A “Freehold Mineral Right” is Canadian Resource Property (CRP) for income tax purposes and is not considered capital property; any gain on the disposition of CRP either on a sale or upon death will be taxed at the 100% inclusion rate.
Income received from CRP is generally treated as investment income and as a result is not considered earned income for RRSP purposes nor is the income eligible for the small business rate for income tax if received by a corporation. A Canadian controlled private corporation which receives royalty income and pays a dividend to its shareholders will be entitled to a refund of some of the corporate taxes paid on the royalty income.
Upon the death of an individual CRP holder there will be a deemed disposition for proceeds equal to the fair market value on the final tax return and by definition the CRP cannot be reported on a “Right or Thing” tax return. If the value of the CRP is significant, the tax liability on the final tax return may create an unwanted tax burden to the estate causing a situation where the only recourse for the estate is to sell the CRP.
Valuation of an interest in CRP has become complicated in that the Canada Revenue Agency (CRA) had previously allowed or not challenged the rule of thumb method of valuing CRP. The rule of thumb method uses a multiple applied to the average annual royalty income received.
Recently the CRA has stated through their audit process that a simple multiple of annual cash flow is not sufficient evidence of value and that a proper valuation should take into account initial production, decline rates, price forecasts and discounts factors. For situations when CRP is not yielding royalty income and a value is needed for estate or tax planning, consultation with a geologist, business valuator and tax specialist should be done prior to commencing the transaction.
For estate planning purposes, a popular strategy is to incorporate CRP thereby changing an income asset into a capital asset.
Advantages to Incorporation
The transfer of CRP can be done on a tax deferred basis with the ability to “freeze” the value of the estate. This frozen estate value can then be reduced over time on a tax efficient basis. There is also the ability to income split the royalty income with other family members. On death, the disposition of shares will be subject to tax at the 50% inclusion rate thereby reducing the estate tax on the CRP by 50%.
Disadvantages of Incorporation
The tax rate for Income on royalty income will be higher than the personal tax rate. There are potential pitfalls in that obscure tax such as corporate attribution, “kiddie” and land transfer tax may apply after the incorporation of the CRP.
Although incorporation of CRP can be used to minimize tax upon the death of a CRP holder, this strategy may not be appropriate for all situations and professional advice should be sought before proceeding. For more information please contact your local MNP Tax advisor or MNP business valuator.
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