Avocats chez Davis S.E.N.C.R.L.

Tax Planning And Renewable Energy Projects

Although small energy projects can be built and integrated into buildings, most of the renewable energy that will be generated will be done through large scale projects. This provides efficiencies in power generation and ensures that the areas with the best resources (wind, solar, tidal, et cetra) are fully utilized to provide as much clean power as possible. Projects of this magnitude can cost hundreds of millions of dollars, a cost which needs to be paid over 10, 15 or more years.

Reducing the Taxable Income of the Project

At the same time, the project is being taxed on the revenue being generated by the plant. This provides less after tax dollars to pay for the large capital costs of the project. British Columbia currently has a corporate tax rate of roughly 34%. Every taxable dollar provides 66 cents which can be used to pay down the project, while every non-taxable dollar can be fully used to pay down the project. On the scale of millions of dollars of income, this can make a large difference.

Since a multimillion dollar project is usually financed as least partial through debt, it is advantageous to the project if it can pay down that debt faster as this leads to interest savings. Therefore, the more non-taxable revenue, the faster the debt can be paid down, and the less interest that has to be paid to generate clean energy.

One way of reducing taxable income is to deduct a portion of the costs of the assets used to generate that income. The Income Tax Act Regulations sets a rate for every type of equipment and other capital that goes into any business. The higher the rate, the larger the deduction against taxable income. For example, assume a wind project requires a $100 million worth of generating equipments (turbines and related capital). If the capital could be depreciated at a 20% rate, the project would have a $20 million tax deduction every year and the first $20 million worth of income would not be taxable. This would result in an additional $6.8 million of income that did not have to be paid as taxes, and instead could be used to pay down the debt related to the project, thus reducing the interest owing which further increases the gross revenue generated by the project. This type of deduction is known as a capital cost allowance or CCA.

Renewable energy generation in general costs more to produce per kilowatt than power generation through fossil fuels. Why this is and how we can change that (and whether we even should) is a topic for another blog. In recognition of that cost difference however, the federal government has provided some tax incentives for the generation of 'clean energy'. In the mid-1990's a new rate was established, that allows certain pieces of capital used to generate electricity to be depreciated at a rate of 50%. Although all of this tax deduction does not have to be used each year, it does have a limit. No more than 100% of the capital cost of the project can be deducted. This rate helps clean energy projects compete despite the higher costs of generating that type of energy.

The 2007 Budget made two important changes to the CCA for clean energy projects. First, the types of projects that can qualify was expanded to include tidal, photovoltic solar as well as several other emerging technologies. Second, an 'accelerated' CCA, which offers a faster use of the deduction at the 50% rate has been removed from certain types of capital used in the oil sands industry and has been allowed for certain capital in clean energy projects. These changes should help clean energy projects in general, and encourage the development of emergent technologies which previously did not benefit from the high CCA.

Withholding Tax on Interest

The other tax announcement in the 2007 federal budget that will be of interest to many renewable energy projects, is the proposed reduction of withholding taxes on interest payments to non-residents. Currently, when interest payments are made to non-residents between 10 and 25% of the payment has to be remitted to the Canada Revenue Agency as withholding tax. This comes out of the project's pocket, not out the lenders, and ultimately increases the cost of borrowing. There are currently methods to structure long-term debt financing to remove the obligation for withholdings on interest, a structure that Davis& Company LLP has particular experience in as a result of the numerous large project financing we have worked on. However, when enacted, this proposed amendment will likely remove the necessity of these project financing structures, thus reducing the cost of financing large power projects.

A whole host of other issues regarding tax planning and corporate structuring exist with regards to energy projects, those however remained unchanged by the budget, and will be the content of another blog.

Getting Local Buy-In ... Literally

Hats off to the government of Prince Edward Island for coming up with a way to get local residents to literally buy into renewable energy. The governmant launched an "Energy Savings Bonds" initiative last December that has proven to be a hit. The bonds, which are RRSP-eligible, are a 5-year non-redeemable issue that pay an attractive 5% annual rate of interest. Only Island residents may purchase them (whether individual, corporate, society or otherwise). Proceeds of the bond sale are used to pay down government debt taken on to build the recently-completed 30-megawatt Eastern Kings wind farm. More than $5 million of bonds have already been sold, representing nearly 10 percent of the wind farm's $56 million cost. The issue has been capped at $20 million. Pretty impressive for a province of only 139,000 people. This is in my opinion a nice example of smart and efficient government policy. Purchasing the bonds is entirely voluntary, but those who make the purchase can enjoy the triple satisfaction of helping the environment, helping the local economy, and getting a decent rate of return too. And, while we aren't privy to the interest rate the PEI government pays on the debt it retires with the bond proceeds, we wouldn't be surprised if they are also lightening their interest burden a little in the process. For relatively little expense and no new regulatory burden, the government is effectively strengthening public support of renewable energy and facilitating the flow of investment capital into the sector.

Unintended Consequences Of Government Efforts To Promote Renewable Energy -- Japan's Recent Experience

As the British Columbia government considers options for achieving the ambitious goals set out in its recent Throne Speech and Energy Plan II, it would do well to consider the lessons to be learned from other jurisdictions.

Take Japan as an example. In 2003, Japan adopted a Renewable Portfolio Standard (RPS) system. Under this system, Japan's main energy producers are obliged to source a certain quota of their total production from renewable energy sources. The government sets the target quota periodically, and the quota increases incrementally each year to at least 2014 (the latest year for which a target has been set). This is sometimes referred to as a fixed-quantity system, and is similar to the regulatory regimes preferred in most states of the USA and parts of Europe including the UK, Italy and Sweden.

The energy producers may meet their obligation in three ways by producing renewable energy directly, by purchasing renewable energy directly from independent power producers, or by buying New Energy Certificates (NEC). Under the NEC system, a producer of renewable energy will be allocated an NEC for each kilowatt-hour (kwh) of renewable electricity it produces. It may then sell its NECs on the open market in addition to selling the electricity itself, creating a second income stream to help offset the higher cost of producing renewable energy. By law, the price for NECs must fall between 4 and 11 yen per kwh (approximately 4 - 11 cents Canadian) but the market will set the price within that range.

The intent of the RPS is to combine government regulation with a market mechanism to efficiently achieve the government policy objective of increasing renewable energy. However, recent reports in the Japanese media suggest the policy is having some undesirable unintended consequences.

One unintended consequence is that renewable energy suppliers are reluctant to build new production capacity because of flaws in the NEC market mechanism. One flaw lies on the supply side if the aggregate production of renewable energy plus NECs in any given year is greater than the established quota, then there is a risk of the NEC market evaporating entirely to the extent of the oversupply. One renewable energy producer in Tokyo found this out the hard way when it generated 422 million kwh of electricity in 2005 but has been unable to find a buyer for 160 million kwh worth of its NECs. Another flaw lies on the demand side since the only buyers are the relatively few Japanese main energy producers, the demand side of the market is illiquid in practice, especially in the present where the annual quota is still fairly low. As a result, the market price for NECs has tended to be stuck firmly in the lower end of its 4 - 11 yen price range. A related difficulty lies in matching new supply with new demand as the annual quota increases. Under the market system, renewable energy producers have no way of knowing whether or not there will be abuyer for their NECs when they bring new capacity on-stream. The NEC market flaws create considerable risk and uncertainty to be borne by the renewable energy providers and which results in a significant disincentive to building new renewable energy production capacity.

Another unintended consequence is that the introduction of the RPS is threatening to undermine Japan's highly successful solar panel program. Japan's annual solar power generation capacity has soared in recent years to approximately 1.42 million kwh, thanks in large part to the installation of solar panels on some 170,000 residential rooftops. This extensive proliferation of small-scale production capacity was made possible by a combination of government subsidies and voluntary measures by the main energy producers to purchase surplus panel power at rates far above the market price of electricity. With the introduction of the mandatory RPS system, however, the main energy producers are now openly questioning whether or not to continue with their earlier voluntary commitments.  Recognizing that solar power continues to be expensive to produce, the government decreed that solar power producers would receive NECs equivalent to double the power actually produced. Given the flaws in the NEC market mechanism and the low price for NECs, however, this is still insufficient to effectively replace the higher tariffs that the main energy producers pay under their vountary schemes. The net result is that the RPS system may have the peculiar effect of encouraging further development of renewable energy but discouraging further proliferation of distributed solar energy production.

For further information on these issues, please see "New Initiative Fails to Spark Enthusiastic Response" and "Renewable Energy Under Clouds", both on page 14 of the March 5, 2007 edition of The Nikkei Weekly.

BC Hydro Announces 2007 Bioenergy RFEOI

In the first step towards a Bioenergy Call for Power, BC Hydro announced today that it is conducting a request for expressions of interest ("RFEOI") with regards to the use of wood fibre as a fuel source for power production in BC.  Although not a requirement for submitting an eventual bid, the RFEOI process does feed into the formation and drafting of the eventual call for power.  Now is the time to highlight concerns and interests.  

Interested parties can submit a RFEOI form which outlines a very high level business plan for producing Bioenergy.  This form asks interested parties to describe the company that would bid into the process, its major investors and to list some potential fuel sources.  These three issues alone of course raise a number legal issues regarding the appropriate corporate structure to use, efficient tax planning, contracting with fuel suppliers, whether or not an enviornmental assessment is required, what other permits are required, whether to look for private equity funding or to seek debt financing and whether to build a new plant or expand an existing one - which of course leads to more legal issues and so forth.  Although BC Hydro and the Minister of Forests have compiled information on Pine Beetle wood fuel supplies , they are not offering any advice on the above issues. 

The deadline for submission of RFEOI's is the 17th of April, and there will be an information session in Prince George, BC on the April 3rd.  In the meantime, there are a lot of issues to start considering.