Canadian Developments in Oil and Gas Taxation

Jim Greene

Tax Policy Branch

OECD Workshop - November 18-19, 2010

2

Outline

Oil and gas – federal and provincial roles

Corporate tax treatment of oil and gas production and past

reforms

Oil sands and accelerated CCA

Approaches to estimating cost of accelerated

deductions/tax deferrals

3

Jurisdiction over Oil and Gas

Canada has a federal system of government

Provinces generally have ownership/control of natural resources

- Exception for offshore resources and 2 of 3 northern territories, where there

is a federal role

With respect to production of oil and gas:

- Federal government levies corporate income tax

- Provinces levy

• corporate income tax

• royalties

• bonus bids on leases, rentals, etc.

4

Oil and Gas Production

Production and Royalties - Canada - 2009

0100200300400500600700800900

1,000

Territ

ories

British

Colum

bia

Alber

ta

Saska

tche

wan

Atlant

ic P

rovinc

es

Res

t of C

anad

a

MBOE

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Source: National Energy Board, Canadian Association of Petroleum Producers

Royalties ($M)

Oil Production Natural Gas Marketable Production Royalties $M

5

Oil and Gas Royalties

As resource owners, provinces levy royalties on oil and natural

gas production

Structures and rates vary across jurisdictions and resources

Conventional oil and gas royalties generally a percentage of value

of production

- Rate determined by a formula typically sensitive to price, well

productivity and sometimes well vintage

Royalties for offshore, oil sands, and some less conventional

onshore resources have a multi-tier structure. Typical:

- 1st tier based on gross revenue

- 2nd tier based on net revenue

6

Corporate Income Tax – Rates

Common federal income tax rate for all sectors (including

oil and gas) since 2007

Federal rate = 18% in 2010

- Will decrease to 16.5% as of 2011 and 15% as of 2012

Provincial rates in 2010 range from 10% (Alberta) to 16%

(PEI and Nova Scotia)

- Weighted average is 11.5%

- Provincial tax bases same as or similar to federal base

Federal goal is 25% combined federal + provincial rate

7

Corporate Income Tax – Base

Corporate income tax levied on:

- Current revenue + net capital gains (50% inclusion)

- Less: operating expenses, capital depreciation and interest cost

Capital cost allowances (CCA) based on prescribed rates generally based on useful life of assets

Operating losses

- Carry forward 20 years, carry back 3 years

- Limited loss transfer between related entities

Targeted provisions for some investments/sectors

- Small business, R&D, resource extraction, etc.

8

Corporate Income Tax – Royalty Costs

Provincial levies other than income taxes (e.g. capital, payroll and

property taxes) are deductible for federal CIT purposes as a current

business expense

Traditionally, royalties deductible also

- 1974 – Royalties made non-deductible

- 1976 – Resource Allowance introduced as proxy for royalty costs

• Deduction equal to 25% of “resource profits”; intended as a ceiling

• Over time, came to exceed royalties in some cases; acted as a floor

- 2003-2006 – Resource Allowance phased-out and royalty deductibility

phased-in to ensure deduction only for actual royalty costs

- Syncrude Remission Order (1976) allowed deductibility of both royalties and

resource allowance for this early oil sands project – order expired 2003

9

CIT - Oil and Gas Capital Costs

Tangible Capital Costs

- 25% per year (declining balance basis) capital cost allowance (CCA) for most resource extraction equipment

Intangible Capital Costs

- Exploration Expenses (CEE) – e.g. seismic surveys & drilling exploratory wells – 100%

- Development Expenses (CDE) – e.g. drilling production wells – 30% per year

- Oil and Gas Property Expenses (COGPE) – e.g. resource leases – 10% per year

- “Flow-through shares” allow non-taxable companies to transfer exploration and development expenses to investors

- Former earned depletion deduction eliminated 1990

• Deduction on account of exploration and development costs that supplemented deduction for actual costs

10

Policy Direction

Rationalization of resource measures:

- Elimination of earned depletion, resource allowance, and Syncrude

Remission Order

“Level the playing field” by extending similar provisions to

renewable energy production :

- accelerated capital cost allowance for renewable energy generation

equipment (wind, solar, geothermal, tidal, etc.) – Class 43.2 (50%)

- flow-through shares for project start-up expenses

11

Oil Sands - The Resource

Oil sand is a mixture of sand, clay, water and bitumen – a highly viscous heavy petroleum

Located in three major areas in northeast Alberta

Production:

- Doesn’t flow naturally to a well

- Can be mined from open pits (if less than ~70 meters deep), or extracted in situ using horizontal stimulated wells (deeper deposits)

- Processing required to separate bitumen and sand

- Bitumen must be upgraded before being refined into fuel

170 billion barrels of proven reserves

12

Oil Sands - History

1967: GCOS mining operations began

1972: accelerated capital cost allowance for mines (including oil sands mines)

1978: Syncrude mining operation began, with partial government ownership – eventually divested

1985: first in situ production

1996: accelerated capital cost allowance extended to in situ projects

1997: Alberta introduces generic royalty regime

2007: federal phase-out of accelerated CCA (2011-15) announced

2007: new Alberta royalty framework announced (effective 2009)

13

Oil Sands – Capex, Production

June 2010 Forecast by Canadian Association of Petroleum Producers

Capital Expenditures in the Oil Sands

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: Canadian Association of Petroleum Producers

$ M

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Accelerated CCA - General

Canadian capital cost allowance (CCA) regime - cost of assets deducted at a fixed rate generally reflecting useful life of assets of that type

- Matches costs with revenues they help create

Faster rates (“accelerated CCA”) result in higher deductions in early years of an investment; lower deductions later

Resulting deferral of tax improves rate of return

Accelerated CCA used to encourage investment in various contexts:

- Assets used in research and development

- Clean energy generation equipment

- Manufacturing and processing equipment (temporary 2007-2011)

- Mining assets

- Oil sands assets

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Accelerated CCA for Oil Sands - Description

Regular CCA rate for resource extraction equipment is 25%

Accelerated CCA available since 1972 for new mines (including oil sands mines) and major mine expansions

Expanded to in situ oil sands projects in 1996

Additional allowance/deduction supplementing regular CCA deduction

- up to remaining undepreciated cost, not exceeding taxpayer’s income from the project for the year – i.e. project ``ring-fenced``

Effectively defers tax until cost of capital assets recovered out of project earnings

Intended to helped reduce risk associated with early investments in a novel resource

16

Accelerated CCA for Oil Sands – Phase-out

Phase-out of accelerated CCA for oil sands announced in Budget 2007

- Special incentive no longer required given maturity of sector – technological advancements, improved economics, self-sustaining investment – and environmental considerations

- Improve neutrality between oil sands and other sectors

To provide investment stability given long project timelines, accelerated CCA grandfathered for assets

- acquired before March 19, 2007 announcement; or

- acquired before 2012 that are part of a project phase on which major construction began before March 19, 2007

For other assets, accelerated allowance will be phased down over 2011 to 2015:

Draft amendments to implement the phase-out released for comment on May 3, 2010

Year 2010 2011 2012 2013 2014 2015

Allowable Percentage of

Additional Allowance

100 90 80 60 30 0

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Accelerated CCA for Oil Sands – Revenue Cost

Revenue cost of accelerated CCA (limited to project income)

complex to determine in this context

- Depends on project-specific factors such as timing and quantum of

investment, production and profitability, which are difficult to forecast, as

well as broader factors like oil prices and input costs

- Can vary considerably year to year based on mix and size of projects,

and position of each project within its investment life cycle

Forecast to average $300M annually on a nominal cash-flow basis

for 2007-2011 (about 0.02% of GDP)

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Estimating Cost of Accelerated Deductions / Tax Deferrals

Estimating tax expenditure associated with accelerated deductions / tax deferrals has particular challenges

Two approaches examine impact from different perspectives

- Current cash-flow approach measures impact on taxes in a particular year

• Important for short-term government budgeting purposes

- Present-value approach forecasts impact over a number of years of an investment or group of investments made in one period

• Estimates time value benefit provided to an investment or group of investments

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Cash-Flow Approach – Single Investment

Early years, deduction under

accelerated rate higher than

under benchmark – positive

tax expenditure

Later years, deduction under

accelerated rate lower than

under benchmark – negative

tax expenditure

Sum of annual tax

expenditures = 0

Tax Value of Deductions - Current Cash-flow Basis

-10

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

*Simplified example: investment of $1000 in Year 1, tax rate of 10%, benchmark

depreciation rate of 20%, accelerated depreciation rate of 50% (both declining balance) and

no reduction in 1st year deduction.

Benchmark Rate Accelerated Rate Tax Expenditure

Tax expenditure = difference in a year between tax value of

deduction at accelerated rate and deduction at benchmark rate.

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Cash-Flow Estimate - Aggregate

Focus on current year

revenue impacts

Result dependent on:

- Projected investment

profile

- Time at which estimate

is made

Aggregate tax expenditure on many investments

Net tax expenditure in a year = taxes deferred on investment in current and recent years less recoveries of taxes deferred on investments in earlier years

-40

-30

-20

-10

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 10

$

Simplif ied example: investment of $1000 each year, tax rate of 10%, benchmark rate of 20%, accelerated rate of 50% (both declining balance). Tax expenditure in respect of each year's investment in a dif ferent colour.

Aggregate Tax Expenditure

21

Cash Flow Tax Expenditure – Varies with Investment Profile

Same assumptions as previous

examples; only change is

investment profile

- Investment profile and “maturity” of

measure are key determinants of

tax expenditure

Aggregate Tax Expenditure - Declining Investment

0

200

400

600

800

1,000

1,200

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Investment

-15

-10

-5

0

5

10

15

20

25

30

35

40

Tax Expenditure

Aggregate Tax Expenditure - Growing Investment

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Investment

0

20

40

60

80

100

120

Tax Expenditure

Aggregate Tax Expenditure - Stable Investment

0

200

400

600

800

1,000

1,200

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Investment

0

5

10

15

20

25

30

35

40

45

Tax Expenditure

22

Present Value Approach

Present value of annual cash-flow tax expenditures (pos. and neg.) over the life of an investment or group of investments

Forward looking – a forecast

Single investment (e.g. firm perspective): NPV of tax deferral over the life of particular investment

Aggregate (e.g. government perspective): NPV of positive and negative tax expenditures resulting from investments made in a particular year

Private and public discount rates may differ

Tax Value of Accelerated Deduction - Single Investment

-10

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Simplified example: investment of $1000, tax rate of 10%, benchmark depreciation

rate of 20%, accelerated rate of 50% (both declining balance)

Benchmark Rate Accelerated Rate Tax Expenditure

NPV (8%) of tax

expenditures = $19.76

23

Present Value Approach - Uplift

NPV of a tax expenditure for capital investment can be used to

calculate the fiscal uplift:

Uplift = NPV of tax expenditure

NPV of capital investment

Previous example would be $19.76 / $1,000 = 0.2%

Measure of level of fiscal support relative to the size of the

investment – i.e. tax support is equivalent to an upfront grant of X%

Facilitates comparison across projects and incentives

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Thank you

Canadian Developments in Oil and Gas Taxation

Jim Greene

Senior Chief

Resource and Environmental Taxation

Business Income Tax Division

Tax Policy Branch

Finance Canada