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The Small Explorers and Producers Association of Canada Submission in Response to Finance Canada's Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships) consultation:

The 15% Solution

A Submission By The Small Explorers And Producers Association Of Canada On The Taxation Of Flow-Through Entities, Corporations And Their Respective Stakeholders

November 23, 2005

Introduction

The Small Explorers and Producers Association of Canada ("SEPAC") represents over 400 enterprises engaged in the oil and gas exploration and development business across Canada. Our members include both corporations and flow-through entities. Major producers tend to be members of the Canadian Association of Petroleum Producers ("CAPP") rather than SEPAC. Our members are small to mid-sized organizations active primarily in the conventional oil and gas sector in the western sedimentary basin They employ thousands of people, many of whom are located in rural communities across western Canada. The economic activity generated by our members is vital to the survival of many of these rural communities. As well our members are the single most important group in the discovery of and production of conventional reserves. The larger producers focus on major projects, conventional and non-conventional, national and international. Only the smaller producers are able to efficiently exploit the numerous small pools of oil and gas in western Canada which remain.

The Role Of Royalty Trusts

Flow-through entities in our sector consist mainly of royalty trusts. Over the last few years, these royalty trusts have come to play a very significant role in the industry. Initially, there was some resentment over the tax advantage which royalty trusts enjoyed over corporations. However, as the industry evolved, royalty trusts found a niche in the market where they now work to compliment the efforts of small and large corporations.

Because royalty trusts must distribute a large portion of their cash flow in order to attract and retain investors, they are not well-suited as start up oil and gas companies. This is because during the first several years, a junior company must reinvest all of its cash flow in exploration and production in order to build a reserve base. Often, this activity is funded with flow-through share capital, in whole or in part.

The problem which junior companies have faced in the past is lack of an exit strategy. Because they tend to hold interests in a variety of small fields, they are of no interest to the majors. For the same reason, they are poor candidates to become majors themselves. This is where royalty trusts have proven to be invaluable. Royalty trusts need income to distribute to their unitholders. It doesn't particularly matter whether the income comes from one major field or a number of minor ones. So there have been hundreds of transactions over the past few years where royalty trusts have bought out junior companies. As long as royalty trusts are not hobbled by a punitive tax change, we expect this to continue. So royalty trusts now provide the number one exit strategy for most junior companies. It means that engineers and geologists can spend a career building up a small company with good prospects of realizing on their investment when they retire. Alternatively, if the management team is fortunate enough to grow the production quickly, they may sell out early and launch a new junior and get back to what they do best: discovering and producing oil and gas.

Royalty trusts play a second important role as well. Once the majors have fully developed a large field and produced most of the reserves, they no longer have any incentive to hold it. Due to their size, junior companies are generally not able to purchase these assets. As a result, these assets often ended up being sold to non-resident interests. This has changed significantly with the rise of royalty trusts. Royalty trusts now comprise the largest part of the buyers of properties from the majors. This has several beneficial effects. It keeps the revenues in Canada. It allows the majors to raise capital to fund new ventures such as oil sands work. It puts the assets in the hands of a party who has a vested interest in maximizing cash flow from the property without the impediment of competing interests for capital and manpower within the organization. The result is that the properties are better managed and more fully exploited. Finally, when the royalty trusts acquire these packages from the majors, then often spin out all or part of the exploration lands to a new entity which we refer to in the industry as an exploreco. Explorecos have become very common and play a key role in new capital formation for oil and gas development activities. So royalty trusts play a very important role in making sure that properties which are no longer of interest to majors are fully produced and that related exploration opportunities are pursued.

Fiscal Considerations

We have carefully considered the fiscal estimates made in the discussion paper, in particular the estimated current annual tax loss of $300 million and the possibility of that growing to $1 billion or more. As a small, non-profit, mostly volunteer organization, we do not have the resources to undertake our own fiscal analysis. We do however have a very good handle on what is going on in our industry. Based on that knowledge, we believe that the net fiscal impact of royalty trusts has in fact been positive for the federal government and not negative and that the same will continue to apply going forward. Record tax revenues and government surpluses in recent years certainly suggest that this is the case. We believe this is occurring for the following reasons.

1. Royalty Trusts Increase Personal Tax Revenues on Distributions

All but the largest oil and gas companies generally do not pay dividends. When they do pay dividends, those dividends benefit from the dividend tax credit and thus are not fully taxable in the shareholders hands. Royalty trusts pay very substantial distributions. Those distributions are fully taxed in the unitholders hands. Those distributions would not have happened had the properties been held in a corporation. The personal tax on those distributions is a major win for government revenues.

2. Royalty Trusts Increase Capital Gains Tax Revenues

As explained above, royalty trusts have resulted in a large increase in capital transactions in our industry. This includes junior companies selling out to royalty trusts, royalty trusts buying packages from majors and the creation of numerous explorecos. Most of these transactions give rise to significant capital gains and hence capital gains tax. As well, distributions made by royalty trusts, to the extent they are a return of capital, reduce the adjusted cost base of the units. As a result, trades in royalty trust units often trigger a capital gain. With the high level of interest in the royalty trust sector, the number of these trades is substantial.

3. Royalty Trusts Increase Economic Activity

Without royalty trusts there would be fewer junior start-ups, less property rationalization by the majors, fewer explorecos, less capital raising, less drilling activity, less oil and gas production and less income paid to the men and women working in the industry. Governments of all levels have benefited fiscally from the activities of royalty trusts.

In summary, our view is that, at least in our industry, royalty trusts have increased government tax revenues, not decreased them, and that will continue.

Efficiency Considerations

The oil and gas sector is probably the most capital intensive sector of the economy. This is true not only for major projects such as the oil sands, but also in the conventional sector where our members operate. It takes several million dollars to start a junior oil and gas company. It takes many more millions to carry out a drilling program in order for it to have a reasonable chance of success. Capital formation is vital to the industry. Royalty trusts have given the biggest boost to capital formation our industry has ever seen. By appealing to investors who seek a regular cash distribution, royalty trusts have tapped a vast pool of capital which was previously unavailable. That capital has gone directly into increased exploration and development.

Royalty trusts have also allowed industry players to focus on what they do best. The majors focus on massive projects such as oil sands, offshore and international. Royalty trusts focus on maximizing production from proven reserves. Juniors go out and find new reserves.

Royalty trusts have been very good for the efficient operation of our industry.

The Playing Field

Corporations in our sector are currently taxed at a combined federal/Alberta rate of 37.6%. The highest marginal rate for individuals in Alberta is 39%. The effective rate on dividends is about 24%. The resulting effective tax rate on income earned via a corporation is 52.6%. Income earned via a royalty trust bears an effective tax rate of 39%. This spread of 13.6% certainly makes for an uneven playing field as between the two forms of business organization. Part of the gap will close automatically over the next couple of years when resource company tax rates are finally allowed to fall to the lower rates all other sectors already enjoy. This will reduce the corporate tax rate to 33.6% and the effective rate on income earned through a corporation to 49.5%. The gap of 10.5% as compared to a royalty trust will still be substantial.

We agree that it makes sense to narrow this gap. We believe that to achieve this by imposing the corporate tax regime on royalty trusts, one of the alternatives discussed in the consultation paper, would have a devastating effect on our industry. It would kill the royalty trust sector and all of the advantages described above would be lost.

The 15% Solution

Our suggestion is that the way to narrow the gap and level the playing field is to enrich the dividend tax credit such that the combined federal/Alberta rate on dividends would be reduced to 15% from 24%, making the rate competitive with the rate in the United States. The effective rate of earning income through a corporation would be reduced to 43.6% (once the lower corporate tax rates tax effect - perhaps the reduction in corporate rates could be accelerated as part of this process). The gap between the two tax regimes in Alberta would thus be reduced to 4.6%. The gap would be different in other provinces, but should generally be quite small. Both the federal and the Alberta government have announced plans to further reduce corporate tax rates over time. The federal target rate is 19% and the Alberta target rate is 8%, making for a total rate of 27%. Together with a 15% dividend rate this would make for a combined rate of 38% thus fully eliminating the gap as compared to the trust regime at the highest personal marginal rate.

At the end of the day, the playing field would be level, allowing organizations to chose their form of legal structure based on business considerations, not tax considerations. Government revenues should be largely unaffected, particularly when the fiscal advantages noted above are taken into consideration.

A table outlining our tax calculations is attached for your reference.

Tax Exempt Unitholders

The discussion paper notes that some unitholders, such as pension plans and rrsps, are tax exempt, thus further reducing the tax revenue associated with flow-through entities. We strongly disagree with this view. Tax exempt entities will be obliged to distribute this income to their beneficiaries in due course and that income will be fully taxable. With our aging population this will happen sooner rather than later. This income will be locked in and a guaranteed source of tax revenue for years to come. Furthermore, the income held in the tax exempt entity will be reinvested thus creating economic activity and generating tax revenues.

Non-Resident Unitholders

The discussion paper alleges a further loss of tax revenue associated with non-resident unitholders of flow-through entities. Of course there will be some lost tax revenue when a non-resident makes an investment in Canada rather than a Canadian. That is the case no matter what type of corporate organization is used. In the same way, Canadians pay less tax in foreign countries when they invest there than do locals. This simply encourages the flow of international capital. In the oil and gas sector, foreign capital is vital. There simply is not enough domestic capital to get the job done. So a tax regime which encourages foreign investment is not a bad thing, but a good thing.

It should also be noted that Canadian royalty trusts have begun to acquire international production. This has the effect of bringing more income into the Canadian tax system. The royalty trust structure allows these Canadian businesses to make competitive bids for these international assets.

Conclusion

Thank you for allowing us the opportunity to share our views on this very important issue. On behalf of over four hundred small to medium sized oil and gas enterprises we urge you not to underestimate the devastating effect that imposing the corporate tax regime on royalty trusts would have. We genuinely hope that our 15% solution, or something like it, might be a viable alternative.

Yours sincerely,

Ross D Freeman
Co-Chair
SEPAC Finance Committee