This article is an overview of the Canadian income tax considerations relevant to Canadian renewable and conservation expenses ("CRCE") initially introduced in the March 1996 Canadian Federal Budget as a new category of deductible expenses and related recent amendments included in the March 2012 Canadian Federal Budget which were enacted in December 2012 and the March 2013 Canadian Federal Budget.
The CRCE regime was introduced to place the “renewable energy sector” on a level playing field with the non-renewable resource sector namely, oil, gas and mining, by treating CRCE as a deductible pool of expenses with tax treatment similar to that of Canadian exploration expenses ("CEE") under section 66 of the Income Tax Act (Canada) (the "Act"). As the upfront soft costs incurred in developing and exploring for oil and gas and minerals can be very significant, the Act contains provisions that in many cases permit immediate deductions for such expenditures referred to as CEE. Similar issues exist for developers/operators of environmentally friendly or otherwise known as green, renewable or next generation energy projects (e.g., wind, solar, run-of-river, cogeneration, biofuels, etc.).
Canadian Tax Treatment of Development Expenses Under the CRCE Regime
Before the introduction of CRCE, development expenses could generally be characterized as eligible capital expenditures or added to the cost of the equipment or other property. In either case, there was a significant disincentive to undertaking speculative work in the green energy or renewable energy sector. Under the CRCE regime, expenses incurred for certain renewable energy-related development work, subject to certain specific exceptions as described in the Income Tax Regulations (Canada) (the “Regulations”) to the Act, are fully deductible when incurred and can be carried forward indefinitely.
CRCE generally includes intangible expenses incurred by a "principal-business corporation" (as defined in the Act) and payable to an arm's length party in connection with the development of an energy project wherein at least 50% of the capital cost of the depreciable property in the renewal energy project is property described in Class 43.1 (a “Class 43.1 Asset”) or Class 43.2 (a “Class 43.2 Asset”), under the Canadian taxation system for capital cost allowance ("CCA") under Schedule II to the Regulations.
Qualifying expenses under the CRCE regime generally include expenses related to:
- The cost of temporary roads to the site;
- Pre-feasibility studies;
- Negotiation costs that are not property or finance related;
- Site approval costs;
- Evaluations and feasibility studies;
- Environmental or other site specific feasibility studies;
- Site preparation costs;
- Start-up and/or commissioning;
- Training of operators and maintenance personnel;
- The cost of building service connections for the transmission of electricity or power; and
- The cost of acquiring and installing test wind-driven turbines (provided however that a favourable opinion regarding the testing of a specific wind turbine is obtained from Natural Resources Canada).
Non-qualifying expenses under the CRCE regime generally include certain soft costs such as:
- Project management fees;
- Legal fees;
- Interest and financing fees; and
- Accounts payable to non-residents and partnerships that are not Canadian partnerships.
Non-qualifying expenses may be deducted under other provisions of the Act or allocated to the actual cost base of the equipment or other property.
Class 43.1 Assets
Separate CCA classes are prescribed in the Regulations to the Act for various types of tangible fixed assets used in a business and the cost of the assets in each class can be depreciated at prescribed rates. The Class 43.1 Technical Guide prepared by the Canada Revenue Agency ("CRA") provides an extensive list of the expenses that qualify for CRCE. Class 43.1 Assets include new assets used in systems to conserve energy or that use renewable forms of energy such as water, heat, wind, certain waste fuels or heat exchange/recovery systems that recirculate heat from thermal waste. Simply put, some of the types of systems that qualify under Class 43.1 are cogeneration systems that generate electricity and reusable heat that do not exceed an efficiency rating of 6,000 BTU per kilowatt-hour; electricity generating equipment, heat production and recovery equipment, fossil fuel equipment, feed water and condensate equipment; energy systems that produce power from sunlight; wind energy systems (i.e., 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; and small hydro electric projects that have an annual rate capacity not to exceed 50 megawatts. These types of Class 43.1 Assets qualify for a 30% CCA deduction on a declining basis subject to the half-year rule.
Class 43.2 Assets
Class 43.2 Assets include certain assets that would otherwise be Class 43.1 Assets but are new and acquired after February 22, 2005. Class 43.2 Assets consist of certain highly fossil-fuel efficient and renewable energy generation equipment. If the particular asset qualifies as a Class 43.2 Asset, the CCA deduction is increased to 50% on a declining basis. Providing accelerated CCA in this context is an exception to the general practice of setting CCA rates based on the useful life of assets. Accelerated CCA provides a financial benefit by deferring Canadian taxation. This incentive for investment is premised on the environmental benefits of low-emission or no-emission energy generation equipment.
Recent amendments have expanded Class 43.2 with respect to waste-fuelled thermal energy equipment and equipment of a district energy system that uses thermal energy provided primarily by eligible waste-fuelled thermal energy equipment. These amendments have also expanded Class 43.2 to include equipment that uses the residue of plants, generally produced by the agricultural sector, to generate electricity and heat (bio-waste). These measures should encourage investment in technologies that can contribute to a reduction in emissions of greenhouse gasses and air pollutants in support of Canada’s targets as set forth in the Federal Sustainable Development Strategy. These measures may also contribute to the diversification of Canada’s energy supply.
Waste-Fuelled Thermal Energy Equipment
Waste-fuelled thermal energy equipment produces heat using wastes (e.g., wood waste) and fuels from waste (e.g., bio-gas and bio-oil). Such equipment is included in Class 43.2 subject to the requirement that the heat energy generated from the equipment is used in an industrial process or a greenhouse. The recent amendments expand Class 43.2 by removing this requirement to allow waste-fuelled thermal energy equipment to be used in a broad range of applications, including but not limited to space and water heating and wood waste which could be used as an alternative to heating oil for space and water heating in commercial complexes such as shopping centres, hospitals and government buildings.
Equipment of a District Energy System
District energy systems transfer thermal energy between a central generation plant and a group of buildings by circulating steam, hot water or cold water through a system of underground piping, which can be used for heating, cooling or industrial processing. Certain equipment that is part of such district energy system qualifies as a Class 43.2 Asset if the system distributes thermal energy primarily generated by one or more of an eligible co-generation system, a ground source heat pump, active solar heating equipment and/or heat recovery equipment. The recent amendments expand Class 43.2 by adding equipment that is part of a district energy system that distributes thermal energy primarily generated by waste-fuelled thermal energy equipment.
Energy Generation from Residue of Plants
The residue of plants (e.g., straw, corn cobs, leaves and similar organic waste produced in the agricultural sector), can be used in a number of ways, including the production of heat, electricity, bio-fuels and other bio products. The recent amendments add the residue of plants to the list of eligible waste fuels (eg. bio-gas, bio-oil, digester gas, landfill gas, municipal waste, pulp and paper waste, and wood waste) that can be used in waste-fuelled thermal energy equipment included in Class 43.2 or a co-generation system included in Class 43.1 or 43.2, provided however that users must do so in an environmentally responsible manner and abide by all applicable federal, provincial, territorial and local environmental laws and regulations.
Proposed Amendments in 2013 Canadian Federal Budget
The 2013 Canadian Federal Budget proposes to expand Class 43.2 by making biogas production equipment that uses more types of organic waste eligible for inclusion in Class 43.2, including pulp and paper waste and wastewater, beverage industry waste and wastewater and separated organics from municipal waste, and the range of cleaning and upgrading equipment used to treat eligible gases from waste that is eligible for inclusion in Class 43.2, to all such cleaning and upgrading equipment.
These proposed measures will apply to property acquired on or after March 21, 2013 that was not used or acquired for use before March 21, 2013.
"Flow-Through" Share Financings
A new opportunity for equity financing has blossomed as a result of the ability of a "principal-business corporation" to renounce CRCE to its shareholders. A “principal-business corporation” includes, but is not limited to, a corporation of which the principal business is any of, or a combination of, producing, refining or marketing of petroleum, petroleum products or natural gas; exploring or drilling for petroleum or natural gases; mining or exploring for minerals; generating energy using Class 43.1 or Class 43.2 Assets and the developing projects for which it is reasonable to expect that at least 50% of the capital cost of the depreciable property to be used in each project would be the capital cost of Class 43.1 or 43.2 Assets. This source of capital may be an integral part of a principal-business corporation's financing requirements.
The introduction of the "flow-through" share rules to the renewable energy sector has provided access to financing for small to medium sized energy companies. "Flow-through" shares are true equity shares and are generally garden-variety common shares. A "flow-through" share is generally issued pursuant to a subscription agreement under which the subscribers agree to purchase the "flow-through" shares and the issuer agrees to incur an amount equal to the subscription price on CRCE and to renounce that amount of CRCE to the shareholders in accordance with the rules under the Act. 100% of CRCE renounced to a shareholder can generally be deducted by the shareholder from ordinary income and reduce the shareholder’s liability for income tax.
The amount of CRCE renounced to the shareholder cannot exceed the initial subscription price for the "flow-through" shares. The CRCE must be renounced to the shareholder during the period that begins on the day the agreement is entered into and ends 24 months after the end of the month in which the subscription agreement is entered into.
The "flow-through" share provisions contain a "look-back" rule that provides an additional tax advantage. Under the "look-back" rule, CRCE incurred in the year after the "flow-through" share subscription agreement is concluded may be renounced to the shareholders effective in the first year so that all the CRCE incurred in both the first and second year can be deducted in the first year.
In summary, the three main Canadian federal income tax incentives offered to "green” energy projects are as follows:
- The immediate deduction available for certain expenses incurred in the development of CRCE-related projects;
- The accelerated CCA permitted for Class 43.1 Assets and Class 43.2 Assets used in CRCE projects; and
- A "flow-through" share mechanism which allows "principal-business corporations" to finance their operations and also to allocate certain expenditures to their shareholders for the purposes of assisting shareholders in sheltering their personal income from Canadian taxation.