like the modification respecting the notion of related corporations in the context of the Resources Credit, the concept of “control” will be replaced with the broader meaning of association, i.e. that of the “associated group”.

A mining corporation will thus no longer be allowed to issue flow-through shares providing for an entitlement to the “super” deductions if it is associated with another corporation (for example, a sister corporation) which derives gross income from the operation in reasonable commercial quantities of a mineral resource or an oil or gas well.

The modifications to the flow-through share regime are intended to apply to shares issued after Dec. 31, 2013.

Analysis and conclusion

The decision to postpone for one year the decrease of the Resources Credit rates seems to indicate that the decline in mining investments in Quebec, particularly respecting mineral exploration activities, has continued during the last few months and that the Government seeks to stimulate this sector after a 2013 filled with uncertainty and turmoil. As to the restrictions ­pertaining to the eligibility to the Preferential Rate and the “super” deductions, these technical changes were foreseeable since the underlying tax policy has always been to direct this kind of tax incentive toward corporations that lack access to the necessary funds to finance their exploration activities. However, it remains that these restrictions could have unexpected consequences on the financial projections of some mining corporations and the representations made to Quebec investors in the context of the issuance of flow-through shares.

The extension of the Exploration Credit will apply to expenses renounced under a flow-through share agreement entered into after March 2014. Although the other changes to the federal tax legislation will not be in full effect for a few years, it does not mean that mining corporations should not start to take them into account immediately.

As for the modifications to the Quebec income tax regime, one must exercise caution as a governmental information bulletin does not have the force of law. In the context of a minority government and an imminent general election, it remains to be seen whether these measures will be adopted as announced by the Quebec legislature.

Furthermore, it was brought to our attention that the Quebec Minister of Finance is currently reconsidering the viability of the technical requirement that no gross income be earned from the operation in reasonable commercial quantities of a resource, which would in its actual form, be detrimental to operators earning gross income from royalty whereas such royalty income is generally only used to pay for non-flow-through expenses.

It is deplorable that mining corporations operating in Quebec are once again facing major uncertainties with respect to fundamental aspects of the income tax system applicable to them.

— Based in Montreal, Emmanuel Sala is a partner in Lavery, one of Quebec’s largest law firms. His practice is focused primarily on mergers, acquisitions, corporate reorganizations and the financing transactions of Canadian and foreign corporations, particularly renewable energy and natural resource companies. He is also a CPA and gives advice on the goods and services tax, the harmonized sales tax and the Quebec sales tax, and is active in the resolution of tax disputes and voluntary disclosure relating to both income tax and sales taxes.

Jean-Philippe Latreille is an associate at Lavery’s Montreal office, and practises tax law as a member of the firm’s Business Law Group. He advises businesses from various industry sectors as well as individuals on tax issues, particularly relating to income taxes, commodity taxes and the application of particular tax laws.

See www.lavery.ca for more.