Capital Allowance. for Manufacturing Corporations in Canada and the United States

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1 Capital Allowance for Manufacturing Corporations in Canada and the United States Released November 2013

2 author`s biography Odette Pinto PhD, MBA, CGA Odette Pinto is an assistant professor at MacEwan University s School of Business in Edmonton, conducting research and teaching courses in income tax and international business. Odette obtained her PhD (Accounting) from the University of Alberta in January, 2010, having previously obtained a MBA from the University of Alberta in 2002, with a major in International Business. She is also a Certified General Accountant, and her career has focused primarily on income tax. Odettehas completed the In-Depth tax course, offered by the Canadian Institute of Chartered Accountants, and much of her work experience in public accounting has been as a tax consultant.

3 executive summary Executive Summary: The financial crisis and economic upheaval in 2007 and 2008 led to economic stimulus measures in countries around the world. In Canada, accelerated capital cost allowance (ACCA) was introduced in 2007 to allow for a faster write-off and cost recovery for manufacturing equipment. In the United States, the Economic Stimulus Act was introduced in February 2008 with generous Section 179 deductions (primarily for small businesses) and special depreciation allowances, commonly referred to as bonus depreciation allowance. These were introduced to recover the cost of capital assets more quickly, with larger write-offs in the early years. While bonus depreciation in the United States applies to most classes of property, Accelerated Capital Cost Allowance (ACCA) has a very limited application for manufacturing equipment (since 2007) and clean energy equipment (since 2010). Furthermore, bonus depreciation in the U.S. allows for a more significant write-off in the year of purchase than ACCA, as both bonus depreciation and regular MACRS depreciation are computed in the year of purchase, and the half-year convention is not applicable to bonus depreciation while the half-year rule is applicable to ACCA. Bonus depreciation in the United States has been extended to December 31, 2013, while ACCA in Canada has recently been extended to December 31, This paper reviews and compares the Canadian and U.S. systems of tax depreciation (capital allowance) for Machinery and Equipment, both before and after the introduction of ACCA in Canada and special deduction allowances in the United States. It uses examples of assets that are comparable and provide some sample calculations of deductions. It concludes that capital allowances and the tax treatment for capital assets provide for faster write-offs in the United States, putting Canadian manufacturers at a disadvantage with manufacturers in the United States.

4 TABLE OF CONTENTS Table of contents Content Introduction 1 Capital Cost Allowance (CCA) system in Canada 2 Modified Accrual Cost Recovery System (MACRS) in the United States 2 A comparison of the CCA system (Canada) and MACRS (United States) 2 Accelerated Capital Cost Allowance (ACCA) in Canada 4 U.S. Economic Stimulus packages between the years 2008 to Section 179 in the United States 5 Special Depreciation Allowance (Bonus Depreciation) in the United States 5 Highlight of the differences between ACCA (Canada) and Bonus Depreciation (United States) 6 Impact of the Capital Allowance systems in Canada and the United States 7 Conclusion 9 Apendix Apendix 1 CCA Class 43 (Canada) vs. MACRS Class 28 (United States/US): Assets used in the Manufacture of Chemicals & Fertilizers 9 Apendix 2 CCA Class 35 (Canada) vs. MACRS Class (USA): Locomotives & railcars 10 Apendix 2A CCA Class 7 (Canada) vs. MACRS Class (USA): Locomotives and Railcars 11 Apendix 2B CCA Class 10(y)(Canada) vs. MACRS Class (USA): Locomotives only 12 Apendix 3 ACCA Class 29 (Canada) and Bonus Depreciation Class 28 (USA): Assets used in the manufacture of Chemicals and Fertilizer 13 Apendix 3A CCA Class 7 and 10(y) (Canada) and Bonus Depreciation Class (USA): Locomotives and railcars 14 TOC

5 CONTENT Introduction Capital expenditures are major expenditures of large amounts, require a long-term commitment, affect strategic planning and have a significant effect on a corporation s cash flow. Since capital expenditures are expected to benefit a corporation over a long period of time, they are written off for tax purposes (deductible from income) over a period of time. In Canada, the Capital Cost Allowance system describes how capital expenditures are allocated as tax deductions while in the United States, the Modified Accrual Recovery System (MACRS) applies. Capital Cost Allowance (CCA) in Canada and Depreciation Allowance in the United States are tax concepts that can be compared to the accounting concept of depreciation (amortization). The underlying principle is the matching principle, with the allocation of the capital expenditures over a period of time that approximately reflects the life of the capital assets. However, generally corporations get faster write-offs for capital assets for tax purposes than for accounting purposes, as generally accepted accounting principles require a closer adherence to the matching principle. The financial crisis and economic upheaval in 2007 and 2008 led to economic stimulus measures in countries around the world. In Canada, accelerated capital cost allowance (ACCA) was introduced in 2007 to allow for a faster write-off and cost recovery for manufacturing equipment. In the United States, the Economic Stimulus Act was introduced in February 2008 with generous Section 179 deductions (primarily for small businesses) and special depreciation allowances, commonly referred to as bonus depreciation allowance. These were introduced to recover the cost of capital assets more quickly, with larger write-offs in the early years. Qualified property eligible for the bonus depreciation is defined, and there are some restrictions. However, while bonus depreciation in the United States applies to most classes of property, Accelerated Capital Cost Allowance (ACCA) has a very limited application for manufacturing equipment (since 2007) and clean energy equipment (since 2010). Furthermore, bonus depreciation allows for a more significant write-off in the year of purchase than ACCA, as both bonus depreciation and regular MACRS depreciation are computed in the year of purchase, and the half-year convention is not applicable to bonus depreciation while the half-year rule is applicable to ACCA. Bonus depreciation in the United States has been extended to December 31, 2013, while ACCA in Canada has recently been extended to December 31, The results of this research study indicate the differences between CCA (Canada) vs. MACRS (United States), with MACRS generally allowing for a faster write-off of capital expenditures. The results also indicate differences between ACCA in Canada and Bonus Depreciation in the United States. Bonus Depreciation generally provides for a higher write-off in the year of purchase of a capital asset because a taxpayer can claim both bonus depreciation and the regular MACRS deduction in the year of purchase. Another important difference is that while Bonus Depreciation applies to most classes of assets, ACCA is primarily directed to manufacturing equipment. The comparisons between CCA vs. MACRS and ACCA vs. Bonus Depreciation suggest the differences between the capital allowance systems in the two countries are significant. The results also suggest that ACCA is needed in Canada in order to level the playing field between Canadian manufacturing corporations and their counterparts in the United States. 1

6 CONTENT Capital Cost Allowance (CCA) system in Canada The CCA system was introduced with the inception of the Income Tax Act in The CCA system consists of various classes of assets, with detailed and often lengthy descriptions of what assets belong in a particular class. The CCA deduction for a fiscal period is calculated on a class-by-class basis, with CCA rates assigned to each class. The most common method used to calculate CCA is the declining balance method, with the applicable CCA rate applied to a declining residual value in a class (called the Undepreciated Capital Cost or UCC). Asset additions, and dispositions, are recorded to the appropriate class and the capital cost allowance for a fiscal period is determined on a class-by-class basis, with the CCA rate applied to the declining balance in each class (i.e. the Undepreciated Capital Cost or UCC). One of the underlying principles of the tax system in Canada is economic stabilization; hence the federal government utilizes the CCA system for economic policy initiatives. This often results in changes to CCA classes, description of assets in classes and the CCA rates. Changes have often been introduced for economic reasons e.g. incentives to stimulate an industry during an economic recession, and such changes affect capital investment decisions. In March 1972, manufacturing equipment (i.e. assets used in manufacturing and processing) was allocated to Class 29, with a straight line CCA rate of 50%. This rate continued in effect until the 1987 tax reform provisions, with the CCA deduction for manufacturing equipment (Class 39) decreased to 40% and additional phased in reductions to 25% in Effective February 25, 1992, manufacturing equipment is included in Class 43, with a 30% CCA rate applied on a declining balance basis, with the 30% rate applicable until March, 2007, when ACCA was enacted by re-enacting Class 29, which allows for accelerated CCA for manufacturing equipment. Modified Accrual Cost Recovery System (MACRS) in the United States The MACRS system was introduced with tax reform in the United States in 1986, taking effect on January 1, MACRS consists of two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). IRS Publication 946 outlines which of the two systems are applicable. Generally, the GDS applies as the ADS is only required in limited situations, for specific listed property, tangible property used predominantly outside the United States during the year, farming property and taxexempt use property. The broad classifications of GDS are based according to the cost recovery period (i.e. the period over which the cost of property is written off). The majority of the manufacturing equipment classes (which are classified for different industries) are five- or seven-year properties. For example, assets used for manufacturing chemicals and allied products, which includes chemicals and fertilizers, are classified as five-year property with the recovery of the full cost in six years.locomotives and railcars (i.e. the completed, manufactured assets) are seven-year properties, with full cost recovery in eight years. Under MACRS, the capital allowance is determined on an asset-by-asset basis. The declining balance and straight line methods are both used, with most asset categories using a double-declining balance basis (200%) for the initial years and switching to straight line computations at a pre-determined optimal time period, which are indicated in the tables provided in IRS Publication 946. Thus, the MACRS system generally allows for a faster write-off of the underlying capital expenditures in the early life of a capital asset, despite the application of the half-year convention in the year of purchase for all MACRS classes. A comparison of the CCA system (Canada) and MACRS (United States) Similarities: Cost is the basis for both the CCA system and MACRS. Both countries have similar rules that determine whether improvements to a capital asset are a capital or current expenditure. The determining rules in both countries are based on assessing if there has been an increase in the value of an asset and/or if there is an enduring benefit. Manufacturing equipment is assigned to a separate class that is distinct from office equipment, computers and other general equipment, which could be other assets of a manufacturing corporation. The primary asset class for large manufacturing corporations, in both countries, is the assigned class for manufacturing equipment. he concept underlying the half-year rule in Canada and the half-year convention in the United States is similar. 2

7 CONTENT However, there are more specific rules in the United States in the determination of the acquisition date of a capital asset, which thus affects the application of the half-year convention. Differences: The capital allowance, calculated under MACRS in the United States, is calculated on an asset-by-asset basis. On the other hand, CCA, calculated under the CCA system in Canada, is calculated on a class basis. This makes MACRS more complex and difficult than the CCA system as individual assets have to be tracked and there is limited opportunity to aggregate assets for MACRS calculations. In Canada, the most common method used is the declining balance method, with the assigned CCA rate applied to the residual balance (UCC) in a class. In the United States, there are three acceptable methods: the 200% declining method (referred to as the doubledeclining method), the 150% declining method, and the straight-line method. The use of the double-declining balance method in an asset s life, with a switch to the straight-line method in an optimal time period, allows for a faster recovery of capital expenditures under MACRS (see Appendix 1). In Canada, there is one class for all manufacturing equipment as opposed to various manufacturing classes for equipment used in different industries in the United States. This makes it easier for the U.S. government to give preferential treatment to particular industries based on the economy, etc. The CCA classes and rates for manufacturing equipment under the CCA system have changed several times, including changes made since On the other hand, there has been very limited change in the MACRS classes for manufacturing equipment based on industry classifications since its inception in In the United States, bonus depreciation has been achieved through enactment of Section 168, rather than by adjusting the MACRS classes and/or rates. CCA is an optional claim in Canada, with a corporation having the ability to claim an amount from zero to the maximum (based on applying the CCA rate to the UCC) while MACRS is a mandatory claim in the United States. This provides for more tax planning opportunities in Canada. For example, loss corporations can defer claiming CCA if they want to limit their losses because of the loss carry-forward rules. Although there are similar rules in both countries that determine if improvements to an asset should be capitalized or expensed, the treatment of the capitalized improvement amount differs. In Canada, capitalized amounts are recorded as additions to the appropriate class, while in the United States capitalized amounts for improvements are recorded as separate assets, as MACRS calculates capital allowance on an asset-byasset basis, rather than a class-by-class basis. Although the half-year rule (Canada) and half-year convention (United States) are similar and generally limit the depreciation allowance to one-half the cost of net capital purchases in the year of purchase of an asset, the United States also has a mid-quarter convention. The mid-quarter convention reduces the MACRS depreciation allowances for capital assets purchased in the last calendar quarter of a year. Furthermore, the half-year rule in Canada applies to the net additions to a class while the half-year convention in applies to all asset purchases in the United States. Dispositions of assets are deducted from the appropriate class (at the lesser of the cost or the proceeds of disposition), therefore CCA is not allocated in the year of disposition of an asset and a terminal loss deduction only applies when the last asset in a class has been disposed of. On the other hand, in the United States, one-half of the normally calculated capital allowance is allowed in the year of disposition. Therefore, there is an offset for the half-year convention in the United States but no such offset for the half-year rule in Canada (except for certain assets, for example passenger vehicles in Class 10.1) Appendix 1 provides sample, comparative calculations that compare CCA deductions in Canada vs. MACRS deductions in the United States for manufacturers of chemicals and allied products, including fertilizers. Similarly, Appendix 2 provides comparative calculations for certain railway industry assets, including locomotives and railway cars. The sample calculations in Appendix 1 and Appendix 2 are based on a purchase of a capital asset that cost $100,000, and serve to illustrate the differences in the write-off and cost recovery of capital assets between Canada and the United States. 3

8 CONTENT Both appendices illustrate the faster write-offs of capital assets in the United States, particularly in the early years. For example, the difference in the cumulative write-off and cost recovery in the first three years of ownership of a capital assetis highlighted Financial Crisis The financial crisis in the United States triggered a global financial crisis that required a response by governments around the world, including Canada and the United States, to prevent a market collapses and a significant global economic crisis. In Canada, the federal government responded to the impending crisis by introducing several measures, including the enactment of accelerated capital cost allowance (ACCA) for certain capital expenditures, primarily manufacturing and processing equipment described in Class 29 of Schedule II of the Income Tax Regulations. The government introduced ACCA to stimulate capital investment in the manufacturing industry, which was struggling in the aftermath of the financial crisis. In the United States, the economic stimulus packages commenced in 2008, with annual extensions until These stimulus packages included the introduction of Section 179, with a generous deduction directed primarily at small business corporations, and Section 168(k) with special depreciation allowances (commonly referred to as bonus depreciation ) directed to all business corporations, including manufacturing corporations. Accelerated Capital Cost Allowance (ACCA) in Canada The federal government s tax policy has recognized the importance of the manufacturing industry to the country and has given preferential treatment for capital cost allowance for manufacturing and processing equipment. Class 29 was initially introduced in 1972 and continued in effect until January 1, Thereafter, Classes 39 and 43 were introduced with CCA rates of 40% and 30% respectively, applied on a declining balance basis, with the 30% rate remaining in effect until Class 29, with a 50% CCA rate applied on a straight-line basis, allows for cost recovery of capital expenditures in three years (25% in the first year, 50% in the second year and 25% in the third year, because of the application of the half-year rule). In effect, Class 29 allows for an accelerated capital cost allowance (ACCA) when compared to Class 43, with a 30% declining balance rate. ACCA was enacted to stimulate certain industries, primarily the manufacturing industry, by allowing for the faster write off of the cost of capital expenditures, and has been used from time to time by the federal government to stimulate the manufacturing industry during recessions or other economic downturns, for example in March 2007 in response to the financial crisis. The 2007 financial crisis led to a recession that significantly threatened the global economy and several countries, including Canada and the United States, which introduced incentives to kick-start a sluggish economy. In March 2007, the federal government enacted an accelerated capital cost allowance (ACCA) for manufacturing equipment, by reactivating Class 29. ACCA has been in effect for capital asset purchases after March 18, 2007, used in the manufacture of goods for sale or lease. However, in 2010, ACCA was extended to include clean energy generating equipment. Furthermore, the federal government has granted extensions to ACCA since its enactment in 2007, with the most recent extension being with the 2012 Federal Budget, granting an extension of ACCA up to December 31, U.S. Economic Stimulus packages between the years 2008 to Economic Stimulus Act of 2008 Enacted on February 13, 2008 Section 179 deduction limits were increased, with the maximum deduction increased to $250,000 and the threshold limitation increased to $800,000 (Section 179 applied primarily to small business). The 50% special depreciation allowance (bonus depreciation) was introduced to recover the costs of capital expenditures faster. The 50% rate for bonus depreciation allows for the write-off of 50% of the cost of the capital asset in the year of purchase, with the remaining balance subject to the regular MACRS depreciation allowance. The half-year provision does not apply to 50% bonus depreciation allowance but does apply to the regular MACRS depreciation allowance calculated in the first year (i.e. the year of purchase). 4

9 CONTENT 2. American Recovery & Reinvestment Act (ARRA) of 2009 Enacted on February 17, 2009 Further increase the Section 179 deduction limits, applicable for small business The 50% bonus depreciation was extended for the 2009 year 3. Hiring Incentives Act (HIRE) of 2010 Enacted on March 10, 2010 Section 179 limits introduced in 2009, continued for 2010 No mention of the 50% bonus depreciation being extended for Small Business Jobs and Credit Act of 2010 Enacted on September 27, 2010 Section 179 deduction limits further increased for the years 2010 and 2011 to a maximum deduction of $500,000 and a phase-out threshold of $2,000,000. However, discussions with manufacturing industry representatives indicate that Section 179 continues to be primarily applicable to small business corporations Extended the 50% bonus depreciation for Tax Relief Act of 2010 Enacted on December 17, 2010 Extended the Section 179 deduction limits until December 31, 2013 The major provision in this Act was the increase in the Bonus Depreciation to 100% of new equipment cost, including manufacturing equipment, for qualified property purchased between September 9, 2010 and December 31, 2011 (December 31, 2012, for long-periodproduction-property (LPPP)). It should also be noted that the bonus depreciation allowance applies after the Section 179 maximum deduction, if applicable (S 179 applies primarily to small businesses). Furthermore, the regular MACRS deduction is calculated after the special depreciation allowance (bonus depreciation, at either 50% or 100%). For example, if the 50% bonus depreciation applies, in the year of purchase of a qualifying asset, a manufacturing corporation would get both the 50% bonus depreciation and the regular MACRS deduction (which is calculated by applying the appropriate rate to the remaining balance [cost] of the asset after deducting the bonus depreciation). Section 179 in the United States A taxpayer can elect to recover all, or part of, the cost of certain qualifying property, up to a limit, by deducting it in the year the property is placed in service (Publication 946, page 15). Qualifying property includes tangible property used in manufacturing. The maximum Section 179 deduction is $500,000 (in 2012). However, since there is a dollar-fordollar reduction if the cost of qualifying property is more than $2,000,000 (in the 2012 year), the Section 179 generally only applies to small business. It should be noted that although Section 179 was first increased with the introduction of the economic stimulus package in 2008, both the maximum deduction amount and threshold limitation amount have changed (see below). The Section 179 deduction is unique to the United States, as there is no similar deduction for capital expenditures incurred by small businesses in Canada. Special Depreciation Allowance (Bonus Depreciation) in the United States Section 168(k) of the IRS code allows for special depreciation allowances, commonly referred to as bonus depreciation. This special depreciation allowance was initially introduced in the United States in September 2001 and the federal government has utilized Section 168 for economic stabilization purposes and to stimulate capital investment between September 2001 and December 31, The special depreciation allowance was re-enacted and included with the Economic Stimulus Package in 2008 to stimulate the economy in the aftermath of the financial crisis. Bonus depreciation has been extended annually since 2008, through other stimulus measures, and has been in effect continually for capital purchases from 5

10 CONTENT January 1, 2008 up to December 31, The 100% bonus depreciation was applicable for a limited period of time (i.e. for purchases between September 9, 2010 and December 31, 2011,or December 31, 2012 for long-period-productionproperty). However, it was a powerful measure because in effect, capital purchases were totally written off in the year of purchase. Representatives from the manufacturing industry in the United States indicate that the introduction of the 100% bonus depreciation was the most significant economic stimulus in the Tax Relief Act of Bonus depreciation was included with the Economic Stimulus Act in February 2008 and is applicable for capital expenditures from January 1, 2008 until December 31, Although some limitations apply to qualifying property, generally bonus depreciation applies to most capital expenditures of large dollar amounts.this differs from ACCA in Canada, which only applies to manufacturing equipment and clean energy equipment. Similar to the ACCA in Canada, extensions for the bonus depreciation deduction have been granted, generally on an annual basis, for one-year periods and with an announcement made with the annual federal budget in February each year. To date, the Obama administration has not indicated intent to extend the bonus depreciation allowances beyond December 31, 2013, but as the announcement is generally made in February each year, it is still early to predict the likelihood of a further extension to bonus depreciation. The bonus depreciation rate, enacted with the 2008 Economic Stimulus Act, was 50%, applied on a straight-line basis and with no application of the half-year convention in the year of purchase. The 50% bonus depreciation rate was effective until September 8, 2010, when the rate was increased to 100% for capital asset additions after September 9, 2010, and before December 31, Furthermore, the 100% bonus depreciation was extended to December 31, 2012 for long-period-production-property (LPPP). The three main conditions for LPPP are i) the property must have acquired the property after December 31, 2007; ii) the property has a recovery period of at least 10 years; and iii) the estimated production period must exceed one year and the estimated production cost must exceed $1,000,000.As the total time for production must be more than one year, assets that are produced in less than one year would not qualify for the LPPP extension to December 31, For example, rail cars are generally manufactured in approximately three months and therefore do not qualify for the LPPP extension. On the other hand, some assets may meet the conditions required to qualify as LPPP. The 50% bonus depreciation rate has continued to apply after the 100% bonus depreciation period expired, and is effective until December 31, Highlight of the differences between ACCA (Canada) and Bonus Depreciation (United States) In Canada, ACCA (Class 29) results in the following write-offs for capital expenditures for 2008 to 2015: Year 1: asset purchased, cost is the basis Year 1: ACCA = 25% of the cost of the asset Year 2: ACCA = 50% of the cost of the asset Year 3: ACCA = 25% of the cost of the asset In the United States, for the manufacturing equipment classes (e.g. Class 28), for the years 2008 to 2013: Year 1: asset purchased, cost is the basis Calculation, with all available deductions, in Year 1: Cost of the asset: Section 179 deduction, if applicable Balance for depreciation Deduct the 50% or 100% bonus depreciation Balance available for MACRS depreciation Deduct the regular MACRS depreciation Balance carried forward to Year 2 XXX (XXX) XXX (XXX) XXX (XXX) XXX Note: the half-year convention applied to the regular MACRS depreciation in Year 1. In Year 2 and subsequent years, the MACRS depreciation is calculated as per tables provided in IRS Publication

11 CONTENT The bonus depreciation rules from 2008 to 2013 have allowed corporations in the United States to claim both bonus depreciation (50% or 100%) and regular MACRS depreciation allowance in the year of purchase, which has allowed for a substantial write-off and cost recovery of capital expenditures in the year of purchase. This is an important difference between ACCA and Bonus Depreciation and generally results in larger write-offs in the early years. Another difference is that bonus depreciation applies to most classes of assets in the United States while ACCA applies primarily to manufacturing equipment. The effect of this difference is evident for the railway industry, as locomotives and rail cars qualify for bonus depreciation in the United States but do not qualify for ACCA in Canada. This is illustrated in Appendix 3A. Furthermore, representatives from the manufacturing industry indicate that the introduction of the 100% bonus depreciation was the most significant economic stimulus in the Tax Relief Act of 2010, as it allowed for the full recovery of capital expenditures in the year of purchase and created a significant incentive to invest in capital assets, despite the fact that the 100% bonus depreciation allowance was only applicable for a relatively short period of time. Appendices 3 and 3A provide sample calculations that highlight the differences between ACCA (Canada) and Bonus Depreciation allowance (USA). The sample calculations are based on federal calculations only, with effects at the provincial level in Canada and the state level in the United States not included. For example, the state of Minnesota revises the bonus depreciation calculation for all corporations, including manufacturing corporations. Impact of the Capital Allowance systems in Canada and the United States The impact of the faster write-off of capital expenditures is of critical importance to a manufacturing corporation, as capital expenditures are substantial and affect a corporation s cash flow and its capital investment decisions. Furthermore, it affects a manufacturing corporation s long-term decisions, especially as the capital expenditures are substantial and affect the long-term productivity of a corporation. This is especially important in Canada, as statistical data and the extant literature indicate manufacturing makes the highest contribution to productivity and growth in the country. ACCA directly affects a corporation s cash flow, which impacts a corporation s ability to invest in new technology and labour incentives, and technology enhancements and labour incentives have a direct impact on productivity. Furthermore, the country s economists suggest Canada needs significant capital investment enhancements to manufacturing technology for Canadian manufacturing corporations to be internationally competitive. Statistical data also indicates that Canadian corporations have a significant amount of idle cash on their balance sheets, which is referred to as dead cash as it is not being utilized toward growth and increased productivity in the country. ACCA would be an incentive for corporations to invest in capital expenditures, thereby utilizing the dead cash on corporate balance sheets. Yet, some representatives from the Canadian manufacturing industry have indicated that CCA is not a significant factor in considering major capital investments and suggest that other, more direct and effective means of encouraging capital investment, for example, the use of investment tax credits. Capital investments are significant in amount and require a long-term commitment by corporations. However, in order to be effective, consistency, stability and certainty are needed in the incentives to capital investment (e.g. the accelerated write-off of capital expenditures [through ACCA] or encouraging capital investment with investment tax credits). ACCA has been extended for one- or two-year periods since 2007, but a permanent ACCA would provide the consistency and stability necessary to support capital investment. In addition, as technology enhancements are essential for maintaining international competitiveness, CCA incentives to support such enhancements would also be beneficial to Canadian manufacturers. In the United States, MACRS provides for a doubledeclining balance method with a switch to the straightline method at the optimal period. When compared to the declining balance method used in Canada, MACRS generally provides for a faster write-off of capital expenditures in the early years of ownership. For example, over 56% of the cost of locomotives and rail cars (MACRS Class 00.25) is writtenoff in the first three years of ownership. This is significantly different from Canada, especially for rail cars, where only 33% is written off in the first three years (see Appendix 2A for details). For assets used in the manufacturing of chemicals and fertilizers, Class 43 in Canada allows for a cost recovery of 58% in the first three years, while Class 28 in the United States allows for 71% cost recovery in the first three years. Furthermore, Class 28 (U.S.A.) allows for a full recovery of the capital cost in eight years, while in Class 43 (Canada), the full cost recovery period exceeds 20 years (see Appendix 1 for details). Thus, the differences between CCA (Canada) and MACRS (USA) can be significant in the early life of a capital asset. Canadian manufacturing corporations would benefit from the faster write-off of capital expenditures in the early 7

12 CONTENT years, for example this could be achieved using a straightline method instead of the declining balance method in the calculation of CCA. Appendices 2 and 2A illustrate the significant difference in depreciation allowance for rail cars in Canada and the United States (i.e. CCA vs. MACRS). Furthermore, in Canada, the CCA rate for rail cars is substantially lower than the rate for other transportation property. For example, automotive equipment in Class 10 has a 30% declining balance rate and long-haul transportation equipment in Class 16 has a 40% declining balance rate, as compared to railcars in Class 7 or 35, with effective CCA rates of 15% and 13% respectively. On the other hand, in the United States, rail cars are included in the same class as locomotives (Class 00.25), with over 56% of cost recovery in the first three years and a full cost recovery in eight years. This disparity results in a significant difference in the cost recovery period between Canada and the United States for example, this difference is apparent for corporations that own and lease railcars. These differences between CCA and MACRS suggest that, to some extent, ACCA levels the playing field between Canadian manufacturing corporations and their counterparts in the United States. Appendix 3 illustrates the differences between ACCA (Canada) and Bonus Depreciation (USA). As Bonus Depreciation and MACRS are applicable in the year of purchase, there is a significant difference between ACCA and Bonus Depreciation in Year 1 (i.e. year of purchase). Furthermore, the 100% bonus depreciation was very significant as it essentially allowed corporations to expense capital expenditures during that period. Discussions with representatives from manufacturing corporations in the United States indicate that although the short-term 100% bonus depreciation was effective for capital purchases for a short period of time, between September 9, 2010, and December 31, 2011 (2012 for L.P.P.P), it was a major incentive and significantly encouraged capital expenditures in the United States. Bonus depreciation applies to most capital assets while ACCA is more specifically directed to manufacturing equipment. Again, this is significant as corporations from most industries in the U.S. are able to take advantage of bonus depreciation. Therefore, for the railway industry, bonus depreciation applies to locomotives and railcars purchased from January 1, 2008 to December 31, 2013, (Class 00.25) while ACCA does not apply to locomotives (Class 10(y)) or railcars (Class 7 or 35) owned by Canadian corporations from 2008 on (see Appendix 3A). Furthermore, other major capital expenditures owned by U.S. manufacturing corporations could also qualify for the bonus depreciation, while only manufacturing equipment and clean energy equipment qualify for ACCA in Canada. This is an important distinction that affects all Canadian manufacturing corporations. Other factors that need to be examined include: i) differences in the corporate tax structure, including impending changes to the corporate tax rate in the United States recently suggested by the Obama administration; ii) the effectiveness of investment tax credits vs. accelerated capital cost allowance; iii) the use of other tax credits (for example employment and research credits available in the United States); and iv) the impact of exchange rate fluctuations. Furthermore, previous research has demonstrated that the CCA system in Canada is archaic and needs to be cleaned up and modernized. For example, there is some redundancy in the system and unnecessary complexity. Measures to simplify the CCA system would benefit all Canadian corporations by improving effectiveness and reducing compliance costs and effort. A follow-up research study to address these, and other, factors would be useful to more completely assess the effects of differences in the tax regimes that affect the competitiveness of Canadian manufacturing corporations with their counterparts in the United States. 8

13 CONTENT CME Concluding Remarks Business investments in Machinery and Equipment (M&E) are a key-driver of productivity. In an advanced manufacturing sector strongly driven by major improvements in automation processes, increased used of robotics, and the use of internet to generate and analyze real-time data about the performance of production lines and products, M&E becomes a major driver of competitiveness. These investments are crucial because Canada suffers from a low level of productivity compared to other industrialized nations. From a policy perspective, investment incentives in M&E is one of the most rapidly deployable mechanisms for sustainable productivity improvements, mostly because more M&E investment will help employees produce more per hour, reduce quality control deviations, and facilitate process improvements, energy efficiency and raw material usage. In other words, smart fiscal incentives such as the Accelerated Capital Cost Allowance (ACCA) improve the global competitiveness of the Canadian Manufacturing sector, while making sure we produce goods in the most efficient way. Since 2009, investments in M&E by Canadian firms have been increasing rapidly, mostly as a result of the ACCA. In 2011, investments in M&E reached $13.6 billion, on its way back to the pre-recession level (see table below). Canadian Manufacturers` annual investments in M&E, Both Canada and the U.S. have implemented accelerated depreciation rates for certain types of assets in order to increase business investments, especially during and after the global financial and economic crisis. Based on the analysis provided in this paper: CME strongly recommends that the ACCA becomes a permanent feature of the Canadian tax system, recognizing the importance of capital expenditures for the future of our sector and for increased productivity in the Canadian economy. We also strongly encourage the federal government to review all the classes of assets and to align them with the U.S. depreciation rules in order to provide a level-playing field in the fiscal treatment of business investments. 9

14 executive summary Appendix APPENDIX 1 CCA Class 43 (Canada) vs. MACRS Class 28 (United States/US): Assets used in the Manufacture of Chemicals & Fertilizers Date of Purchase of Asset Write-off (expense) Class 43 (Canada) 30% Declining basis Class 28 US) 5-year class CCA Prior to the introduction of ACCA in Canada in March 2007 MACRS Prior to the enactment of the bonus depreciation, Jan 1, 2008 Year 1 15,000 20,000 Year 2 25,500 32,000 Year 3 17, % 19, % Year 4 12,495 11,520 Year 5 8,747 11,520 Year 6 6, % 5, % Year 7 4,286 Year 8 3,000 Year 9 2,100 Year 10 1,470 Year 11 1,329 Year Year Year Year Year Year Year Year Year There after 85 NOTES: 1. Class 43 (Canada): assets used to manufacture goods for resale or lease. 2. Class 43 (Canada): 58% of the capital expenditure is written-off in three years and 86% in six years 3. Class 28 includes assets used in the manufacture of chemicals and allied products, which includes fertilizers 4. Class 28 (USA): 71% of the capital expenditure is written-off in three years and 100% in six years 5. Half-year rule or convention applies in the year of purchase, in both countries. 10

15 executive summary Appendix APPENDIX 2 CCA Class 35 (Canada) vs. MACRS Class (USA): Locomotives & railcars Date of Purchase of Asset Write-off (expense) Class 35 (Canada) 13% effective rate Class (USA) 7-year class (GDS) After May 25, 1976 and before Feb 27, 2000 Locomotives &rail cars Election after Feb 27, 2000 (i.e. elects out of Class 7) Rail cars only Year 1 6,500 14,290 Year 2 12,155 24,490 Year 3 10, % 17, % Year 4 9,200 12,490 Year 5 8,004 8,930 Year 6 6,964 8,920 Year 7 6,058 8,930 Year 8 5, % 4, % Year 9 4,586 Year 10 3,990 Year 11 3,470 Year 12 3,020 Year 13 2,635 Year 14 2,285 Year 15 1,988 Year 16 1,729 Year 17 1,504 Year 18 1,309 Year 19 1,139 Year , ,000 NOTES: 1. Class 35: Locomotives and rail cars purchase before Feb 27, 2000 Railcars (after Feb 27, 2000) can be included in Class 35 (election required). 2. Class 35: 29% of the capital expenditures written-off in three years and 65% in eight years. 3. Class 00.25: Locomotives and railcars 4. Class 00.25: 56% of the capital expenditures written-off in three years and 100% in eight years. 11

16 executive summary Appendix APPENDIX 2A CCA Class 7 (Canada) vs. MACRS Class (USA): Locomotives and Railcars Date of Purchase of Asset Write-off (expense) Class 7 (Canada) 15% Declining basis Class (USA) 7-year class (GDS) After February 27, 2000 Locomotives and railcars Year 1 7,500 14,290 Year 2 13,875 24,490 Year 3 11, % 17, % Year 4 10,025 12,490 Year 5 8,521 8,930 Year 6 7,243 8,920 Year 7 6,156 8,930 Year 8 5, % 4, % Year 9 4,448 Year 10 3,781 Year 11 3,214 Year 12 2,732 Year 13 2,472 Year 14 2,101 Year 15 1,501 Year 16 1,411 Year 17 1,199 Year 18 1,019 Year Year there after 4, , ,000 NOTES: 1. Class 7: Locomotives &rail cars purchased after Feb 27, 2000 (CCA rate = 15%) For rail cars: can elect out of Class 7 and use Class 35 (effective CCA rate = 13%) For locomotives: after Feb 25, 2008, Class 10(y) applies (CCA rate = 30%) 2. Class 7: 33% of capital expenditures are written-off in three years and 70% in eight years. 3. Class (MACRS): Locomotives &railcars are both included 4. Class 00.25: 56% of capital expenditures are written-off in three years and 100% in 8 years 12

17 executive summary Appendix APPENDIX 2B CCA Class 10(y)(Canada) vs. MACRS Class (USA): Locomotives only Date of Purchase of Asset Write-off (expense) Class 10(y)(Canada) 30% Declining basis Class (USA) 7-year class (GDS) After February 25, 2008 Locomotives only Year 1 15,000 14,290 Year 2 25,500 24,490 Year 3 17, % 17, % Year 4 12,495 12,490 Year 5 8,747 8,930 Year 6 6,122 8,920 Year 7 4,286 8,930 Year 8 3, % 4, % Year 9 2,100 Year 10 1,470 Year 11 1,329 Year Year Year Year Year Year Year Year Year there after , ,000 NOTES: 1. Class 10(y) (Canada): Locomotives (only) purchased after February 27, Class 10(y) (Canada): 58% is written-off in three years and 93% in eight years 3. Class (USA): Locomotives and rail cars, in the MACRS seven-year GDS class 4. Class (USA): 56% is written-off in three years and 100% in eight years 5. Half-year rule or convention applies in the year of purchase in both countries 13

18 executive summary Appendix APPENDIX 3 ACCA Class 29 (Canada) and Bonus Depreciation Class 28 (USA): Assets used in the manufacture of Chemicals and Fertilizer Year of Purchase Write-off (expense) Class 29 Canada Class 28 USA/5-year Calculation and comments Mar 19, 2007 to Sept 8, 2010 Bonus depreciation = 50% Sept 9, 2010 to Dec 31, 2011 (up to Dec 31, 2012, for LPPP, Long-Production- Period-Prop.) Bonus depreciation = 100% Jan 1, 2012 to Dec 31, 2013 (or Jan 1, 2013 to Dec 31, 2013 for LPPP) Bonus depreciation = 50% Year 1 25,000 60,000 Bonus = 50,000 + MACRS = 10, 000 Year 2 50,000 16,000 MACRS = 16,000 Year 3 25,000 9,600 MACRS = 9,600 Year 4 0 5,760 MACRS = 5,760 Year 5 0 5,760 MACRS = 5,760 Year 6 0 2,880 MACRS = 2,880 Year Year , ,000 Year 1 25, ,000 Bonus dep= 100,000 (full amt.) Year 2 50,000 0 MACRS Year 3 25,000 0 MACRS Year MACRS Year MACRS Year MACRS Year MACRS Year MACRS 100, ,000 Year ,000 Bonus dep = 50,000 + MACRS Year ,000 MACRS = 16,000 Year ,600 MACRS = 9,600 Year 4 0 5,760 MACRS = 5,760 Year 5 0 5,760 MACRS = 5,760 Year 6 0 2,880 MACRS = 2,880 Year Year ,000 NOTES: 1. Class 28 = Chemicals and allied products (e.g. includes manufacture of chemicals and fertilizers) 2. ACCA has been extended to Dec 31, 2015; same calculations (per above) apply to 2014 and ACCA applies to CCA Class 29 Manufacturing equipment, and a limited number of other classes. 3. Bonus depreciation (50%) (USA) is effective until Dec 31, Bonus depreciation applies to most MACRS classes % bonus depreciation, applicable for the period September 9, 2010, to December 31,

19 executive summary Appendix APPENDIX 3A CCA Class 7 and 10(y) (Canada) and Bonus Depreciation Class (USA): Locomotives and railcars Year of Purchase Write-off (expense) Class 7 Railcars Class 10(y) Locomotives Class USA/7-year Calculation and comments Jan 1, 2008 to Sept 8, 2010 Bonus Depreciation = 50% Sept 9, 2010 to Dec 31, 2011 (up to Dec 31, 2012, for LPPP, long production period prop.) Bonus Depreciation = 100% Jan , to Dec 31, 2013 Bonus depreciation = 50% Year 1 7,500 15,000 57,145 Bonus = 50,000 + MACRS = 7,145 Year 2 13,875 25,500 12,245 MACRS = 12,245 Year 3 11,794 17,850 8,745 MACRS = 8,745 Year 4 10,025 12,495 6,245 MACRS = 6,245 Year 5 8,521 8,747 4,465 MACRS = 4,465 Year 6 7,243 6,122 4,460 MACRS = 4,460 Year 7 6,156 4,286 4,465 MACRS = 4,465 Year 8 5,233 3,000 2,230 MACRS = 2,230 70,347 93, ,000 Year 1 7,500 15, ,000 Bonus deprec= 100,000 (full amt.) Year 2 13,875 25,500 0 MACRS Year 3 11,794 17,850 0 MACRS Year 4 10,025 12,495 0 MACRS Year 5 8,521 8,747 0 MACRS Year 6 7,243 6,122 0 MACRS Year 7 6,156 4,286 0 MACRS Year 8 5,233 3,000 0 MACRS 70,347 93, ,000 Year 1 7,500 15,000 57,145 Bonus = 50,000 + MACRS = 7,145 Year 2 13,875 25,500 12,245 MACRS = 12,245 Year 3 11,794 17,850 8,745 MACRS = 8,745 Year 4 10,025 12,495 6,245 MACRS = 6,245 Year 5 8,521 8,747 4,465 MACRS = 4,465 Year 6 7,243 6,122 4,460 MACRS = 4,460 Year 7 6,156 4,286 4,465 MACRS = 4,465 Year 8 5,233 3,000 2,230 MACRS = 2,230 70,347 93, ,000 NOTES: 1. Year 1 = year of purchase of asset 2. Class 7 (Canada): Railcars after February 27, 2000 (unless an election to include in Class 35, with a 13% effective rate) 3. Class 10(y) (Canada): Locomotives purchased after February 25, Class (USA): Locomotives and railcars MACRS 7 year GDS class 5. ACCA is not applicable for Class 7 railcars or Class 10(y) m Locomotives (Canada) 6. Bonus Depreciation is applicable for Class Locomotives and railcars (USA) 15

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