Income Tax Incentives for Solar Energy Development in Canada. By Laura Monteith, Ash Gupta, and Thomas J. Timmins of Gowling Lafleur Henderson LLP

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1 Income Tax Incentives for Solar Energy Development in Canada By Laura Monteith, Ash Gupta, and Thomas J. Timmins of Gowling Lafleur Henderson LLP This article provides a brief summary overview of several of the principal tax incentives for commercial solar energy projects in Canada under the Income Tax Act (Canada) (the Act ) and the Income Tax Act Regulations (the Regulations ). Solar Energy Incentives There are three significant tax incentives available with respect to solar energy: 1. accelerated capital cost allowance ( CCA ) for certain assets; 2. immediate write-offs in respect of Canadian Renewable and Conservation Expenses ( CRCE ); and 3. the benefits of being able to issue so-called flow-through shares. In addition, certain tax credits may be available for Scientific Research and Experimental Development related to solar energy. The ability to access these tax incentives depends on a variety of factors, such as the type of investment, situs (Canadian resident or non-resident) and the type of investor (e.g., single purpose funds, fund-offunds, individual, corporation, etc.) and the entities comprising the investment structure (i.e., corporation, partnership or trust). Certain investment structures allow investors to maximize their ability to access the tax incentives described below, while strict limits are imposed on the use of other structures. As a result, careful tax law planning is required for every solar energy project and for investors considering an investment in solar energy. 1. Capital Cost Allowance Accelerated CCA rates available for certain types of solar energy assets are found in Schedule II of the Regulations under Class 43.1 and In order for a property to be eligible for inclusion in Class 43.1 or 43.2, it must: 1. be situated in Canada; 2. be acquired by the taxpayer for use by the taxpayer, or by a lessee of the taxpayer, for the purpose of earning income from a business carried on in Canada or from property situated in Canada; 1 and 1 Where Class 43.1 property meets the definition of specified energy property in subsection 1100(25) of the Regulations, the amount of CCA that may be claimed is generally limited to the income earned from such property (subsection 1100(24) of the Regulations). This restriction does not apply where the purchaser uses the property in

2 not have been used for any purpose before the taxpayer acquired the property. 2 Most electricity generating and distributing equipment qualifies as Class 1 property for which only a 4% CCA rate is prescribed (electricity transmission and distribution assets have a higher 8% rate). However, renewable energy and energy conservation systems, including wind, small hydro, solar and cogeneration assets that produce electricity fall within Class 43.1, qualifying for a 50% CCA rate under Class 43.2 (subject to the half-year rule which applies in the year of acquisition) for property acquired after February 22, 2005 and before 2020, for the full range of renewable energy equipment included in Class 43.1 and for certain high-efficiency cogeneration equipment. For equipment acquired before or after that time, the rate is 30%. In order to qualify under Class 43.1, the solar energy asset must be available for use 3 and fall within paragraph (d) of Class With respect to solar energy, the following types of assets will generally qualify: Fixed location photovoltaic equipment that is used by the taxpayer, or a lessee of the taxpayer, primarily for the purpose of generating electrical energy from solar energy if the equipment consists of solar cells or modules and related equipment including inverters, control, conditioning and battery storage equipment, support structures and transmission equipment. There are a number of assets that may be part of a solar energy system which are not eligible under Class 43.1 including, electrical distribution equipment and facilities, other back-up generating equipment (such as a diesel engine, main switch or power bar), vehicles, telephone equipment, access roads, sidewalks and other assets normally included in Class 10 or Canadian Renewable and Conservation Expenses CRCE is a category of deductible expenses that are included in a taxpayer s Canadian Exploration Expense ( CEE ) pool. In general terms, CRCE are those development costs associated with the development of a project that consists primarily of equipment eligible for inclusion in CCA for Class 43.1 or 43.2 (as described above). Such expenses will be considered CRCE if they are payable to arm s length persons or partnerships that are Canadian residents or Canadian partnerships (i.e., a partnership all of the members of which are Canadian residents). 4 However, only certain development costs in respect of a Class 43.1 or 43.2 project will qualify as CRCE, including expenses for: their own business or when certain ownership conditions are satisfied (e.g., principal business corporation or a partnership each member of which is a principal business corporation ). 2 Used, reconditioned or remanufactured equipment will not be eligible unless: (i) it is depreciable property previously included in Class 34 or 43.1 by the person from whom it was acquired or would have been included had the person made a valid election to include the property; (ii) it was acquired by the taxpayer not more than five years after the time it was considered to have become available for use by the person from whom it was acquired; and (iii) the property remains at the site in Canada at which it was used by the person from whom it was acquired. The testing and commissioning of otherwise new equipment prior to purchase will not normally result in a finding that the property has been used prior to its acquisition: E5. 3 Subsection 13(26) of the Act. 4 Regulation 1219(1).

3 the purpose of making a service connection to the project for the transmission of electricity to a purchaser; 2. the construction of a temporary access road to the project site; 3. a right of access to the project site; 4. clearing land to the extent necessary to complete the project; 5. process engineering for the project; 6. the drilling or completion of a well for the project; and 7. a test wind turbine that is part of a wind farm project of the taxpayer. Specifically excluded is any expense that is: 5 1. interest, compound interest, an expense regarding financing, or an annual fee regarding the borrowing of money, deduction of which is permitted under section 20 of the Act; or 2. incurred by a taxpayer directly or indirectly that is: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) for the acquisition of, or the use of or the right to use, land; for grading or levelling land or for landscaping; payable to a non-resident person or a partnership other than a Canadian partnership ; included in the capital cost of property that would otherwise be depreciable property; an expenditure that would be an eligible expenditure or that would be included in the cost of inventory of the taxpayer; an expenditure on, or in respect of, scientific research and experimental development; Canadian development expense or a Canadian oil and gas property expense; incurred for a project, in respect of any time at or after the earliest time at which a property described in Class 43.1 or 43.2 was used in the project for the purpose of earning income; incurred in respect of the administration or management of a business of the taxpayer; or a cost attributable to the period of the construction, renovation or alteration of depreciable property, other than property described in Class 43.1 or 43.2 that relates to the construction, renovation or alteration of the property or the ownership of land during the period. The expenses that are specifically excluded from having CRCE status may be deducted under other provisions of the Act or allocated to the cost of capital or depreciable property. It is important to note that it will not be possible for expenses incurred after the project commences to earn income to qualify as CRCE. 5 Regulation 1219(2).

4 - 4 - As with CEE expenses, generally, CRCE expenditures are fully deductible in the year in which they are incurred. Unused CRCE may be carried forward and deducted against income earned in future years. 3. Flow-Through Shares In certain circumstances, expenditures added to a corporation s CEE pool may be renounced and passed on to the corporation s shareholders through the so called flow-through share rules under the terms of a flow-through share agreement. In general, such agreements allow a principal business corporation to raise funds for financing its proposed energy conservation or renewable energy project by issuing flowthrough shares. A principal business corporation (as defined in subsection 66(15)) includes, among other things, a corporation the principal business of which is any of, or a combination of: 1. the generation or distribution of energy or the production of fuel using property described in 43.1 or 43.2; and 2. the development of 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 property described in Class 43.1 or Thus, it is a question of fact as to whether the principal business of a corporation satisfies the criterion specified in subsection 66(15) of the Act, which must be determined by reference to all of the surrounding circumstances, and in particular, a review of all the various activities carried on by the corporation and the assets to be acquired and used in the project. Corporations whose principal business is generating energy using Class 43.1 or 43.2 properties, or corporations that are still in the development stages for such a principal business, will be allowed to raise investment capital by issuing flow-through shares. In general terms, a corporation that issues flowthrough shares will be entitled to renounce or flow-through qualifying expenses to the holders of such shares, with the result that those shareholders will be entitled to deduct the expenses as if they had incurred them themselves. It should be noted that there are many legislative and administrative restrictions and requirements that must be satisfied in order for a corporation to be able to issue flowthrough shares and renounce expenses to holders of flow-through shares Scientific Research and Experimental Development The Scientific Research and Experimental Development (SR&ED) program is a federal tax incentive program to encourage Canadian businesses to conduct R&D in Canada. Claimants can apply for SR&ED investment tax credits for expenditures on wages, materials, machinery, equipment, overhead, and outside SR&ED contracts. A Canadian-controlled private corporation can earn a refundable investment tax credit of 35% up to the first $3 million of qualified expenditures for SR&ED carried out in Canada (shared between associated corporations ), and 20% on any excess amount. Other Canadian corporations, proprietorships, partnerships, and trusts can earn a non-refundable investment tax credit of 20% of qualified expenditures for SR&ED carried out in Canada. Work qualifying for SR&ED must be systematic and must address scientific or technological uncertainties, advance understanding of science or technology, have scientific and technical content, and can include experimental development to advance, improve or innovate materials, devices, products, or processes, as well as support work in engineering, design, programming, data collection or testing in support of experimental development. ( Routine data collection or testing, and routine engineering, is not included). In some provinces (notably Ontario, Quebec and Alberta) SR&ED expenditures qualify for additional tax credits as well. 6 See subsections 66(12.6) and 66(12.61) of the Act, and subsections 1206(1),(4.1) and (4.2) of the Regulations.

5 - 5 - Gowlings is in your corner Gowlings is a full service national law firm with expertise in all aspects of solar energy projects, including tax efficient investment structures, to assist stakeholders in developing innovative and forward-looking solutions in developing solar energy projects. This publication is for informational purposes only. It is not, and should not be taken as legal advice. You should not rely on, or take or fail to take any action based upon, this information. Never disregard professional legal advice or delay in seeking it because of something you have read in this publication. Gowlings professionals will be pleased to discuss resolution to specific legal concerns you may have. For more information or to contact one of our legal professionals, please visit us at gowlings.com. Gowlings 2011

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