25 November 2005 External T.I. 2005-0122351E5 - Service Connection and CRCE

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 the cost to design and purchase certain property will qualify as CRCE under paragraph 1219(1)(a) of the Regulations as having been incurred for the purpose of making a service connection to a qualifying project for the transmission of electricity to a purchaser.

Position: Question of fact whether purpose test in paragraph 1219(1)(a) of the Regulations satisfied. In addition, costs that relate to the acquisition of property by the taxpayer are expressly excluded from qualifying as CRCE under that paragraph. Even if purpose test satisfied, a PBC which has incurred CRCE/CEE will be precluded from renouncing an amount in respect thereof to an investor in flow-through shares to the extent of the assistance the PBC has received, is entitled to receive or can reasonably be expected to receive at any time that can reasonably be related to such CEE.

Reasons: Nature of determination as well as the wording of the relevant provisions of the Act and Regulations.

2005-012235
XXXXXXXXXX A.A. Cameron
(613) 347-1361
November 25, 2005

Dear XXXXXXXXXX:

Re: XXXXXXXXXX (the "Company")
Interconnection Costs for Small Hydro-Electric Projects

We are writing in response to your electronic mail messages of March 23, August 3 and August 25, 2005 wherein you requested a technical interpretation regarding whether certain costs relating to the development of several small hydro-electric projects will qualify as Canadian renewable and conservation expense ("CRCE") pursuant to section 1219 of the Income Tax Regulations (the "Regulations").

XXXXXXXXXX

Having regard to the above factors and the provisions of paragraph 1219(1)(a) of the Regulations, you have asked for our interpretation regarding:

i) whether the cost of the design and equipment required to make the interconnection to the high-voltage transmission line of Transmission will qualify as CRCE (i.e., costs for the substation, system protection and communications); and

ii) whether, if the Company pays for the transmission lines (XXXXXXXXXX kV) from the generators to the point of interconnection, but these lines are owned by Transmission, the cost of these lines will qualify as CRCE.

Our Comments

Written confirmation of the 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 submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. However, we can provide the following comments of a general nature that may be of some assistance.

Overview regarding 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, in general terms, expenses incurred by a taxpayer in the development of a project for which it is reasonable to expect that at least 50% of the capital cost of the depreciable property to be used in the project would be the capital cost of any property that is described in Class 43.1 of Schedule II to the Regulations ("Class 43.1") may constitute CRCE to the taxpayer provided they are payable to a person with whom the taxpayer is dealing at arm's length and to the extent they are not specifically excluded from CRCE under subsection 1219(2) of the Regulations, e.g., certain expenses in respect of overhead and management, financing and interest, or the acquisition, or use of, land. 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.

Qualifying Projects

A small hydro-electric project of the type referred to above will be eligible for inclusion in Class 43.1 provided that the proposed amendments to Class 43.1, which were published in the Canada Gazette Vol. 138, No. 51 on December 18, 2004 and which are applicable after December 10, 2001 (the "Draft Amendments"), are promulgated. Under the Draft Amendments a hydro-electric installation of a producer of hydro-electric energy having a rated capacity at the hydro-electric installation site that does not exceed 50 megawatts will be eligible for inclusion in Class 43.1 (under the existing legislation only those installations having an annual average generating capacity not exceeding 15 megawatts upon completion of the site development may qualify). In particular, under clause (d)(ii)(B) of Class 43.1 [and subject to the generating capacity limitations contained in the proposed amendments to clause (d)(ii)(A)], the hydro-electric installation of a producer of hydro-electric energy includes the electrical generating equipment and plant, including transmission equipment, of that producer but does not include distribution equipment and property otherwise included in Class 10 or 17 of Schedule II of the Regulations.

Paragraph 1219(1)(a) of the Regulations

Paragraph 1219(1)(a) of the Regulations provides that an expense incurred, in the development of a qualifying project, by a taxpayer:

...for the purpose of making a service connection to the project for the transmission of electricity to a purchaser of the electricity, to the extent that the expense so incurred was not incurred to acquire property of the taxpayer...

will be eligible for inclusion in CRCE provided that the expense is payable to an arm's length party and is not expressly excluded from CRCE as noted above.

The determination of whether a particular cost incurred in the development of a qualifying project will satisfy the purpose test in paragraph 1219(1)(a) of the Regulations must be made with reference to all of the facts and circumstances relevant to the project in question.

Based on our review of the draft "Facilities Agreement" of Transmission (available on the internet and to which you have referred us), it is our understanding that Transmission is responsible for determining the scope of the "interconnection facilities", being the equipment, materials and systems necessary and required to be installed or modified, within either:

i) the facilities owned and operated by the party generating the electricity (such party being the "Generator"), or

ii) the provincial transmission system owned by Transmission,

to permit the interconnection of a new electrical generating facility to the provincial transmission grid. It is also our understanding that interconnection facilities consist of two components:

iii) "direct assignment facilities" (being facilities or portions thereof that are constructed by Transmission for the sole use and benefit of the Generator); and

iv) "network upgrades" (being modifications or additions to transmission-related facilities that are integrated with and support the provincial transmission grid for the benefit of all users).

Transmission is generally responsible for providing all services required to design and install both the direct assignment facilities and the network upgrades. Although the Generator is generally required to pay to Transmission all of the costs associated with this work, all rights to the title and ownership of the interconnection facilities will be with:

(a) Transmission, for such of those facilities that are installed or modified within the provincial transmission system, and

(b) the Generator, for such of those facilities installed or modified within the facilities owned and operated by the Generator.

In the situation where the Generator has entered into an independent power purchase agreement with Hydro, we understand that the direct assignment portion of the interconnection costs is payable by the Generator, while the network upgrade costs will be borne by Hydro once the project has reached commercial operation. However, until commercial operation is achieved, the Generator is financially liable to Transmission for the network upgrade costs and must provide security to Transmission in an amount equal to the estimated network upgrade costs.

A determination by Transmission that particular costs are required to be incurred by a Generator in order to permit interconnection with the provincial transmission system is a factor to be considered in determining whether such costs were incurred for the purpose of making a service connection to the project for the transmission of electricity to a purchaser thereof as required by paragraph 1219(1)(a) of the Regulations. However, to the extent such costs relate to the acquisition of property by the Generator, they would not be eligible for inclusion as CRCE. In this regard, the information relating to the direct assignment facilities in the Facilities Agreement described above, suggests that the Generator would own many of those facilities such that the costs thereof would be excluded from CRCE. However, as noted above, the determination as to whether a particular cost satisfies the purpose test contained in paragraph 1219(1)(a) of the Regulations, as well as to the extent to which a particular cost may so qualify, must be made with reference to all of the facts and circumstances relevant to a project in question.

We would also note that the draft Facilities Agreement of Transmission referred to above appears to contemplate that transmission lines between the electrical generating station of a Generator and the point of interconnection with the provincial transmission system would be property forming part of the facilities of the Generator. In other words, that agreement appears to contemplate that such transmission lines would be owned by the Generator and, if so, the cost of those transmission lines would not qualify as CRCE under paragraph 1219(1)(a) of the Regulations. However, if, in a particular situation, the transmission lines between the electrical generating station of a Generator and the point of interconnection with the provincial transmission system were not owned by the Generator, the cost of such transmission lines should generally be eligible for inclusion in CRCE pursuant to paragraph 1219(1)(a) of the Regulations.

Finally, we would note that in the event that the Generator is only required to post security with Transmission for the network upgrade costs, the posting of such security would not constitute an expenditure of the Generator. Consequently, any amount posted as security would not be eligible for inclusion in CRCE or otherwise be deductible. Also, any costs incurred with respect to the posting of security would likely represent financing costs, which are not eligible for inclusion in CRCE pursuant to paragraph 1219(2)(a) of the Regulations.

CRCE and Flow-Through Shares

Pursuant to paragraph (g.1) of the definition of "Canadian exploration expense" ("CEE") in subsection 66.1(6) of the Act, expenses incurred by a taxpayer that qualify for inclusion in CRCE will also be included in the taxpayer's CEE. A taxpayer that qualifies as a "principal-business corporation" ["PBC", as defined in subsection 66(15) of the Act] may be able to renounce amounts, in respect of the CEE incurred by it, to an investor that has acquired a "flow-through share" ["FTS", also as defined in subsection 66(15) of the Act] in its capital stock. However, amounts may only be renounced to a particular investor in respect of CEE incurred by the taxpayer on or after the date the agreement in writing relating to the acquisition of the FTS was made. With regard to the definition of PBC, it provides, in part, that such term "means a corporation the principal business of which is any of, or a combination of," certain specified activities including:

(h) the generation of energy using property described in Class 43.1 of Schedule II to the Income Tax Regulations, and

(i) 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 of Schedule II to the Income Tax Regulations...

In addition, it should also be noted that pursuant to paragraph 66(12.6)(a) of the Act, the amount that a PBC may be able to renounce, in respect of CEE it has incurred, to an FTS investor is reduced by the amount of any assistance [as defined in subsection 66(15) of the Act] that the PBC has received, is entitled to receive or can reasonably be expected to receive at any time, and that can reasonably be related to the CEE. As such, notwithstanding that a cost incurred by a PBC for the purpose of making a service connection to a qualifying project may qualify for inclusion in CRCE under paragraph 1219(1)(a) of the Regulations, the PBC may be precluded from making a renunciation to a FTS investor in respect of such cost. As noted above, it is our understanding that in the situation where a Generator is actually required to pay (and not merely to provide security for) the portion of the interconnection costs referred to as "network upgrades", such amount will be reimbursed by Hydro once the project has reached commercial operation. In our view, to the extent that these network upgrade costs have been included as CRCE, any such reimbursement would be assistance that a PBC may reasonably be expected to receive that relates to the cost of the network upgrades. Therefore, to the extent that such interconnection costs qualify as CRCE and CEE to the PBC, the provisions of paragraph 66(12.6)(a) of the Act would preclude the PBC from renouncing an amount in respect of such CEE to a FTS investor. In addition, once the PBC has received or becomes entitled to receive this assistance, the amount thereof would reduce the "cumulative Canadian exploration expense" of the PBC pursuant to item J of the definition of such term in subsection 66.1(6) of the Act.

Other Considerations

It should be noted that a proposed amendment to Class 17 of Schedule II to the Regulations, 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. As noted above, the closing words to subparagraph (d)(ii) of Class 43.1 (i.e. the provision relating to small hydro-electric installations) provide that property otherwise included in Class 17 of Schedule II to the Regulations is excluded from Class 43.1 under that subparagraph. Consequently, if proposed paragraph (a.1) of Class 17 is promulgated in the form announced on March 16, 2001, electrical generating equipment for the projects referred to above 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 CCA regulations relating to Classes 17 and 43.1 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.

We would also note that the federal budget of February 23, 2005 contains a proposal under which certain property otherwise eligible for inclusion in Class 43.1 may be eligible for inclusion in a new class having a capital cost allowance rate of 50 per cent. In particular, under this proposal small hydroelectric facilities (similar to those proposed by the Company), acquired on or after February 23, 2005 and before 2012, that would otherwise be included in Class 43.1 would be eligible for the new class.

We trust that these comments will be of assistance.

Yours truly,

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