6 September 2005 External T.I. 2005-0143071E5 - Class 43.1(d)(ii)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: whether certain depreciable property related to a small-scale hydro-electric installation will meet the requirements of Class 43.1(d)(ii)

Position: provide general comments on the types of assets that will qualify

Reasons: as per legislation; NRCan' s file XXXXXXXXXX dated July 18, 2005 and NRCan's Class 43.1 Technical Guide

2005-014307
XXXXXXXXXX Catherine Bowen
(613) 957-8284
September 6, 2005

Dear XXXXXXXXXX:

Re: Class 43.1 Small-Scale Hydro-electric Installation

Your request for an opinion on the technical eligibility of a small-scale hydro-electric installation for inclusion in Class 43.1 of Schedule II ("Class 43.1") of the Income Tax Regulations (the "Regulations") received by Natural Resources Canada ("NRCan") on June 28 has been forwarded to us for reply. This proposed installation will be located on XXXXXXXXXX. We understand that you have received a copy of NRCan's guide entitled Class 43.1 Technical Guide and Technical Guide to Canadian Renewable and Conservation Expenses (CRCE) (the "Technical Guide").

Our Comments

Written confirmation of the income tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request as described in Information Circular 70-6R5 dated May 17, 2002 issued by the Canada Revenue Agency. Such rulings can only be issued for transactions that are seriously contemplated and there is a fee charged for this service. As your proposed installation appears to be in the preliminary stages, it is unlikely that an advance income tax ruling could be issued even if it was requested. Therefore, while we cannot provide any comments with respect to your particular fact situation or to any specific asset, the following general comments may be of assistance.

Class 43.1

In order for any property to be eligible for inclusion in Class 43.1, it must:

? be situated in Canada;

? be acquired by a taxpayer for use by the taxpayer, or to be leased by the taxpayer to a lessee for use by the lessee, for the purpose of earning income from a business carried on in Canada or from property situated in Canada; and

? not have been used for any purpose before the taxpayer acquired the property (other than for certain used equipment that is depreciable property that was eligible for inclusion in Class 34 or 43.1 of the vendor, remains at the same location as used by the vendor and has been acquired by the taxpayer within five years from the time it became available for use to the vendor).

A property will only be considered not to have been used for any purpose where it is new at the time that it is acquired. New equipment that is demonstrated for or tested by a prospective purchaser of that particular piece of equipment will not normally be considered to have been used for a purpose. Consequently, the testing and commissioning of an otherwise new system prior to the purchaser taking possession will not normally result in a finding that the property has been used prior to its acquisition.

However, a property that is used regularly by the vendor for demonstration purposes is considered to have been used by the vendor.

It is our opinion, subject to the other comments provided in this letter, that depreciable property relating to a small-scale hydro-electric facility of a producer of hydro-electric energy consisting of:

a) an overflow spillway (overflow weir),

b) an intake screen,

c) a gate between the overflow spillway and the surge chamber,

d) a surge chamber to regulate the water flow to the turbine,

e) a penstock to convey water to the powerhouse,

f) a turbine with a generator (including controls and turbine inlet valve/gate) that has an annual average generating capacity not exceeding 15 MW upon completion of the site development,

g) a powerhouse along with a reinforced concrete substructure/foundation and related ancillary systems,

h) a step-up transformer and voltage protection equipment,

i) a fence surrounding the transformer and protection equipment,

j) a transmission line up to the interface with the local electrical distribution system or the isolation switch of the local electrical utility system, and

k) a metering station

will be eligible for inclusion in Class 43.1 by virtue of subparagraph (d)(ii) thereof. A hydro-electric installation that has an annual average generating capacity not exceeding 15 MW upon completion of the site development will qualify for inclusion under the existing wording of clause (d)(ii)(A) of Class 43.1 as well as under the draft amendment to that clause issued on February 5, 2002 which proposes to increase the generating capacity to a maximum of 50 MW for property acquired after December 11, 2001.

However, in our view,

a) a utility isolation switch - a disconnect switch located at the point of interconnection with the local electrical distribution line,

b) a small gravelled area located beside the power house which serves as a works yard both during and after construction, and

c) a prefabricated metal building used to shelter the powerhouse

will not be eligible for inclusion in Class 43.1.

Subparagraph (d)(ii) of Class 43.1 does not include property otherwise included in Class 10 or 17 of Schedule II of the Regulations. A proposed amendment to Class 17, which was announced on March 16, 2001, provides that electrical generating equipment (subject to certain exceptions that are not relevant to your situation) acquired after February 27, 2000 will be included in that class by virtue of proposed paragraph (a.1) thereof. Consequently, if proposed paragraph (a.1) of Class 17 is promulgated in the form announced on March 16, 2001, a small-scale hydro-electric installation would not be eligible for inclusion in Class 43.1. We understand, however, that the Department of Finance issued a comfort letter on October 17, 2003 indicating that it was aware of this issue and intended to recommend to the Minister of Finance that the proposed amendment relating to Class 17 be clarified to ensure that electrical generating equipment that is currently described in proposed subparagraph (a.1)(i) of Class 17 will be eligible for inclusion in Class 43.1.

It should be noted that the February 23, 2005 federal budget announced that renewable energy generation equipment, including small-scale hydro-electric facilities, that would otherwise be included in Class 43.1 and that is acquired on or after the date of the budget and before 2012 will qualify for a new capital cost allowance class with a 50% capital cost allowance rate. Should this change be promulgated, the equipment that qualifies for inclusion in Class 43.1 as noted above may qualify for this new class.

Canadian renewable and conservation expenses

Certain expenses incurred in the pre-production development phase of renewable energy and energy conversation projects may, where it is reasonable to expect that at least 50% of the capital cost of the depreciable property to be used in the project would qualify for inclusion in Class 43.1, meet the definition of "Canadian renewable and conservation expense" ("CRCE") in subsection 1219(1) of the Regulations if, among other things, they are payable to

? a person or partnership with whom the taxpayer is dealing at arm's length, and

? a Canadian resident or a Canadian partnership (i.e., a partnership all of the members of which are Canadian residents). An exception to this rule applies where a taxpayer purchases a test wind turbine for a qualifying project.

However, certain expenses, such as expenses in respect of overhead and management, financing and interest, or the acquisition, or use of, land, are specifically excluded from CRCE under subsection 1219(2) of the Regulations. In addition, any expense incurred for a project in respect of any time at or after the earliest time at which a property described in Class 43.1 was used in the project for the purpose of earning income is expressly excluded from CRCE under subparagraph 1219(2)(b)(ix) of the Regulations. The capital cost of depreciable property, including that described in Class 43.1, as well as an eligible capital expenditure will not generally qualify as CRCE.

The "Technical Guide" provides a list of some of the types of expenses that do and do not qualify as CRCE. The determination of whether a particular expense incurred by a taxpayer will qualify for inclusion in CRCE must be made based upon a review of all of the facts relevant to a particular situation. However, where expenses do qualify as CRCE, they are added to a taxpayer's Canadian exploration expense pool (as per paragraph (g.1) of the definition of "Canadian exploration expense" in subsection 66.1(6) of the Income Tax Act (the "Act"). They can be deducted entirely in the year they are incurred or carried forward indefinitely and deducted in later years.

CRCE can also be renounced (or passed along) to shareholders of a "principal business corporation" through a flow-through share agreement. In general, these agreements allow such corporations to raise funds for financing their proposed energy conservation or renewable energy projects by issuing flow-through shares. However, amounts may only be renounced to a particular investor in respect of CRCE incurred by the corporation on or after the date the agreement in writing relating to the acquisition of the flow-through share was made. The shareholders can deduct the CRCE renounced to them against their own income. A "principal business corporation" (as defined in subsection 66(15) of the Act) includes, among other things, a corporation the principal business of which is any of, or a combination of

? the generation of energy using property described in Class 43.1, and

? the development of projects for which it is reasonable to expect that at least 50% of the capital cost of the depreciable property to be used in each project would be the capital cost of property described in Class 43.1.

Our comments are provided in accordance with the practice outlined in paragraph 22 of IC-70-6R5. We trust our comments are of assistance.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch

c.c. Micheline Brown
Engineering, Research and Technical Team
Industrial Programs Division
Office of Energy Efficiency
Natural Resources Canada
580 Booth St., 18th Floor
Ottawa ON K1A 0E4