Article by Bill Maclagan, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Taxation - March 2005
For a number of years, Canada has offered tax incentives to encourage the development of efficient or so-called Green Energy Projects. These incentives include an accelerated capital cost allowance deduction for the capital cost of certain assets and an immediate deduction for certain expenses incurred in the development of Green Energy Projects. In the February 23, 2005 Budget (the Budget) the Minister of Finance has proposed to amend the Income Tax Act (Canada) (Act) and the regulations thereto (Regulations) to enhance these incentives. The Budget proposes to increase the maximum capital cost allowance (CCA) in respect of these assets to 50%, broaden the types of assets that are eligible for the accelerated CCA and enhance the immediate deduction of other expenditures.
Other non-tax incentives to stimulate the development of wind and renewable energy projects are also proposed in the Budget.
Capital Cost Allowance: Class 43.1.
Under the Canadian system for CCA, separate CCA "classes" are prescribed for various types of tangible fixed assets used in a business and the cost of the assets in each class are written down at a prescribed maximum annual rate.
Class 43.1 assets include assets used in systems to conserve energy or that use renewable or green types of energy such as solar, water, wind, certain waste fuels or that reuse thermal waste. Specifically, the types of systems that qualify under Class 43.1 include:
- Cogeneration systems that generate electricity and useable heat, and that do not exceed a heatrate (efficiency rating) of 6,000 BTU per kilowatt-hour and use eligible fuel sources, including fossil fuels and certain waste fuels. Included are electrical generating equipment, heat production and recovery equipment, feed water and condensate equipment.
- Systems that produce energy from sunlight.
- Wind energy systems (i.e., windmills that convert wind to electrical energy), including wind driven turbines, electrical generating equipment, supports, battery storage equipment and transmission equipment.
- Heat recovery systems that reuse heat from thermal waste, heat exchangers, compressors and boilers.
- Small hydroelectric projects acquired after December 11, 2001, that have an annual rated capacity not exceeding 50 megawatts, including the electrical generating equipment and plant.
Used equipment is only permitted in Class 43.1 in limited circumstances.
These types of assets currently qualify for a 30% CCA deduction, on a declining balance basis, subject to a rule which limits the CCA to one-half the normal amount in the first year. Thus, there is a significant tax incentive for owning property that qualifies under s. 43.1.
The Budget proposes to increase the maximum CCA rate to 50% for certain Class 43.1 assets acquired on or after February 23, 2005 and before 2012. These assets will be allocated for tax purposes to a separate new class. It is proposed that the incentive will be reviewed before 2012 and a decision made as to whether or not to extend it indefinitely. The assets eligible for the new rate class include cogeneration equipment that would otherwise be included in Class 43.1, if the equipment is part of a high efficiency cogeneration system with an annual heatrate from fossil fuel that does not exceed 4,750 BTUs per kilowatt-hour of electricity production. Those systems which exceed the 4,750 BTU limit but do not exceed 6,000 BTUs will still be eligible for the 30% rate. Renewable energy generation equipment including wind turbines, small hydroelectric facilities, geothermal energy equipment and systems that produce energy from sunlight will also be eligible for the enhanced 50% CCA rate if acquired on or after February 23, 2005 and before 2012.
Two new types of property will also be eligible for Class 43.1 treatment and potentially for the 50% CCA rate. Class 43.1 and the new class will be extended to include certain specified distribution equipment that is part of the district energy system used by the taxpayer or a lessee primarily to provide heating or cooling to a district or group of buildings through the use of heat produced by electrical cogeneration equipment that otherwise meets the requirements of Class 43.1 including the heatrate efficiency requirements. Eligible components will be pipes, pumps, chillers, meters and control equipment and heat exchangers attached to the main line of the district energy system. Assets that are part of the internal heat and cooling system of the host building are not eligible. This change applies to eligible equipment acquired on or after February 23, 2005. If the distribution assets are acquired after February 23, 2005 and before 2012 and they distribute heat produced by cogeneration equipment that is eligible for the 50% CCA rate, the distribution assets will also be eligible for the 50% CCA rate.
The Budget also proposes to extend the eligibility for Class 43.1 treatment to equipment used to produce biogas (primarily methane) from the anaerobic digestion of manure. Eligible equipment will be property that is part of a system used by the taxpayer or a lessee primarily to produce, store and use biogas for production of heat for use in an industrial process or electricity and that is an anaerobic digestor reactor, a buffer tank, biogas piping, biogas storage tank, biogas scrubbing equipment or generation equipment. Again, this change applies to equipment acquired after February 23, 2005 and, if the equipment is acquired prior to 2012, it will be eligible for the enhanced 50% CCA.
In financing a project, accelerated CCA is often a significant inducement for investors. Partnership structures are used so that the CCA can be claimed by the partners and used against other income in the early years of a project when no income may be generated from the project itself. To combat perceived abuses caused by these structures, "specified energy property rules" generally limit CCA to the income earned from the project. This limitation does not apply however if the principal purpose of a project is to generate energy for use in the owner’s business that is other than the sale of energy. This allows the accelerated deduction to be used by those who build green energy projects for their own businesses and then sell the surplus energy to a hydro grid.
The Budget proposes to extend these specified energy property rules to assets which are entitled to higher CCA rates as proposed in the Budget.
Capital Cost Allowance: Other Energy Related Assets.
The Budget also proposes to accelerate the CCA for other energy related assets so as to more accurately reflect the useful life of such assets. The rate for combustion turbines that are used to generate electricity will increase from 8% per year to 15% per year. The rate for electricity transmission and distribution assets will increase from 4% to 8% as will the rate for oil and gas transmission pipelines. The CCA rate for oil and gas transmission pipelines will increase from 4% per year to 8% per year. Distribution pipelines that distribute gas to ultimate consumers will continue to be eligible to a 4% rate. Currently, there is some confusion as to the CCA rate which should apply to compression and pumping equipment on the oil and gas transmission pipelines. The Budget proposes to clarify this issue and set a 15% CCA rate.
The above change will apply to assets acquired on or after February 23, 2005.
The Budget also proposes to allow a separate class election to be made in the year of acquisition for transmission pipelines and related equipment. This will permit the taxpayer to claim a terminal loss once the property is disposed of even if the taxpayer continues to own other assets which, absent the election, would be held in the same CCA class. This will assist a taxpayer if a project is terminated sooner than expected.
Canadian Renewable and Conservation Expense (CRCE).
The upfront soft costs incurred in developing and exploring for fossil fuels can be prohibitively expensive. As a result, for many years the Canadian Income Tax Act has contained provisions that in many cases allow immediate deductions for such expenditures, called Canadian exploration expenses (CEE). The same problems exist for developers of green energy projects.
In 1996, a new class of CEE was created called "CRCE". CRCE is a deductible pool that is treated like other CEE. CRCE represents the intangible expenses incurred by a taxpayer and payable to arm’s-length parties in connection with the development of a project. In order to qualify as CRCE, it must be reasonable to expect that at least 50% of the capital cost of the depreciable property in the project will be property described in Class 43.1. The Budget proposes to extend CRCE to cases where at least 50% of the eligible expenditures will be for property described in Class 43.1 or in the new Class which is entitled to the enhanced 50% CCA rate.
Expenses that qualify as CRCE include costs of temporary roads to a site, pre-feasibility studies, site approval costs, land valuations, environmental and other feasibility studies, site preparation costs, costs of acquiring and installing test wind turbines, etc. Expenses that do not qualify include project management fees, insurance, interest and financing fees. Many non-qualifying expenses may be deductible under other sections of the Act.
CRCE puts developers of renewable resources on a similar footing as explorers and developers of non-renewable fossil fuels which have had the ability to deduct CEE on a 100% basis for a number of years.
Wind Power Production Incentives.
In addition to tax incentives, the Canadian Government has provided non-tax related production incentives for wind power. In its 2001 Budget, the government allocated $260 million for Wind Power Production Incentives (WPPI) to be provided on a per kilowatt-hour basis for eligible projects commissioned between March 31, 2002 and April 2007. The stated goal was to stimulate the creation of 1,000 megawatts (mw) of wind power capacity. The Budget proposes to extend this program to a total of $920 million over 15 years to expand the WPPI target to 4,000 megawatts. An incentive payment of 1% per kilowatt-hour of production for the first 10 years will be made to eligible projects commissioned before 2010.
Renewable Power Production Incentives.
The Budget proposes to allocate $886 million dollars over 15 years to stimulate the installation of 1,500 mw of renewable power production. Details of this incentive are to be announced before April 1, 2006.
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