Alberta Royalty Review Part Three: Taxation Introduction

In my prior article, I discussed oil sands royalty regime. In this article, I am going to discuss the taxation regime. Having a solid understanding of both royalty and tax will allow us to better understand Alberta Review Panel Final Report (PDF, 2.25mb).

As before with the royalty discussion, I am going to focus on the high level material only. I am not going to address the minutia.

Once again, I provided a table below with line numbers and item descriptions. Each line will be described in more depth shortly. Please note, the official terminology used by the Alberta and federal governments might differ from my presentation below. I am using the basic terminology that I used when I created the economic models for the NOSTF. If you are unsure of the terms operating costs and capital expenditures, please refer to my earlier article referenced above.

Below I will discuss each line in the above table.

Line 1: Gross Revenue. Gross revenue is the quantity multiplied by price. The quantity is either synthetic crude oil (SCO) or bitumen and the price is the price of the commodity. In the future, I will discuss the SCO versus bitumen. At present, I believe all integrated developers—that is, mining plus upgraders—use SCO pricing and mine developers use bitumen pricing. The mine producers do not produce SCO, so bitumen pricing is obvious. I will comment in the future on bitumen pricing too.

Line 2: Less: Operating Costs. Operating costs are deducted.

Line 3: Equals Preliminary Net Income One. This line simply shows the result of subtracting operating costs from gross revenues.

Line 4: Less. This line sets up the CCA deductions that come next.

Line 5: Capital Cost Allowance (CCA) 41A. Most initial capital expenditures for a mine or an upgrader with an SCO royalty regime are classified as Class 41A. Class 41A, as we will learn in a moment, is a supercharged depreciation class. I am going to cover more about capital cost allowances (CCA) in a future article. For now, CCA is simply the tax deductible expense for capital expenditures. Most new construction capital expenditures fall into this category, capital expenditures associated with expansions of greater than 5%, and capital expenditures in excess of 5% of gross revenue. New capital expenditures by definition represent a new project so those expenditures qualify for a supercharged write-off. Significant plant expansions also qualify for a class 41A treatment. If a developer spends more than 5% of gross revenue, an amount that is typically equal to the maintenance capital, then the regime assumes that the developer is spending capital to reduce the cost structure. Effectively, class 41A is meant to capture significant capital expenditures in the forms of new greenfield projects, major production expansions, and major cost reduction programs. On Line 5, 25% of the class 41A capital expenditure is expensed. That means it is deducted in a similar manner to operating cost.

Line 6: Capital Cost Allowance (CCA) 41B. This is similar to class 41A capital expenditures above, but these capital expenditures are not typically associated with new greenfield projects, major expansions, nor cost reduction programs. Instead, 41B capital expenditures are typical maintenance capital projects. Every year, the plant must replace motors, pipes, and other pieces of equipment. These capital expenditures are typically classified as 41B. On Line 6, 25% of the class 41B capital expenditure is expensed. The difference between CCA 41A and CCA 41B will become apparent in a moment.

Line 7: Equals Resource Profit Before Allowance. This line represents the gross revenue less operating costs, less CCA 41A and 41B deductions.

Line 8: Less. This line sets up additional deductions.

Line 9: Additional Class 41A CCA Deduction If Line 8 is positive and there is additional CCA 41A capital that has not been deducted, then it can be deducted here. In effect, CCA 41A capital qualifies for 100 % deduction. It is as though CCA 41A were an expense and not capital. By taxation standards, this is an extremely rich and aggressive deduction. Please note, recent budgets have changed this provision. This discussion relates back to the NOSTF.

Line 10: Resource Allowance. If, after deducting the Additional Class 41A capital, the sum total is still positive, then a resource allowance deduction of 25% is taken. Resource allowance was a proxy for provincial royalty. Note that regardless of the actual royalty amount, even if only 1% of gross revenue, the resource allowance of 25% still applied. This feature too has changed with recent federal budgets.

Lines 11 and 12: Canadian Development Expense (CDE) and Canadian Exploration Expense (CEE). These are capital expenditures associated with purchasing and quantifying the oil sands reserves. CEE is depreciated at 30%. Compared to 41A and 41B capital, CDE and CEE capital expenditures are small. CCA 41A and CCA41B account for greater than 95% of all capital, so Lines 11 and 12 are not important.

Lines 13: Equals Preliminary Net Income Two. This line is a subtotal.

Lines 14: Less: Loss Carryforwards. If Line 13 is a negative value, it creates a loss carryforward. Loss carryforwards can be applied against future income for up to seven years. Loss can also be applied against prior income for a period of up to three years. For our purpose, we will simply focus on the forward loss carryforwards.

Lines 15: Equals Preliminary Net Income Three. This line is the sum after applying the loss carryforwards. If this sum is positive, then taxes are paid in the next line. If the value is negative, then nothing happens.

Lines 16: Less Taxes Paid. If Line 15 is positive, then the tax rate is applied to the positive value and tax is paid. The federal tax rate, in the mid 1990s, was 29.12%, including large corporation surtax. The tax rate has changed and I will comment in a future article.

Lines 17: Equals Federal Net Income. Gross revenue, less all deductions, less taxes equals Federal Net Income.

The presentation above is for a new company starting a greenfield development. There are flow through intricacies for developers who are expanding or who existing companies entering the oil sands industry. While these rules are very important for developers, they are beyond the reach of this article. The above information provides a solid basis for understanding the federal taxation regime that was present in the late 1990s.

Below I have provided a table for the Alberta taxation. I will not comment on each of the lines because the provincial and federal taxation calculations are very similar.

The operating costs as well as CCA 41A and CCA 41B are the same for the federal taxes. The maximum of royalties paid or resource allowance might allow for some differences. Those differences, if any, affect the remainder of the calculation. The provincial tax rate was 15.5%. That too has changed and will be discussed later in a future article.

The tax calculation is more complex than the royalty calculation. That said, it is neither overly complex nor difficult. One of the superchargers was the 41A immediate write-off of capital expenditures. When economics are tight, that provision is of huge benefit to a developer. I will be addressing the CCA 41A issue soon in a future article.

When working through the federal tax, I mentioned that the resource allowance was a proxy by the federal government for provincial royalty. This is an important point to keep in mind. With the resource allowance, which has been changed, the federal government effectively limited the Alberta's ability to raise its royalty. The federal government only allowed a 25% deduction. If the province raised its royalty beyond 25%, the federal government would not recognize the additional amount above 25% as a federal deduction. Each government wants its piece of the economic pie.

Another set of important points are the historical federal and provincial tax rates. The federal rate, including large corporation tax, was 29.12% and the provincial rate was 15.5%.

With an appreciation of the historical oil sands fiscal regime, we are now better positioned to understand the Alberta Royalty Review and to provide comments. I will provide another article again on Monday, Columbus Day in the U.S. and Thanksgiving Day in Canada. The article will outline my general impressions of the Alberta Royalty Review, and then I write follow-up articles to provide more detail.

If you have questions, feel free to leave a comment or contact me through e-mail.

Calgary model Judith Aldama is featured in the photograph, which is hosted at Flickr. If you click on the picture of Judith, you will be taken to where you can view a larger version and see even more pictures of her.