Photo credit: SayCheeeeeese, CC0, via Wikimedia Commons
Last month, Finance Canada released their proposed legislation (the “Proposals”) for, among other things, the Clean Technology Investment Tax Credit (the “Clean Tech ITC”), an incentive first announced back in 2022.¹ The Proposals provide much needed (and long awaited²) guidance on how taxpayers can qualify for this tax credit. That said, there are a number of details in the legislative framework that place restrictions and limitations that would seem to frustrate the very purpose of the credit, which is to “encourage the investment of capital in the adoption and operation of clean technology property in Canada.”³
One could argue that the limitations imposed in the Proposals are necessary measures that ensure only “legitimate businesses” are able to access valuable incentives, and as such are good fiscal policy. We do not agree and would argue that there is little to be gained (and much to be lost) by arbitrarily excluding taxpayers from critical government incentives because of how they have chosen to structure their businesses. Moreover, the restrictions imposed in the proposed legislation, specifically the restriction against tax shelters utilizing the Clean Tech ITC,⁴ may effectively preclude anyone from claiming the Clean Tech ITC in 2023.
Criteria of Clean Technology Property
Since the Fall 2022 Economic Statement, it has been clear that eligibility for the Clean Tech ITC program would be determined (at least in part) by reference to the eligibility criteria for depreciation under Capital Cost Allowance Class 43.1 of Schedule II of the Income Tax Regulations (the “Regulations”). The Fall 2022 Economic Statement explicitly referred to certain sub-classes of property from Class 43.1 as the “types” of equipment that would be eligible for the credit.⁵ In keeping with this, part of the definition of “clean technology property” under subsection 127.45 of the proposed legislation requires that the property fit under one of the seven categories of property listed in paragraph (d) of that definition, which are, for the most part, pulled directly from paragraph (d) of Class 43.1.
As a brief note, Capital Cost Allowance Class 43.1, broadly speaking, pertains to clean technology equipment and affords a 30% depreciation rate to qualifying property. Paragraph (d) of Class 43.1 identifies 20 or so types of equipment that can be eligible for depreciation under that Class. Examples of these sub-classes include solar power generating equipment under subparagraph (d)(vi) and electricity storage equipment under subparagraph (xviii), both of which are also included in the seven categories of property eligible for the Clean Tech ITC. However, to actually qualify for the depreciation under Class 43.1, the equipment must also meet a set of additional criteria found in (e) of that Class.
To illustrate, solar technology equipment would be the right “type” of equipment if, according to subparagraph (d)(vi) of Class 43.1, it was fixed location photovoltaic equipment used by the taxpayer (or lessee) primarily for the purpose of generating electrical energy from solar energy. It would not, however, qualify for the depreciation pursuant to paragraph (e) of Class 43.1, unless it is:
- Situated in Canada;
- Acquired by the taxpayer (or leased by the taxpayer) for use by the taxpayer (or by the lessee) for the purpose of gaining or producing income from a business carried on in Canada or from property situated in Canada; and
- Not have been used for any purpose before it was acquired by the taxpayer UNLESS the property was depreciable property included (or in some cases, that would have been included) in Class 34, 43.1 or 43.2 of the person from whom it was acquired.
Given that Finance Canada explicitly draws from Class 43.1(d) in enumerating what types of property will be eligible for the Clean Tech ITC, it might have made sense for the eligibility criteria for the definition to parallel the additional criteria in paragraph (e) of Class 43.1. That is not quite what Finance Canada has done. The definition of “clean technology property” in the Proposals requires that the property, in addition to falling under one of the enumerated seven categories of eligible property, is:
- Situated in Canada and intended for use exclusively in Canada;
- For any purpose whatsoever, not been used, or acquired for use or lease, before it was acquired by the taxpayer; and
- If it is to be leased, be leased to a qualifying taxpayer, and leased in the ordinary course of carrying on business in Canada.⁶
While this proposed criteria for the Clean Tech ITC is perhaps reminiscent of the criteria in paragraph (e) of Class 43.1, it deviates from that source in some strange ways. As a result, despite the clear relation between the two incentives, some equipment that would be eligible for depreciation under Class 43.1 may not be eligible for the Clean Tech ITC. This is unfortunate. Both programs reward taxpayers for investing in clean technology equipment in Canada and an inconsistent set of eligibility criteria between the two creates unnecessary risk and potential hassle.
No Prior Use or Acquisition
One of the more striking deviations from the Class 43.1 criteria is the strict prohibition against prior use, or prior acquisition for use or lease of the equipment, for any purpose whatsoever before it was acquired by the taxpayer. Effectively, this means that only equipment that is brand new can be eligible for the Investment Tax Credit. The Class 43.1 eligibility criteria do have limitations but will accommodate some prior use of the equipment in circumstances where it was also depreciable property under Class 43.1 for the previous owner.⁷ Class 43.1 also does not have any explicit prohibition against prior acquisition as exists in the proposed criteria for the Clean Tech ITC. Thus, while a taxpayer may in some circumstances be able to claim depreciation under Class 43.1 on property that was previously owned, they would not appear to be able to claim the Clean Tech ITC even if the equipment wasn’t available for use to that previous owner.
At this point, it is worth briefly mentioning accelerated first-year depreciation under subsection 1100(2) of the Regulations, which is another sizeable Canadian tax incentive for investment in clean technology equipment. Property eligible for depreciation under Class 43.1, if it meets the criteria for “accelerated investment incentive property” under subsection 1104(4) of the Regulations, may be depreciated at the accelerated first year rate of 100% in 2023, which means it can be fully written off in that first year. A taxpayer can only use this accelerated depreciation in the year it becomes available for use and the property cannot have been previously depreciated by the taxpayer or anyone else.⁸ While this restriction does limit availability of the accelerated depreciation to equipment that is essentially brand new, it can still accommodate prior ownership if the equipment had not yet become available for use for that previous owner, and therefore could not be depreciated.
The Clean Tech ITC is much more restrictive than both capital cost allowance under Class 43.1 and accelerated first year depreciation in that it prohibits not only prior use, but also prior acquisition. Such restrictive criteria may end up discouraging investment in clean technology equipment, particularly for smaller businesses. In many industries a ‘turn-key’ or ‘build & sell’ business model is just more efficient because it puts risk on the entity more familiar with the business of building a clean energy projects than say the owner of properties.
It also appears that there are much narrower permissible circumstances for leasing eligible property under the Clean Tech ITC. According to the proposed criteria, the lessee of the equipment must be a taxable Canadian corporation and the principal business of the lessor must be selling or servicing equipment of the type leased or must be a lending/leasing business. This seems to foreclose against structures where perhaps a commercial property owner wishes to acquire clean technology equipment, like solar panels, and lease those panels to the tenants of the property.
Other Restrictions in the Proposed Legislation
Opportunity for subsequent disposition of clean technology equipment is further limited by the recapture rules in the Proposed Legislation. Under the proposed subsections 127.45(12) & (13), a portion or the entire amount of the Clean Tech ITC claimed in respect of a property could end up being added back to the taxpayer’s income if, within 20 years of acquiring the ITC, the property is converted to a non-clean technology use, exported from Canada, or disposed of. This restriction makes it riskier for the investor to acquire the property and finance it, as any type of disposition (repossession by a lender or sale on bankruptcy) would trigger adverse tax consequences for the investor.
Overall, the various rules and restrictions against prior use, acquisition and subsequent disposition, taken together could frustrate conventional business models such as professional turn-key project developers or other leveraged investment structures.
Exclusion of Non-corporations
The new 30% Clean Tech investment Tax credit, as it is proposed, would only be available to “taxable Canadian corporations”. For a whole host of reasons, many business owners choose not to incorporate their businesses and instead operate as sole proprietors or as partnerships. That a business in not incorporated does not in any way diminish the potential usefulness of clean technology for that business nor does it diminish the environmental need for businesses to adopt clean technology as quickly as possible. How a business is organized should not have any bearing on whether it qualifies for a tax credit intended to promote adoption and operation of clean technology property in Canada. Imposing such a restriction on the Clean Tech ITC seems to be a completely arbitrary limitation.
Limiting eligibility to taxable Canadian corporations would also preclude investment of capital by individual taxpayers that may not be operationally involved in businesses that wish to implement clean technology or that just want to invest in a more tax efficient manner. Structures like limited partnerships are useful because they enable taxpayers to invest in a business without having to be involved in the business’ operations. The very restrictive definition of “qualifying taxpayer” in the proposed legislation substantially limits the appeal and opportunity for individuals, charities and other investor groups to fund clean technology projects and unquestionably undercuts the stated purpose of the Clean Tech ITC of encouraging investment of capital in this important sector.
Prohibition Against Tax Shelters
Perhaps the biggest concern we have with the proposed legislation is the proposed subsection 127.45(11) precludes utilization of the tax credit in circumstances where the clean technology property is a tax shelter. This prohibition is especially troublesome because, as far as we can tell (and we would love to be wrong about this, so we would appreciate any critiques), it may effectively render the clean technology tax credit inaccessible for 2023.
A “tax shelter” is defined under subsection 237.1(1) of the Act, and in very simplified terms, is an interest in property that, because of its tax attributes, can be expected to yield tax benefits over a period of four years that equal or exceed the cost to the taxpayer of acquiring the property. For this calculation, all tax benefits are added together into one sum, whether those benefits are amounts deductible from income (and this is important for later), amounts deductible from taxable income, deductions from tax payable, or amounts deemed under the Income Tax Act (the “Act”) to be paid on account of tax payable. If the sum of the “Tax Benefit” as defined equals or exceeds the cost of the taxpayer’s interest in the property, then a tax shelter exists under subsection 237.1(1), and by extension, under subsection 143.2(1).
In addition to receiving a 30% refundable tax credit under the Clean Tech ITC, a qualifying investment in clean technology property will also likely be depreciable at a 30% rate under capital cost allowance Class 43.1. That investment would also likely be eligible for accelerated first year depreciation under subsection 1100(2) of the Regulations which, for equipment that becomes available for use in 2023, amounts to an effective first year depreciation rate of 100%. By our calculations (and again, someone please tell us if we got this wrong somehow because it just seems so wrong), these incentives, taken together, unavoidably create a tax shelter situation for 2023 and as a result, render the investment tax credit inaccessible for its first year.
To illustrate, a $1M investment in clean technology property in 2023 would generate a $300K tax credit, which amount is deemed to have been paid on account of the taxpayer’s tax payable for the year. This means that the “Tax Benefit” for tax shelter purposes of the credit is $300k for that year. The same property would then be depreciable at the accelerated first year rate of 100% of the remaining capital cost of the property, which is $700K, amounting to a $700K deduction from the taxpayer’s income. For tax shelter purposes, this amounts to another $700k “Tax Benefit”. Since both the $300K tax credit and $700K amount deductible from income would both be included as tax benefits under the tax shelter definition, the total tax benefit in the first year would be $1M, which equals the $1M cost of the property to the taxpayer… so the investment is a Tax Shelter as defined in the Act. Which logically means that the Clean Tech ITC is not available (?!?!).
It should be emphasized that the taxpayer in this situation would not actually be getting back their $1M through the Clean Tech ITC and accelerated depreciation of the clean technology property since this benefit functions as a deduction from income. The actual benefit to the ‘eligible taxpayer’ for a $700K deduction from income (i.e., the actual reduction of taxes payable), assuming a corporate tax rate in Ontario of 26.5%, would be approximately $186K. This, in addition to the tax credit, equals $486K in reductions/refunds from taxes payable, or 48.6% of the initial investment. While this is still a good incentive, it is certainly not a first-year return of 100% of the investment, as the tax shelter provisions seem to imply.
In an attempt to avoid a tax shelter situation in 2023, a taxpayer might think they could claim slightly less than the total amount they are entitled to under these tax incentives, theoretically keeping the total tax benefits below the cost threshold for the purposes of the tax shelter calculation. On a textual reading of the tax shelter provisions, however, this would not work. The language used in the definition of “tax shelter” refers to amounts deductible in calculating the tax benefits of the property. Thus, the relevant amount with respect to the depreciation is the amount that MAY be deducted, rather than the amount that actually is deducted.
The reference in the tax shelter provisions to amounts deemed under the Act to be paid on account of tax payable also seem to similarly restrict a taxpayer from claiming a reduced tax credit or deferring claiming the credit since the amount deemed paid on tax payable under the proposed legislation is based on the capital cost of the property in the year, not an amount elected by the taxpayer.
Lastly, being creative, one might think that this whole Tax Shelter problem could be avoided by deferring claiming the tax credit until five years after acquisition, because the tax shelter definition covers a four-year period. However, under the proposed legislation a taxpayer must claim the tax credit within one year of the end of the year in which the property was acquired.
Since the accelerated first year depreciation rate will be reduced to 75% in 2024 (and be gradually phased out by 2028), the tax shelter issue should be avoidable after the end of this year. Nevertheless, it seems problematic, more than a little careless, and maybe a bit duplicitous, that this tax incentive, which is proposed to have come into force on March 28, 2023, would be technically inaccessible for all of 2023.
Incentivizing Investment in Canadian Clean Technology
From what we can see, the proposed legislative framework for this important tax incentive appears to undercut the very purpose of the incentive, which is to promote investment in clean technology in Canada. By prohibiting application of the tax credit in tax shelter situations, excluding non-corporations from utilizing the tax credit and otherwise limiting availability of the tax credit, the Department of Finance appears to be unnecessarily narrowing access and throttling an incentive program that could be a major boon for Canada’s economy and environmental well-being. If we are to promote investment in clean technology in Canada, then we must implement incentives that are competitive with those of our trading partners. The absolute ceiling for Canada’s Clean Tech ITC is 30%. A project that meets practically the same criteria in the United States would likely generate an Energy Credit of at least 40% (and in the right circumstances, as much as 70%)⁹, with far fewer restrictions on who can access that credit. What incentive is there for investors to invest in clean technology projects in Canada when they can so obviously receive better, and more logically coherent, tax treatment elsewhere?
Please note that the above does not constitute tax or legal advice, but is a comment on publicly available documents at this time that may or may not be enacted into law at some time in the future.
Jonathan N. Garbutt
Barrister & Solicitor, Owner Dominion Tax Law
Barrister & Solicitor, Associate at Dominion Tax Law