Canadian governments have a long standing policy of actively promoting the development of green energy sources with fiscal and tax incentives. At the federal level, the tax incentives take two broad forms, being an accelerated write-off for the cost of generation and related equipment, and a current deduction of development related expenses. At the provincial level, some of the provinces offer investment tax credits related to the cost of generation and related equipment, provided the project is located in that province. Others offer various forms of relief related to payroll taxes, property taxes and other local costs. This article will focus on the federal tax benefits.
Accelerated CCA for Qualifying Green Energy Systems
There are significant tax advantages in allowing a project owner to deduct the cost of electricity generation and related equipment under the accelerated capital cost allowance ('CCA') provisions in the Income Tax Act. In order to qualify for the accelerated CCA deductions, the project owner must fit within one of approximately 20 types of renewable or clean energy systems described in Class 43.1 and 43.2 of Schedule II to the Income Tax Regulations.
Once qualified, property acquired before 2020 is eligible for an accelerated 50 percent CCA deduction calculated on a declining balance basis. There is another rule in the Income Tax Act which restricts the CCA deduction in the year the property is acquired to one-half of the normal deduction. There are several other limitations which are discussed below.
The list of eligible energy systems expands periodically as new technology is reviewed and approved by Natural Resources Canada. No new systems were introduced in the 2013 federal budget, but some significant changes were made to expand the scope of existing qualifying systems.
First, the category that includes biogas production equipment was expanded such that more types of organic waste qualify the system for the accelerated CCA deduction. Prior to the budget, eligible biogas production equipment was limited to equipment using sludge from an eligible sewage treatment facility, food and animal waste, manure, plant residue or wood waste. As a result of the budget, biogas production equipment acquired after March 20, 2013 that uses pulp and paper waste and wastewater, beverage industry waste and wastewater (for example, winery and distillery wastes) or separated organics from municipal waste are now eligible for the accelerated CCA deduction.
Second, the 2013 federal budget has removed restrictions on the types of cleaning and upgrading equipment used to treat eligible gases from waste (biogas, digester gas and landfill gas) that are eligible for the accelerated CCA deduction. Accordingly, all types of cleaning and upgrading equipment acquired after March 20, 2013 that are used to treat eligible gases from waste are now eligible for the accelerated CCA deduction.
The capital cost of eligible property on which the accelerated CCA deduction can be claimed will generally include all costs associated with the acquisition and installation of the qualifying energy system, including machinery and equipment, related 'soft costs'for design, engineering and commissioning, and other services required to make the system operational. Consequently, the tax deductions available will generate significant tax losses in the early year of projects even where there is a positive cash flow from the project. A number of structuring options have developed for the use of these tax losses, subject to the limitations below.
Limitations on the Deduction of CCA
In the early years of the green energy initiatives, projects were marketed to public investors for the purpose of using these attractive tax losses. The federal government responded by introducing the specified energy property ('SEP') rules.
The SEP rules limit the deduction of CCA on the cost of green energy property to a maximum of the income from such property. Consequently, a tax loss cannot be created by the accelerated CCA.
There are however, a number of important exceptions to these rules. First, the SEP rules do not apply to a corporation whose principal business throughout the year was either: (1) mining; (2) manufacturing or processing; or (3) the sale, distribution, or production of electricity, natural gas, oil, steam, heat or any other form of energy or potential energy. Consequently, if the corporate entity owning the project is principally engaged in one of these business lines, it will be allowed to claim CCA deductions in excess of the income from the project. If the project is owned by a partnership, each member of the partnership must be a corporation which satisfies this principal business test.
Second, the SEP rules do not apply to property used by a project that generates electricity principally for its own use and sells the surplus to public utilities. Third, the SEP rules do not apply to property that is leased by a 'qualified leasing company' to a corporation or a partnership all of the members of which satisfy the principal business test described in the first exception, or to a user described in the second exception.
Other rules in the Income Tax Act such as the tax shelter investment rules may also apply in certain circumstances to limit the use of tax attributes otherwise available to owners of green energy projects. These rules would typically be relevant only if the project entity were able to overcome the SEP restrictions.
Development Expenses
Most development type expenses are either capitalized as project costs, or constitute 'eligible capital property' the cost of which cannot be deducted fully in the year of acquisition but can be depreciated over several years in computing taxable income under a mechanism similar to CCA. In contrast, special treatment is provided for development expenses associated with a renewable energy project.
In the renewable and clean energy context, these qualifying development expenses are described in the definition of 'Canadian renewable and conservation expenses' ('CRCE'). CRCE is defined as an amount related to the development of a project for which it is reasonable to expect that at least one-half of the capital cost of the depreciable property of such project would be included in either Class 43.1 or 43.2 as described above. The amount must also be payable to a Canadian resident with whom the taxpayer is dealing at arm's length to qualify as CRCE.
In addition to attracting a 100 percent write-off rate, CRCE amounts can be passed along to investors through the mechanism of flow-through shares. The mechanism allows a corporate entity owning the project to renounce certain expenditures to shareholders who subscribe for flow-through shares of the corporation. The flow-through shareholders can then deduct expenditures 'renounced' by the corporation against other sources of income, thereby reducing the immediate cost of their investments. Since Canada does not have a concept of tax equity financing which allows investors to subscribe primarily for the tax attributes of an energy project and to exit at a pre-agreed price when those tax benefits are exhausted, the flow-through share financing alternative provided under the Income Tax Act is the closest alternative Canada offers to that type of arrangement.
Conclusion
A number of federal and provincial tax incentives are available to both project developers and project owners in the green energy space. These tax incentives are attractive enough to influence investment decisions and careful thought should be given to how they are best used to expand our green energy footprint in Canada.
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About the author
Stephen Fyfe is National Leader of the Tax Group at Borden Ladner Gervais LLP's Toronto office. Stephen advises a wide range of energy markets participants regarding tax-related issues. He can be reached at 416.367.6650 orsfyfe@blg.com.
May 14, 2024
