5 April 2005 External T.I. 2005-0114331E5 - Warranties and Test Wind Turbines

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 warranties provided by a manufacturer of wind turbines to the corporate purchaser thereof would cause shares intended to be flow-through shares (issued by the purchaser to fund the acquisition of the test wind turbines) to be prescribed shares under paragraph 6202.1(1)(c) of the Regulations.

Position: Such determinations must be made based upon the relevant facts and circumstances, however, warranties given by the manufacturer to the corporate purchaser solely to warrant the reliability of the wind turbine equipment, where those parties deal at arm's length and the terms of the warranties are commercially reasonable, will generally not, in and by themselves, cause shares issued by the purchaser to fund the acquisition of the test wind turbines to be prescribed shares.

Reasons: Consideration of the relevant provisions of the Act and Regulations as well as the nature of the tests involved.

2005-011433
XXXXXXXXXX A.A. Cameron
(613) 347-1361
April 5, 2005

Dear XXXXXXXXXX:

Re: Availability Warranty

We are writing in response to your email message of February 2, 2005 (to Mr. Tom Jewett at Natural Resources Canada) regarding the tax implications of an availability warranty provided by a manufacturer of a wind turbine to the purchaser thereof where that turbine is intended to be a "test wind turbine" as defined in proposed amendments to subsection 1219(3) of the Income Tax Regulations (the "Regulations") described in News Release 2002-063 issued by the Department of Finance on July 26, 2002 (the "Proposed Amendments"). In particular, you have asked for our views as to whether the existence of such a warranty would preclude the costs associated with the acquisition of a test wind turbine from being eligible for renunciation to investors pursuant to subsection 66(12.6) of the Income Tax Act (the "Act").

You have indicated that warranties in respect of wind turbines generally have three main components: a parts and labour guarantee, an availability guarantee, and a power curve guarantee. In addition, you have indicated that the availability guarantee represents the guarantee from the wind turbine manufacturer that the turbine will be available to generate electricity for a certain percentage of time in a given period (generally a year; with it being reasonable to expect that the percentage of availability warranted would at all times be less than 100% and that such percentage would generally be less in the first period of operation than in subsequent periods). Furthermore, it is our understanding that a power curve guarantee relates to the ability of the wind turbine equipment to operate at a specified level of electrical energy generation within a certain period of time after commissioning subject, in particular, to the availability of the wind resource.

You have also represented that, in general, the energy output of a wind turbine is a function of three variables: the strength of the wind resource, the availability of the turbine and the power curve of the turbine. Although the manufacturer's warranty typically guarantees the availability and power curve of the wind turbine, it will not guarantee the wind resource risk, as that risk has nothing to do with the equipment. You also represent that the wind resource risk is the biggest risk associated with a wind energy project.

Your concern appears to relate to whether the existence of the availability guarantee will cause any shares of the issuing corporation to be a prescribed share within the meaning of section 6202.1 of the Regulations. A share which is a prescribed share will not qualify as a "flow-through share" ("FTS", as defined in subsection 66(15) of the Act) with the result that the issuing corporation may not renounce amounts in respect of eligible resource expenses to the holders of the shares.

Our Comments

The particular situation outlined above appears to relate to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Where the particular transactions have been completed, any enquiry should be addressed to the relevant tax services office. Although we cannot comment on your specific situation, the following general comments may be of assistance.

In general terms, the FTS mechanism is intended to raise capital for "exploration" activities in the resource sector (including Canadian renewable and conservation expenses within the meaning of subsection 1219(1) of the Regulations) with the prescribed share rules contained in section 6202.1 of the Regulations intended to ensure that this capital is truly at risk. As such, where a "guarantee" is given in any situation involving the issuance of shares intended to be FTS, the question arises as to whether the prescribed share rules may apply in respect of that guarantee. As noted above, a share found to be a prescribed share is expressly excluded from the definition of FTS.

In order for the cost of a test wind turbine to be an eligible Canadian renewable and conservation expense, the taxpayer acquiring the test wind turbine must be dealing at arm's length with the vendor thereof. As such, it appears that your specific concern relating to the availability warranty to be provided by a manufacturer of wind turbines would be the possible application of paragraph 6202.1(1)(c) of the Regulations. The circumstances under which a share of the capital stock of a corporation will be a prescribed share under that paragraph include where, at the time the share is issued, any person has a contingent obligation [other than an "excluded obligation" as defined in subsection 6202.1(5) of the Regulations] to effect any undertaking in the future with respect to the share or the agreement under which the share is issued (including any guarantee, indemnity or agreement) that may reasonably be considered to have been given to indirectly ensure that: i) any loss that the holder of the share may sustain by reason of the holding or ownership of the share is limited in any respect, or ii) the holder of the share will derive earnings by reason of the holding or ownership of the share.

The provisions of paragraph 6202.1(1)(c) of the Regulations are broadly worded such that an availability warranty from the manufacturer could be considered to represent an "undertaking...with respect to" the flow-through shares issued to fund that acquisition of test wind turbines. This is because such a warranty represents a contingent obligation of the manufacturer to make payments to the purchaser in the future that may indirectly have the effect of limiting a loss that the holder of shares of the corporate purchaser may sustain or result in earnings to the holder. As this obligation would not be an "excluded obligation", the question becomes whether it is appropriate to conclude that the warranty in question "may reasonably be considered to have been given to ensure" this limitation of loss or deriving of earnings to the shareholder.

In our view, the determination of whether a particular warranty provided with respect to a test wind turbine would result in shares issued to fund the acquisition of the turbine being prescribed shares and, therefore, excluded from the definition of FTS must be made based on the relevant facts and circumstances relating to a particular situation. However, it is also our view that an availability warranty provided by a manufacturer of wind turbines to its customers which is provided solely to warrant the reliability of the relevant equipment, and the terms of which were determined through arm's length negotiations and reflect commercially reasonable terms with regard to the wind turbines in question would generally not be considered to have been given to ensure that: i) any loss that the holder of the share may sustain by reason of the holding or ownership of the share is limited in any respect, or ii) the holder of the share will derive earnings by reason of the holding or ownership of the share. Consequently, the existence of such a warranty should not, in and by itself, cause any shares issued by the purchaser corporation to fund the acquisition of the wind turbines to be prescribed shares. However, our view would not be the same if any warranty granted by the equipment manufacturer were to extend beyond assuring the normal reliability of the equipment.

We trust that these comments will be of assistance. However, as stated in paragraph 22 of Information Circular 70-6R5, this opinion is not a ruling and consequently is not binding on the Canada Revenue Agency in respect of any particular situation.

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