"Green" Energy Projects.

This article was originally published in Blakes Bulletin on Tax And Corporate Finance, April 2004

Throughout much of the industrialized world, the drive to encourage the growth of so-called "green energy" sources has been stimulated by both ever-tightening and costly environmental laws and regulations and by tax policy to encourage investment.

Canada is no different.The drive to meet the goals set out in the Kyoto Accord, and to reduce the dependence on fossil fuels, has caused the provincial and federal governments to encourage investment in green energy projects and to develop tax policies to encourage these projects in much the same way that costly exploration for fossil fuels has been encouraged.This has led to growth in independent green energy projects in the hydroelectric, solar power, wind, and cogeneration sectors.

In certain provinces, this has led to a growing "small" hydroelectric generating sector (those that are rated at less than 50 megawatts). Now, small dams are built on smaller rivers instead of the massive projects built in the past.These projects use a renewable energy source and cause less environmental damage than larger projects. Government-sponsored venture capital tax credit programs, coupled with accelerated capital cost allowance writeoff provisions and flow-through share programs, reduce the cost of financing these projects. Crown-owned hydro corporations such as B.C. Hydro agree to acquire the electricity on a long-term basis, thus providing a bankable income stream and a financible project.

This article reviews some of the federal tax incentives offered to encourage green energy projects and reviews the structure of one specific wind-powered electrical generating project.

Federal Tax Incentives

There are three major federal tax incentives offered to projects that use green (or renewable) energy sources, such as solar, wind and water, or that enhance conservation.

The accelerated capital cost allowance permitted for certain hard assets used in the projects.

The immediate deduction available for certain soft costs incurred in the development of these projects.

A "flow-through share" mechanism which allows corporate taxpayers to allocate certain expenditures to shareholders who can then use them as deductions against other income, thereby reducing the immediate cost of their investment.

Each of these incentives is discussed in more detail below.

Capital Cost Allowance Class 43.1. Under the Canadian system for capital cost allowance (CCA), separate CCA "classes" are prescribed for various types of tangible fixed assets used in a business and the cost of the assets in each class can be written off at a prescribed maximum annual rate. Class 43.1 assets include new assets used in systems to conserve energy or that use renewable forms of energy such as solar, water, wind, certain waste fuels or that reuse thermal waste. Generally, the types of systems that will qualify under Class 43.1 include:

Cogeneration systems that generate electricity and useable heat, and that do not exceed a heatrate (efficiency rating) of 6,000 BTU per kilowatt-hour and use eligible fuel sources, including fossil fuels and certain waste fuels. Included are electrical generating equipment, heat production and recovery equipment, feed water and condensate equipment.

Systems that produce energy from sunlight.

Wind energy systems (i.e., windmills that convert wind to electrical energy), including wind-driven turbines, electrical generating equipment, supports, battery storage equipment and transmission equipment.

Heat recovery systems that reuse heat from thermal waste, heat exchangers, compressors and boilers.

Small hydroelectric projects that have an annual rated capacity not exceeding 50 megawatts, including the electrical generating equipment and plant.

These asset types qualify for a 30% CCA deduction, on a declining balance basis, subject to a half-year rule.Thus, there is a significant tax incentive for owning property that qualifies under s.43.1.

In financing a project, this accelerated CCA is often a significant inducement for investors. Partnership structures are used so that the CCA can be claimed by the partners and used against other income in the early years of a project when no income may be generated from the project itself.To combat perceived abuses caused by these structures, "specified energy property rules" generally limit CCA to the income earned from the project.This limitation does not apply, however, if the principal purpose of a project is to generate energy for use in the owner's business that is other than the sale of energy.This allows the accelerated deduction to be used by those who build green energy projects for their own businesses and then sell the surplus energy to a hydro grid.

Canadian Renewable and Conservation Expense (CRCE). The upfront soft costs incurred in developing and exploring for fossil fuels can be prohibitively expensive. As a result, for many years the Canadian Income Tax Acthas contained provisions that in many cases allow immediate deductions for such expenditures, called Canadian exploration expenses (CEE).The same problems exist for developers of green energy projects.

In the 1996 Federal budget, a new class of CEE was created called "CRCE". CRCE is a deductible pool that is treated like other CEE. CRCE represents the intangible expenses incurred by a taxpayer and payable to arm's length parties in connection with the development of a project. In order to qualify as CRCE, it must be reasonable to expect that at least 50% of the capital cost of the depreciable property in the project will be property described in Class 43.1.

Expenses that qualify as CRCE include costs of temporary roads to a site, pre-feasibility studies, site approval costs, land valuations, environmental and other feasibility studies, site preparation costs, costs of acquiring and installing test wind turbines, etc. Expenses that do not qualify include project management fees, insurance, interest and financing fees. Many non-qualifying expenses may be deductible under other sections of the Act.

By introducing CRCE, the Act put developers of renewable resources on a similar footing as explorers and developers of nonrenewable fossil fuels which have had the ability to deduct CEE on a 100% basis for a number of years.

Flow-through Shares. One of the biggest hurdles in a significant power project is financing. One significant form of financing for independent power projects has been non-recourse debt, under which recourse is limited to the hard assets as well as, generally, the income stream provided by the purchaser of the power. In many cases, small power projects can connect to the "grid" and enter into long-term power supply projects with, for example, Hydro-Quebec or B.C. Hydro.The value of that long-term income stream can then be used as security for financing to provide funds to build the project. For developers and early stage projects, this financing can be difficult to obtain.

Concurrent with the introduction of CRCE rules, the Act was also amended to introduce the concept of flow-through shares for the renewable energy and energy conservation sectors.The purpose of these rules is to provide access to equity financing for junior energy companies that, due to the nature of their tax positions, are not able to currently use the expenditures incurred in the development of a renewable energy project as deductions from income.

The concept of flow-through shares has been used for many years in the fossil fuel energy and mineral resource sectors. Flowthrough shares are one of the last officially-sanctioned tax shelters still available. "Flow-through" refers to the ability of a "principalbusiness corporation" to pass its deductions for CEE, including CRCE, to investors who acquire flow-through shares. Flow-through shares are true equity shares in respect of which there are no share conditions or agreements that protect the investor from risk. Generally, common shares are used. A flow-through share agreement is entered into under which the investors agree to subscribe for the flow-through shares and the corporation agrees to incur an amount equal to the subscription price on CEE and to renounce that amount of CEE to the investors. 100% of CEE renounced to an investor is deductible.

Only a principal-business corporation can issue flow-through shares. A principal-business corporation is defined to include a corporation, the principal business of which is the development of projects for which it is reasonable to expect that at least 50% of the capital cost of depreciable property to be used in the projects will be Class 43.1 assets (or a corporation where all or substantially all of the assets of which are shares or debt of one or more related principal-business corporations).

The flow-through share provisions contain a "look-back" rule that provides an additional tax advantage. Under this rule, CEE, including CRCE, incurred in the year after the flow-through share agreement is entered into can be renounced to the investors effective in that first year so that all the CEE incurred in both those years can be deducted in the first year.

The significant benefit of flow-through shares is that CEE, including CRCE, may be renounced to an investor by a principalbusiness corporation that may not need the deductions, permitting the investor to shelter income.The cost of the flow-through shares to an investor is, however, deemed to be nil.

Recent Structure

The tax incentives described above were used in a recent initial public offering. By prospectus dated December 11, 2003, Creststreet Power & Income Fund LP (the Partnership) raised $42.5 million through the issuance of limited partnership units. The funds were used primarily to invest in flow-through shares of two corporations that will construct and then operate wind energy projects to generate electricity for sale to provincial electricity utilities in Quebec and Nova Scotia pursuant to long-term power purchase agreements.The corporations will use the proceeds from the issuance of the flow-through shares to finance the installation of test wind turbines and related infrastructure.These corporations will renounce CRCE incurred in 2003 and 2004 to the Partnership effective in 2003.

The Partnership, being a conduit for tax purposes, will allocate the CRCE to the limited partners. It is estimated that when the deduction in respect of CRCE is added to the investors' share of losses from the Partnership, arising mostly from the first-year amortization of costs of issue, investors will be entitled, in 2003, to deductions equal to approximately 83% of their cost of the limited partnership units.

Unlike many limited partnerships formed to invest in flowthrough shares, the Partnership will not later convert itself into a mutual fund corporation. Instead, it will continue as a limited partnership and will provide liquidity to its investors by listing its units on a stock exchange after the proposed issuance of units mentioned below. Moreover, it will take advantage of the stable cash flows expected when the projects are complete to operate as an income fund.This will be achieved by issuing additional limited partnership units in order to make further investments in the wind energy corporations. Presumably, much of this investment will be made by way of interest-bearing debt to minimize tax paid by the two wind energy corporations.

If corporate tax is minimized, and since the Partnership is itself a non-taxable entity, it will be possible to distribute cash flow generated by the wind energy projects through the corporations and the Partnership to the limited partners on a taxefficient basis.

The Partnership is an interesting example of a structure that uses the tax incentives designed to encourage the development of green energy sources such as wind power.Then, assuming successful completion of the projects, the structure uses the income fund concept to take advantage of stable sources of income and to maximize the after-tax cash flows to investors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Mr Bill Maclagan

Blake, Cassels & Graydon LLP 

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