Taxation on Wind and Solar

Canada’s tax code offers some good incentives to invest in wind and solar. But there are some important restrictions on that incentive that you must be aware of before you invest.

Wind and solar photovoltaic are eligible for Class 43.2 depreciation rates. This new class came into effect on June 1, 2006.  This is referred to as capital cost allowance. This allows you to deduct from income at a rate of 50% declining balance per year. In the first year an asset is in use, you can only deduct half of the amount. So, if a firm invests $1000 in wind or solar, they can deduct $350 from income in the first year, then 50% of the remaining $750 in the second year, or $375, leaving $375. The next year can deduct 50% of that, and so on.  Claiming capital cost allowance is optional, so if a firm is not able to utilize all of their depreciation in a year, it can be saved to claim in the future.
The impact of depreciation on tax is that there is a deduction from taxable income in the amount of allowable depreciation. Reduced taxes early in a project life are critical to project after tax returns, as it delays the payment of taxes into the future. The time value of money makes this important to the return on investment.

There are some important restrictions on the use of this aggressive depreciation rate. Normally, a wind or solar project will not generate enough income to utilize the full capital cost allowance in the early years. The key question is: can a company use the deduction from other income (i.e. income earned in another part of its business), so that it can capture the time value of money associated with delaying the payment of taxes by using the capital cost allowance? You can deduct the depreciation from other income if you are an energy corporation, whose principal business is the production of energy, or if you are a “principal business corporation”. A principal business corporation is defined as one involved in manufacturing, processing, or mining. So that means that a retail or wholesale business that installs photovoltaic on their roof cannot utilize the depreciation against other income – they can only deduct against the income earned by the asset.  The Principal Business Corporation rule does not apply to firms who install photovoltaic for their own consumption.  In Ontario, however, if you install PV for your own consumption, it will save you only about 10 cents/kWh (including transmission, debt recovery etc.).  If you want to sell power into Ontario’s Standard Offer, at 42 cents kWh, then the principal business rules apply, and so if you are not a principal business corporation, you can only utilize the capital cost allowance against the income it generates.
With these restrictions on using the depreciation, is it any wonder that oil and gas companies- energy companies, who have significant profits from other income subject to taxation, are some of the key investors in the wind sector? Start up companies typically have very little taxable income, and so they lose the benefit of the agressive depreciation. Wholesale and retail companies suffer a similar fate.

Photovoltaic has another restriction. If the solar panels are installed on a rooftop, then they are eligible for class 43.1. But if they are integrated into the building, like solar shingles which are coming onto the market, then they are considered as part of the building, and therefore only eligible for the depreciation rate of a building, which is very low. This discrimination against an up and coming solar technology would seem to be unjustified from a public policy perspective.

There is one added benefit available to wind farms, and that is the Canadian Renewable Conservation Expense (CRCE). This allows the construction of “test wind turbines”, to test the wind resource with an operating wind farm. There are numerous restrictions on this, including timing of the deduction, the distance between the test turbines, proof of the ability to construct the rest of the wind farm, the length of time they must operate before completing the wind farm, the expenses allowed, and the proportion of wind turbines eligible for the expense. The use of this expense allows a firm to “flow through” the expense of the test wind turbines to its shareholders, for deduction from their income. The firm issuing the flow through shares gives up the tax savings from depreciation, which on CRCE turbines is 100% of the capital expense, on the test turbines, as the tax savings are utilized by their investors, so it is not a panacea. But of course, investors always like saving tax, so it can be a good way to raise equity capital for a wind farm.

Wind turbines built using CRCE are ineligible for the federal Wind Power Production Incentive (WPPI). In the past, this has been a critical component of the revenue for a wind farm, amount to 1 cent/kWh for 10 years. The program has run out of funds, and while the industry is optimistic that funding will be renewed, today, it is not certain. Many proposed wind projects are in jeopardy if this incentive is not renewed. Between giving up the depreciation, and losing the WPPI, CRCE is principally attractive in finding equity investors, who like tax shelters, but the true economics of the program are limited.
The Canadian Renewable Conservation Expense was introduced in an effort to level the playing field with fossil fuels. With oil and gas exploration, the cost of a test well can be flowed through in a similar way, under the Canadian Exploration Expense. This “test well expense” has occasionally been enriched with an additional deduction of 15% of the investment, in order to encourage investment in drilling. Such an enrichment has never been applied to the wind business.

One potential loophole on the principal business corporation rule would be use of a small wind turbine or solar system for back-up power for a business. Some have suggested that in this case, class 43.1 can be used, and the deduction can be applied against other income. Of course, a battery system would also be required to defend the back-up aspect of the system. In this case, the back-up system would be considered as an essential part of the business operation, and so the conventional specified business corporations rules may not apply. This would potentially allow a small business, reatailer, or home office to use 43.1 as a deduction. I am not aware of any rulings from Canada Customs and Revenue Agency to confirm this.

Overall, Canada tax regime on wind and solar (and some other renewable technologies), is quite good. But the restrictions, including loss of WPPI on CRCE turbines, non-deductibility of depreciation against other income for firms that are not specified business corporations, and the inability of start up firms to benefit from the accelerated depreciation, reduce the effectiveness of these progressive tax measures in a significant way.
Of course, any firm investing in wind or solar, should confirm their own tax status with their advisors. You should confirm your situation with your own tax accountant.

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