This article is a collaboration from Nadine Wightman, CA, CBV and Rob Rabichuk, CA, CBV, CF of MNP's Valuations and Litigation Support team.
Are you or your client at risk for an increased tax assessment from the Canada Revenue Agency (CRA)? Recently, CRA has begun to take a closer look at how the value of a mineral right has been determined for taxation purposes. Care should be taken when calculating the value of a mineral right as it can be a complicated process.
The following article offers insight into the history of ownership of mineral rights, the reason for valuing mineral rights, how mineral rights were historically valued and the proper approach for valuing mineral rights.
History of Mineral Rights Ownership
Historically homestead grants, which included mineral rights, were issued to the early settlers by the Federal Government. Homestead grants issued by the government after the late 1800’s included surface rights only and the mineral rights remained the property of the Crown under the Federal Government. Settlers who purchased land from railway companies or private land holding companies may have received the mineral rights as well as the surface rights. In 1930, the Crown transferred the mineral rights it owned in Saskatchewan to the Provincial Government. According to the government of Saskatchewan, approximately 62.4 million acres of surveyed land are under the jurisdiction of the Province and are managed by Saskatchewan Energy and Mines. The remaining mineral rights, approximately 17.2 million acres, are held by individuals and corporations.
Upon the sale of a piece of land, the mineral rights could be separated from the surface rights of the land. It was and is common practice that if the land was sold, the mineral rights were retained by the original owner. These retained mineral rights generally pass from generation to generation and are very seldom sold. Mineral rights for a piece of land may be of value depending on the minerals beneath the surface.
Why Mineral Rights are Being Valued Today
In today’s market, mineral rights are valued for a variety of reasons but the most common include tax planning, estate planning, divorce, date of death tax returns, as well as purchase and sale transactions. Valuing mineral rights for tax and estate planning for an individual is typically done when a person is looking to estimate his or her tax liability upon the date of death. Mineral right valuation for tax and estate planning for acorporation often involves an income tax reorganization. In this situation, a corporation owns a mineral right and the shareholders intend to “freeze” the value of the business and transfer the future earnings to another person; often the next generation.
Mineral right valuations are often required for purposes of determining the value of the rights for purposes of filing the date of death tax return of the individual. Upon death, the Canadian Revenue Agency (CRA) deems all assets of an individual to be disposed of at their fair market value. This would include interests in any mineral rights.
The historical practice of passing the ownership of a mineral right from generation to generation has resulted in very few purchase and sale transactions of mineral rights. Therefore, while it is uncommon, a purchase and sale situation may arise where a valuation of the mineral right would be required. In recent years there has been some interest from oil and gas companies in purchasing the mineral rights that individuals and corporations own.
Historical Method of Valuing Mineral Rights
In the past it was common practice to value a mineral right using a rule of thumb approach. The multiples used were typically in the range of three times to five times the amount of royalties and lease payments received in the prior year. However, this approach can be materially incorrect and result in a significant overstatement of the value of the right.
While the CRA has historically allowed, or at least not challenged, valuations of mineral rights based on rules of thumb, they have recently begun challenging these types of valuations. The consequence to you and your client (taxes, interest, and penalties) can be significant. CRA has basically taken the view that a simple multiple of annual cash flows is not sufficient evidence of value and they require a proper valuation to be prepared, which takes into consideration the initial production, decline rates, price forecasts and discount rates.
This article is a collaboration between Nadine Wightman, CA, CBV and Rob Rabichuk, CA, CBV, CF of MNP's Valuations and Litigation Support team.
For example, a cash flow of $100,000 at a five times multiple would imply a value of the mineral right of $500,000. If CRA responded that the correct multiple was nine times, the implied value would be $900,000. The difference is obviously significant. We have observed instances where significant decline rates were shown to imply a multiple of two times cash flow which calculates to $200,000. Again this is another significant difference. In this situation, use of a five times multiple would cause your client to pay tax on $500,000 whereas he or she should only have paid tax on $200,000. The tax paid would be significantly higher if CRA can substantiate that nine times is the better multiple.
The Proper Approach to Determining the Value of a Mineral Right
The proper approach to determine the value of a mineral right depends on whether or not there is active mining or production (development) occurring on the property. Where there is no active development on the property, the value of the mineral right can be estimated to be the present value of the lease payments. It’s important to determine whether or not there is active development on the land surrounding the subject property or not. The future potential of development could indicate a value higher than simply the present value of the lease payments.
Where there is active development on the property, the value of mineral rights are generally valued using the present value of the future cash flow approach. The present value of future cash flow approach involves estimating the expected free cash flows the owner of the mineral right would accrue and then discounting those expected free cash flows at a rate that reflects the risks of realization of the expected free cash flows. When using the present value of future flow approach, it’s important to consider the current and future production of the property and the current and forecasted price of the mineral being extracted. An analysis should be undertaken of the current production report for proven reserves and unproven reserves, which can be further divided into probable and possible reserves. A qualified professional engineer is often engaged to assist in the analysis. The forecast of the price of the mineral being mined is often determined through the use of economist reports.
Getting Professional Advice
Given that the value of mineral rights can be a complicated process, it’s important to get the advice of an experienced professional valuator which will minimize the possible consequences of using the wrong value.
MNP is one of the largest chartered accountancy and business advisory firms in Canada. Our teams of Chartered Business Valuators, complemented by a network of business advisors, deliver a balanced perspective on value-focused issues to help our clients gain a clearer understanding of value and what drives it. Working with both individuals and companies, MNP has the industry-leading insight to address valuation challenges related to the valuation of mineral rights.
If you have any questions regarding the valuation of mineral rights, please call Nadine Wightman, CA, CBV at 306.664.8381 or Rob Rabichuk, CA, CBV, CF at 204.336.6206.
Definition of Mineral Right: A mineral right is generally defined as a right to take minerals (including oil, gas, metals, potash, etc.) from land or the right to receive payment from the excavation of such minerals.