Governments in Canada are now actively competing to become environmental leaders. No longer content to merely follow environmental trends, several Canadian provinces have introduced legislation and programs designed to make them leaders not just in their jurisdiction, but across North America. One area at the forefront of this trend is green energy generation: the generation of electricity from renewable energy sources such as wind, solar, water, biomass and biogas. Several Canadian jurisdictions have introduced legislation which offers economic incentives to generate green energy, removes barriers to access the market, reduces red tape in respect of permitting and approvals, and encourages the development of local content in such green energy projects. In Ontario, the Green Energy Act was designed to accomplish these goals and establish Ontario as a North American leader in green energy. British Columbia, Quebec and New Brunswick have also introduced programs and legislation to accomplish similar objectives.
In light of these objectives, the Federal Government has introduced several new tax incentives and has enhanced several existing tax incentives aimed at promoting capital investment in green energy generation projects. The purpose of this bulletin is to help foreign investors understand:
- Canadian corporate taxes applicable to foreign investment;
- the principal Canadian tax incentives available to renewable energy projects in Canada; and
- structuring alternatives for foreign investment in renewable energy projects.
The structuring of inbound investment in renewable energy projects situated in Canada should take into account the unique Canadian tax attributes of renewable energy projects. In particular, property used in a qualifying renewable energy project is eligible for an accelerated write-off of the capital cost of project equipment and an immediate write-off of development expenses. Depending on the speed with which such tax attributes can be marshalled, the foreign investor will either have significant tax losses at the beginning of the project available to shelter other Canadian sources of income, or be able to shelter the cash flow from the project for an extended period of time.
Federal and Provincial Corporate Taxes
The income from a business carried on through a permanent establishment in Canada will be subject to corporate income tax under Part I of the Income Tax Act (Canada) (the "Tax Act"). This corporate tax would apply both to a direct ownership of the project or to an indirect ownership through a partnership. Similar corporate tax would be payable by a Canadian “blocker” (see below) incorporated to own the energy project.
The 2010 combined federal and provincial corporate income tax rates for income earned by a non-Canadian controlled corporation ranges from 28% to 34%, depending on which province the project is located in. Those tax rates are expected to decline as previously announced rate cuts become effective over the next three years. In Ontario, for example, the combined federal and provincial corporate tax rate is scheduled to be reduced to 25% by July 2013.
Most Canadian energy projects are organized within a partnership structure because of the flexibility it provides in allocating taxable income and distributable cash to partners, introducing new partners, and reorganizing the ownership of renewable energy projects on a tax deferred basis. Corporate ownership is also common as it provides limited liability and permits segregated financing, but it is more restricted in its ability to allocate profits and reorganize on a tax free basis.
Capital tax, which is calculated based on invested capital and long-term debt of the business entity, has been eliminated at the federal level and is being phased out in most provinces.
The federal government and most provincial governments also impose various taxes on the sale of goods and services and, in some cases, on the transfer of real property. These taxes include excise, sales and fuel taxes.
In addition to corporate taxes payable in respect of project earnings, amounts paid to a non-resident shareholder are subject to federal non-resident withholding tax. Interest, rents, royalties, dividends, management or administration fees, are all subject to a 25% non-resident withholding tax, subject to reduction under an applicable tax treaty. The recently implemented Fifth Protocol to the Canada-United States Income Tax Convention (the "U.S. Treaty") eliminated withholding tax on cross-border interest payments made to related persons starting in 2010, provided such interest payments are not considered to be “participating interest”.
Renewable Energy Tax Incentives
The two principal federal tax incentives available to taxpayers developing renewable energy projects are the accelerated capital cost allowance (“CCA”) deductions available on renewable energy property described in Class 43.1 or 43.2 of Schedule II to the Income Tax Regulations (the “Regulations”), and the immediate write-off available for development expenses related to renewable energy projects (known as Canadian Renewable and Conservation Expenses ("CRCE")). There are approximately 20 types of energy systems that qualify for these tax incentives, and include systems that incorporate waste fuels, efficient use of fossil fuels, and forms of renewable energy sources used to produce electricity and/or heat. The list of eligible energy systems expands periodically as new technology is reviewed by Natural Resources Canada (“NR Can”) and approved for inclusion in this list.
Generally, most electricity generation equipment has a useful life of more than 20 years and a CCA rate of 8% applied on a declining balance basis.1 However, generation equipment that is part of a qualifying renewable energy system and is acquired before 2020 qualifies for a 50% CCA deduction applied on a declining balance basis. The detailed description of qualifying renewable energy systems and property is provided in paragraph (d) of Class 43.1, as supplemented by the Class 43.1 Technical Guide.2 The types of systems qualifying for this incentive include renewable energy systems (e.g., solar, wind, small scale hydro), systems that use waste fuels, (e.g., landfill gas), and systems that make efficient use of fossil fuels, (e.g., cogeneration and district energy).
There are also several general pre-conditions to qualify under Class 43.1, such as the property must be situated in Canada and must not have been previously used.
Under the Canadian tax system 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 must be depreciated over several tax 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 energy context, these qualifying development expenses are described in the definition of CRCE. In addition to attracting a 100% write-off rate, CRCE amounts can be passed along to investors through the mechanism of flow-through shares. Canada does not allows investors to subscribe only 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 Tax Act is the closest alternative Canada offers to that arrangement.
Briefly, the “flow-through share” mechanism allows a corporate taxpayer 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.
CRCE is defined in section 1219 of the Regulations as an amount related to the development of a project for which it is reasonable to expect that at least 50% of the capital cost of the depreciable property of such project would be included in either special class of renewable energy property (Class 43.1 or 43.2). To qualify as CRCE, an amount must be payable to a Canadian resident with whom the taxpayer is dealing at arm's length.
The definition of CRCE is not exhaustive. Presumably, any non-capital expenditure which is incurred prior to the sale of electricity to the grid could potentially be considered a development expense and be eligible to be included in CRCE, unless the expenditure falls within one of the specific exclusions set out in the definition. These excluded costs are items, such as project management and administrative expenses, legal fees, insurance, financing expenses, and amounts payable to non-residents and to partnerships that are not Canadian partnerships. Such amounts are potentially deductible under other provisions of the Tax Act or can be allocated to the cost of equipment and depreciated.
Test Wind Turbines
Wind energy conversion systems occupy a unique position. Development expenses generally do not include the cost of equipment. However, a significant exception is made for "test" wind turbines. The result is that generally sufficient CRCE expenses can be accumulated in larger wind energy projects to make flow-through share financing a viable source of early-stage financing for these projects.
A “test wind turbine" has a specific meaning set out in the Regulations. In addition to meeting specified conditions, the Minister of National Revenue, in consultation with the Minister of National Resources, must be satisfied that:
- the “device” does not exceed specified planned nameplate capacity limits;
- the wind farm project does not share a point of interconnection to a transmission or distribution system with another project;
- if there is no point of connection to a transmission or distribution system, the project can be connected to another electrical system more than 10 kilometres from any other transmission or distribution system and from which system at least 90% of the electrical energy produced by the project is used in a business carried on by the taxpayer or an arm’s length person or partnership;
- the primary purpose for installing the device is to test the level of electrical energy produced from wind at the place of installation;
- no other test wind turbine is installed within 1,500 metres of the device; and
- no other wind energy conversion system is installed within 1,500 metres of the device until the device has been tested for 120 days.3
There is a significant volume of published Canada Revenue Agency ("CRA") rulings providing opinions on whether particular devices qualify as test wind turbines. Tax rulings have become the norm for larger projects involving third party financing and flow-through share offerings of CRCE.
Limitations on the Transfer of Tax Benefits to Investors
Specified Energy Property Rules
The attractive tax attributes of a renewable energy project may be restricted by specific and complex rules in the Tax Act. The principal restriction is found in the specified energy property (“SEP”) rules which limit the deduction of CCA on the cost of renewable energy property to a maximum of the income from such property, unless the taxpayer’s principal business is the generation or production of an energy or industrial process.
SEP is a property described in any of Class 34, 43.1, 43.2, 47 or 48.4 If a property is included in one of these classes, the CCA deduction in respect of the property that can be claimed by the owner is restricted to the income generated by that property, subject to the following three exceptions:5
- Exception 1: 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. If a partnership is the owner of SEP, each member of the partnership must be a corporation which satisfies this principal business test.
- Exception 2: The SEP rules do not apply to property used by the owner primarily for the purpose of gaining or producing income from a business carried on in Canada (other than the business of selling energy). This exception applies to the large industrial companies in Canada that currently generate electricity for their own use and sell the surplus to public utilities.
- Exception 3: 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 exception #1, or to a user described in exception #2.6
Several other rules in the Tax Act may limit the use of tax attributes otherwise available to owners of renewable energy projects. Most of these restrictions apply to a project entity structured as a partnership. These restrictions would typically be relevant only if the project entity were able to overcome the SEP restrictions.
If the energy project is owned through a limited partnership, the “at-risk rules” apply to limit losses that can be claimed by the partners against other sources of income to the taxpayer’s “at-risk amount”, i.e., the equity balance of its investment. The impact of the at-risk rules can be mitigated if limited partners borrow money to make capital contributions, thereby moving up some of the financing expenses to the partner level. Such planning must be carefully considered in the context of the tax shelter rules.
Specified Member Negative ACB
If the project is structured as a partnership, any “specified member” of the partnership whose cost base in its partnership investment becomes negative in a taxation year will recognize a capital gain for that year. Such situations are common where cumulative cash distributions exceed the capital account of an investor because of the tax deductions generated by project level debt.
Tax Shelter Investment
The tax shelter investment rules can apply to either the direct ownership of renewable energy property or a partnership interest. A property (or partnership interest) is a “tax shelter” if it can reasonably be considered, having regard to statements or representations made in connection with the proposed acquisition of the property (or interest in a partnership), that the purchaser can reasonably expect to receive deductions or other tax benefits (or partnership losses) that would equal or exceed its cost of such property (less any prescribed benefit) within a four year period. Such statements or representations can be very informal, such as tax schedules to a financial model or exchange of emails.
Moreover, many forms of limited recourse financing are included in the definition of "prescribed benefit" such that the cost of such property must be reduced for the purpose of applying the tax shelter definition. For example, any arm’s length debt with a term of more than 10 years is deemed to be a prescribed benefit. If that debt is incurred by a project partnership, the partnership must reduce the tax cost of property acquired with such debt until the debt is repaid.
If the tax shelter rules are applicable, then the “promoter” must register the investment with the CRA or face significant penalties, together with the loss of tax benefits for investors. In addition, the limited recourse rules will apply to reduce the tax attributes of the property (or partnership interest) financed with limited recourse amounts.
Structuring Foreign Investment in Renewable Energy Projects
Generally, instead of making a direct investment in a Canadian renewable energy project, foreign investors will find it more advantageous to use a Canadian corporate blocker ("Canco") to own their investment in the project for a number of reasons.
First, a direct investment in a Canadian renewable energy project will require the foreign investor to file a Canadian tax return which will then be subject to audit by the CRA. That audit review could potentially spill over into other aspects of the foreign investor’s business operations. Moreover, the requirement to compute income using both Canadian and home country tax rules would likely mean differing tax liability calculations with the possibility of a mismatch between foreign tax credits and Canadian tax payable.
Second, Canada levies a “branch tax” on after tax profits that are not reinvested in the Canadian business. The branch tax rate is 25%, although many of Canada's tax treaties provide for a threshold amount (e.g., C$500,000) before the tax is levied, and reduce the tax rate to 5%.
Third, the Tax Act imposes a capital gains tax on non-residents who dispose of TCP, supported by reporting and tax withholding obligations in respect of the disposition of TCP. An interest in a project partnership would be TCP if such share (or partnership interest) derives more than 50% of its fair market value, directly or indirectly, from real or immovable property situated in Canada. The property intensive nature of energy projects often creates uncertainty whether an interest in an underlying project partnership would be TCP because much of its value could be attributable to real or immovable property. Where multiple investors are involved in the sale of partnership interests, that uncertainty is generally resolved by taking the most conservative position which is to withhold and remit to the CRA on the sale the maximum statutory rate of 25% of any sale proceeds. Interposing a Canco allows the sale proceeds to be paid to Canco, which can then manage the issue on its own terms.
Fourth, the attractive tax attributes of renewable energy in Canada often provide an overall tax deferral compared to current taxation in the home jurisdiction if the investment were held directly and subject to less favourable tax treatment. It may also be advantageous not to repatriate taxable income to the foreign jurisdiction if the Canadian tax rate is lower than the home jurisdiction’s tax rate. In that regard, Canada taxes only 50% of capital gains. This is a meaningful advantage in situations where any exit strategy will likely involve a large capital gain—a significant possibility because most of the cash flow generated by a renewable energy project during the ownership period will be sheltered by CCA and other tax deductions.
Implementation of a Canadian Blocker
The usual way to structure foreign investment in Canadian energy projects is to incorporate a Canco to hold either the energy project or an interest in a project partnership.7
Canco can be incorporated an ordinary corporation or, depending on the tax rules applicable in the jurisdiction of the foreign investor, it may be advantageous to organize Canco as an unlimited liability company (“ULC”) under the provincial legislation of Nova Scotia, Alberta or British Columbia. A ULC can be advantageous when the jurisdiction of the foreign investor treats the ULC as a fiscally transparent entity and allows the foreign investor to consolidate losses or income of the ULC against the income of other members of the corporate group, or to directly claim foreign tax credits on Canadian taxes paid by the ULC. Canada would treat the ULC as an ordinary corporation for Canadian tax purposes and, consequently, the ULC would be required to file a Canadian corporate tax return and pay taxes on the income from (and the proceeds of sale of) its investment in the Canadian energy project.
Canadian corporate legislation does not provide a shareholder of a ULC with limited liability, so it would be necessary to interpose a limited liability entity in the foreign jurisdiction between the foreign investor and the ULC.
As a result of the Fifth Protocol amendments to the U.S. Treaty introducing anti-hybrid rules as well as adding a limitation on benefits provision applicable to U.S. residents, the use of a ULC directly owned by a U.S. resident would need to be reviewed carefully to ensure that distributions from the ULC qualify for treaty relief.
Capitalization of a Canadian Blocker
Canco may be capitalized partially with debt. If the debt is owed to an arm’s length non-resident, nonparticipating debt interest paid to the non-resident would be exempt from Canadian non-resident withholding tax.
The capitalization of Canco is subject to Canadian thin capitalization rules, which limit the use of interest bearing debt on a 2:1 debt-to-equity basis. Interest on the debt owing by Canco that is paid or credited to a non-resident owner is generally deductible against the earnings of the energy project, subject to those limitations.
Withholding Tax and Repatriation of Earnings
Canco can distribute cash flow to its foreign shareholder as a return of its original invested share capital, regardless of whether it has retained earnings. No special Canadian tax elections are required and no Canadian withholding tax would arise on a return of capital. The only corporate law requirement that Canco must satisfy before it can return capital is a statutory solvency test which requires, following the distribution of capital, that (1) the net realizable value of Canco’s assets equals or exceeds the aggregate of its liabilities; and (2) Canco is able to pay its liabilities as they become due.
For U.S. residents that qualify for benefits under the U.S. Treaty, the withholding tax exemption on interest payments extends to interest paid on non-arm’s length debt, provided the interest is not “participating interest”. For these purposes, “participating interest” generally means amounts determined by reference to income, profits or cash flow of the debtor. Payments that are participating interest are treated as dividends which are subject to a 5% withholding tax rate if the investor owns 10% or more of the voting stock of the company making the distributions and a 15% rate in other cases. Withholding tax is also payable on rents and other forms of passive income paid or credited to a foreign investor by a Canadian resident at the 25% domestic rate, subject to reduction or exemption under an applicable tax treaty.
Use of a Foreign Blocker
There may be some advantage to interposing a blocker entity established in a foreign jurisdiction to own Canco or the partnership interest. For example, private equity investments are sometimes held through a holding company incorporated in a foreign jurisdiction because of administrative difficulties in obtaining necessary information regarding the residence of multiple levels of individual investors to qualify for treaty benefits. Another reason for using a foreign blocker arises where the foreign investor is subject to export investment restrictions, as it allows the foreign investor to accumulate (and retain) capital outside of its home jurisdiction and enables it to pursue a more flexible investment strategy.
The use of a foreign blocker located in a favourable treaty jurisdiction can be challenged by the CRA on several bases, such as: (1) the blocker is only an agent and not the beneficial owner of the Canadian investment; (2) the blocker’s existence is solely for tax avoidance purposes and therefore treaty benefits may be denied under Canada’s general anti-avoidance rule; (3) the blocker is resident for tax purposes in Canada on the basis that its management and control resides in Canada rather than in the foreign jurisdiction; and (4) a tax treaty limitation on benefits provision applies to deny or limit treaty benefits.8
Planning with a foreign blocker must take into account the taxation of dividends, interest and capital gains in the blocker’s jurisdiction, and the taxation of amounts redistributed by the blocker to the foreign investor.
Exit Strategy: Sale of Energy Project
An important consideration for any inbound investment is the exit strategy, particularly in the case of renewable energy projects which are generally not taxable on their cash flow for a number of years due to the tax incentives described above.
As mentioned above, the Tax Act imposes a capital gains tax on non-residents who dispose of TCP, which would include a share of Canco or an interest in a project partnership if such share (or partnership interest) derives more than 50% of its fair market value, directly or indirectly from real or immovable property situated in Canada.
If Canco shares (or partnership interest, if held directly by the foreign investor) are not TCP, then they can be sold without any Canadian taxation.
If Canco sells its interest in an energy project partnership, only 50% of the capital gain is included in Canco's income which is then taxed at regular federal corporate tax rates. Consequently, in 2011 Canco will pay capital gains tax at an effective rate of 15%, assuming Canco is resident in Ontario. Tax rates are scheduled to be further reduced in 2012 and 2013. The balance of the sale proceeds can be distributed as a combination of a tax-free return of capital and a taxable dividend.
If, instead, a partnership sells the energy project, it would realize a mixture of recapture9 and capital gains, and allocate such amounts to its partners including Canco. Under these three scenarios, the optimal result (solely from a Canadian tax perspective) is to exit by selling either the shares of Canco or the partnership interest.
By way of illustration, if we assume that over the course of its 10 year life, the project makes tax sheltered cash distributions, retires substantially all of its project debt and is sold for proceeds of $100 million (half of which is recapture, half of which is a capital gain) then federal tax payable under the scenarios described above as follows:
- If the partnership sells the energy project, the corporate tax payable is $22.5 million, i.e., $15 million ($50 million @ 30%) plus $7.5 million ($50 million @ 15%);
- Alternatively, if Canco sells its partnership interest, the corporate tax payable is $15 million ($100 million @15%);
- Alternatively, if the foreign investor sells shares of Canco (or a partnership interest if held directly by foreign investor) and such shares (or partnership interest) are not TCP, no Canadian corporate tax is payable.
The significant tax incentives available for foreign investment in Canadian renewable energy projects, coupled with the ability to repatriate capital on a tax advantaged basis provide a foreign investor with the opportunity to both generate tax sheltered cash flow during the ownership period and minimize Canadian corporate tax on the investor’s eventual exit from the investment. In addition, the attractive residual cash flows of most energy projects make these projects beneficial investments even after the tax incentives have been utilized.