Funding a start-up renewable energy project can be a challenging prospect. Those embarking on such an endeavor require adherence to the principles of conservation while making the most efficient use of the funding available.
Fortunately, the Government of Canada has a number of programs that can be employed by renewable energy companies to help attract investors and stretch the funds received.
However, these programs come with risks that should be considered to ensure each program’s advantages are fully realized while ensuring exposure to unnecessary liabilities is minimized.
These programs fall into three general categories: tax incentives, indirect funding and direct funding, each of which have differing structures, benefits and potential pitfalls.
Tax Incentive Programs for Investors
Flow-through shares are a common tax incentive program used by start-up (principal-business) companies as they can be a good option for companies not expecting to earn revenue from their project for several years.
A flow-through share is a non-prescribed, “plain vanilla” common share that allows the company to transfer the qualifying expenditures to the shareholder for a deduction on the shareholder’s tax return.
This tax deduction is often of limited value to the company given that the utilization of the ensuing non-capital losses is uncertain or far off in the future. However, this tax benefit is attractive to investors with significant taxable income to shelter, effectively providing a discount on the flow-through share for the purchaser.
The timing of the transfer, or renunciation, of the qualifying expenditure to the shareholder can occur either before or after the funds from the issuance of flow-though shares are spent by the company.
The former option is referred to as the “look-back rule” and carries with it certain drawbacks. When the look-back rule is applied, the Canada Revenue Agency (CRA) encourages spending by levying Part XII.6 tax “penalties”, which are deductible by the company, on unspent funds shortly after renunciation.
Once in effect, these penalties are calculated monthly at the CRA’s prescribed rate (1% as of the date of this publication) with an additional 10% “penalty” applied at the end of the first calendar year following the year of renunciation.
Should funds remain unspent within 24 months after the month of the signing of flow-through share agreements, the CRA will reverse the shareholder’s tax benefit which can result in the shareholder repaying the associated tax refunds to the CRA, who then, in turn, can force the company to repay the amount of the lost tax benefit if the shareholder agreement contains an indemnity clause. The existence of a limited indemnity for tax losses will not affect the shares’ eligibility for renunciation under the flow-through share program.
These types of unpleasant scenarios can be avoided by applying the look-back rule only to funds to be spent before the trigger date for penalties: February 28 of the calendar year following the year in which the funds were raised.
In many cases, shareholders hungry for an immediate tax benefit will pressure the company to apply the look-back rule on more funding than it can effectively spend prior to incurring penalties. Should this scenario be anticipated, the resulting penalties should be considered in the cost of the financing and, if possible, the company should avoid the inclusion of an indemnity clause in the shareholder agreement.
Indirect Funding for Companies
The single largest indirect funding program in Canada is the Scientific Research and Experimental Development (SR&ED) tax credit program, which allows companies to receive tax credits or generous refunds for qualifying expenditures.
Companies developing new technology including new products, new processes or other new technological knowledge can generate significant qualifying expenditures related to labour costs, materials consumed or transformed, Canadian contractors and other overhead costs directly related to qualifying activities.
The most generous refundable SR&ED tax credits can be available to small and medium-sized private Canadian corporations. Large private Canadian, all public and all non-Canadian corporations benefit through the less generous, non-refundable SR&ED tax credits. There is no defined budget for the program, meaning that any company incurring qualifying expenditures is eligible; however, any claims must be filed within 18 months of the end of the company’s tax year.
There are planning opportunities to consider in order to ensure that a company will remain eligible for the refundable SR&ED tax credits. In the renewable energy sector, companies that are eligible for the SR&ED program generally fall into two categories: independent power producers (IPPs) and service providers to the IPPs.
The capital-intensive and long payback period nature of IPP ventures tends to limit the planning opportunities available to gain cash flow benefits through the SR&ED program. However, there may be opportunities to create a separate research and development (R&D) entity whose structure may enable it to qualify for refundable SR&ED tax credits.
The key requirement to receive the refundable federal credits is that the entity must be a Canadian-controlled private company (CCPC) meaning that it is a Canadian corporation that is not publicly listed or controlled by non-residents. Most provinces also have their own SR&ED credit and some of them may be refundable even if the entity is not structured as a CCPC.
Despite the planning efforts of any initial company structure, it is important to note that small changes within the R&D entity’s structure could prevent the company from participating in the refundable SR&ED tax credits. Further to this, the ultimate determination of eligibility can be made only by the CRA.
This eligibility uncertainty is a significant risk for many companies and the CRA is currently piloting a project that may provide more certainty in terms of eligibility. Service providers can fall into either of the refundable or non-refundable SR&ED tax credit eligibility categories, however they are often more likely to be in a taxable position earlier than an IPP and can therefore take advantage of the cash flow benefit of the SR&ED tax credits regardless of whether those tax credits are refundable or non-refundable.
It’s important for any company claiming SR&ED tax credits that they follow the scientific method and track all potentially related activities and the associated costs contemporaneously. We find that a periodic review of candidate SR&ED activities can be beneficial to maximize the claim.
Direct Funding for Companies
There are a mind-boggling number of direct funding programs related to industry incentives. Many of these programs provide excellent advantages including certainty of funding once approved and a wider scope of activities than are eligible for the SR&ED program. Renewable energy, and new products for the renewable energy sector, are currently attractive candidates for many of these programs.
These programs are typically structured as either grants or loans where the loans are often repaid through a percentage of profits based on the output of the approved project for a period of time after the project is complete, typically on a scale of five to seven years.
There are a number of areas to be aware of with these direct funding programs which can reduce eligibility for the SR&ED program, reducing those tax credits even if the direct funding is in the form of a loan.
Additionally, these programs typically require some degree of matching by the company, meaning that the company will need to raise a specified amount of funding independently which cannot be spent on any activity defined in the project proposal prior to approval, the process for which is not well publicized leading to uncertainty of timing.
Furthermore, there is typically a defined budget on both a geographical region and annual basis for each of the direct funding programs and the funds are generally approved on a first-come-first-served basis for qualifying proposals; the results of which are that an attractive qualifying project may not receive funding in a given year in favour of a less desirable project.
Finally, competing projects are rarely approved in the same geographical region through the same program. To increase a company’s eligibility to receive direct funding incentives, these programs require significant advanced planning, clear articulation of the project goals and benefits in the proposal and flexible time lines.
Canada continues to rate among the best countries in which to develop renewable energy projects due to its abundant natural resources and government incentives designed to encourage innovation.
Companies intending to take advantage of these many programs are wise to plan well ahead with the assistance of accounting, tax and legal professionals. Involvement of such specialists, particularly in the planning stages, can help to select the program best suited for the specific project while assisting in the maximization of the benefits of these programs, while minimizing the risks associated with their application.
Bryndon L. Kydd, CPA, CA. is a Partner in the Natural Resources Group, BDO Canada LLP. Stephen Meadows is Senior Manager, SR&ED Services at BDO Canada LLP. Both are based in Vancouver.