6 February 2006 External T.I. 2005-0156291E5 - Cogeneration System and Class 43.1

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 a proposed cogeneration facility will qualify for inclusion in Class 43.1

Position: General comments provided

XXXXXXXXXX 							2005-015629
								Marc Edelson, LL.B.
February 6, 2006

Dear Sir:

Re: Class 43.1 - Cogeneration System

We are writing in reply to your request to Natural Resources Canada ("NRCan"), dated October 13, 2005, for a technical opinion (the "Request") regarding the eligibility of certain property of a proposed cogeneration system (the "Proposed System") for inclusion in Class 43.1 of Schedule II ("Class 43.1") of the Income Tax Regulations (the "Regulations").

It is our understanding that the Proposed System is to be a standalone XXXXXXXXXX megawatt combined cycle electrical generation system that XXXXXXXXXX (the "Corporation") will construct adjacent to an existing power generating facility. The Proposed System will utilize natural gas, as a feedstock, to power a gas turbine that will generate XXXXXXXXXX megawatts of electrical power. Heat from the gas turbine will be fed to a heat recovery boiler that will, in turn, feed steam to a steam turbine that is part of the Proposed System, as well as to a steam turbine that is part of the existing facility. The new steam turbine will generate XXXXXXXXXX megawatts of electrical power and the existing steam turbine will generate XXXXXXXXXX megawatts of electrical power (XXXXXXXXXX megawatts will be generated as a result of the new heat recovery boiler). The Proposed System, which closely resembles schematic ECG 4.1.1 in the 1998 edition of the Class 43.1 Technical Guide and Technical Guide to Canadian Renewable and Conservation Expenses (CRCE), is expected to achieve a heat rate of less than the 6,000 BTU per kilowatt hour. None of the equipment to be included in the Proposed System will have been used for any purpose before being acquired by the Corporation.

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. A fee is charged for this service. Although we are unable to provide any comments with respect to your particular fact situation otherwise than in the form of an advance income tax ruling, the following general comments may be of assistance.

Paragraph (a) of Class 43.1 describes certain property, other than reconditioned or remanufactured equipment, that would otherwise be included in Class 1, 2, 8 or subparagraph (a.1)(i) of Class 17 of Schedule II of the Regulations. Property described in paragraph (a) that is relevant to your request includes

(i) electrical generating equipment, including any heat generating equipment used primarily for the purpose of producing heat energy to operate the electrical generating equipment,

(ii) equipment, other than fuel cell equipment, that generates both electrical and heat energy and,

(iii) other equipment that is ancillary thereto.

Specifically excluded are buildings or other structures, heat rejection equipment (such as condensers and cooling water systems), transmission equipment, distribution equipment, fuel storage facilities and fuel handling equipment.

Property described in paragraph (a) of Class 43.1 must also satisfy the conditions described in paragraphs (b) and (c) of that class which are described below.

The property:

(i) must be situated in Canada;

(ii) must be acquired by the 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

(iii) must not have been used for any purpose before the taxpayer acquired the property (an exception is available for certain used equipment that is depreciable property that was eligible for inclusion in Class 34 or 43.1 of the vendor, that remains at the same location where it was used by the vendor and that has been acquired by the taxpayer within 5 years from the time it became available for use to the vendor).

Pursuant to subsection 1102(21) of the Regulations, the capital cost of any used equipment that qualifies for inclusion in Class 43.1 as described in (iii) above cannot exceed the original capital cost of the property to the person from whom the property was acquired. Any excess should be included in the class in which the particular property would have been included if it were not eligible for inclusion in Class 43.1.

A property will not be considered 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.

Where the property is part of a system (other than an "enhanced combined cycle system", as defined in subsection 1104(13) of the Regulations), that is used by the taxpayer, or a lessee of the taxpayer, to generate electrical energy, or both electrical and heat energy, using only certain eligible fuels, including fossil fuel (which is defined in the same subsection of the Regulations to include natural gas), it will satisfy the requirements of paragraph (c) of Class 43.1 if the heat rate attributable to fossil fuel (other than solution gas, as defined in subsection 1104(13) of the Regulations) does not exceed 6,000 BTU's per kilowatt-hour of electrical energy generated by the system determined in accordance with clause (c)(i)(B) of Class 43.1.

Property that is part of a system, other than an enhanced combined cycle system, that is to be included in Class 43.1 as a result of being described in paragraph (a) of that Class must satisfy the criteria referred to in the preceding paragraph on an annual basis. In other words, the property must be used by the taxpayer (or a lessee of the taxpayer) in the year to generate qualifying energy, using qualifying feedstock and satisfying the maximum heat rate requirements. A limited exception is allowed, pursuant to subsection 1104(14) of the Regulations, for certain property which is part of an eligible system that was previously operated in a qualifying manner. Where this exception applies, the property will be considered to have been operated in the required manner during a period of deficiency, failure or shutdown of the system that is beyond the taxpayer's control provided the taxpayer makes all reasonable efforts to rectify the problem within a reasonable time. Where the exception does not apply and the property no longer qualifies for inclusion in Class 43.1, subsection 13(5) of the Act requires that the undepreciated capital cost of the property be transferred from Class 43.1 to the other class in which it is described as of the commencement of the particular taxation year. Similarly, if in a subsequent year the property satisfies the annual requirements for inclusion in Class 43.1, subsection 13(5) would again apply to reclassify the property into Class 43.1 as of the commencement of the year.

It should be noted that the February 23, 2005 federal budget (the "Federal Budget") announced that certain highly fossil-fuel-efficient and renewable energy generation equipment that is currently included in Class 43.1 and that is acquired after February 22, 2005 and before 2012 may be eligible to be included in proposed new Class 43.2 which will be entitled to a capital cost allowance ("CCA") rate of 50 per cent, calculated on a declining balance basis. It is proposed that equipment eligible for inclusion in this new class will include cogeneration equipment that would otherwise qualify for inclusion in Class 43.1 and that is part of a high-efficiency cogeneration system with an annual heat rate from fossil fuel that does not exceed 4,750 BTU's per kilowatt-hour of electricity production. As well, the Federal Budget proposed that property included in proposed Class 48, generally describing combustion turbines (including associated burners and compressors) acquired after February 22, 2005, would be included in Class 43.1 provided the conditions in paragraphs (a), (b) and (c) of Class 32.1 described above are satisfied.

Where Class 43.1 property meets the definition of "specified energy property" in subsection 1100(25) of the Regulations, the amount of CCA that may be claimed on that property is generally limited to the income earned from such property (as per subsection 1100(24) of the Regulations). However, where Class 43.1 property is acquired to be used by the owner primarily for the purpose of gaining or producing income from a business carried on in Canada (other than the business of selling energy produced by the property) or from another property situated in Canada (e.g., rental property), this restriction does not apply. In other words, as long as the purchaser of a property that qualifies for inclusion in Class 43.1 is using it in its own business, the property will not normally be affected by these rules restricting the amount of CCA that can be claimed.

We trust that these comments will be of assistance.

Yours truly,

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch