By Tom Routley

As you read this, the US Senate and House will be revisiting their respective energy bills. In a concerted effort to push for energy and environmental efficiency within the end-user marketplace, both the Senate and House finalized tax incentive packages earlier in the summer; the House tax package was passed into its broader energy bill, but the Senate package has not yet been included. Each set of tax packages contain measures clearly intended to increase the Return-On-Investment (ROI) for commercial and industrial energy consumers who are making appropriate capital investments in efficiency projects.

This is not a new approach. It is just getting better. And it is not just the US federal government that wants to give companies tax breaks. Virtually every level of government in the US and Canada is leaning towards making energy efficiency a priority and is willing to put up the necessary cash. Tax has always played a large part in achieving government economic policy agendas, and energy and environmental efficiency is just the latest target. This latest wave of tax breaks is moving beyond the producers to the users, and away from the esoteric to real cash and earnings benefits. However, consumers need to know the various forms that these tax breaks will take so that they can take maximum advantage of the benefits

What do these tax incentives look like?

There are currently three that are well worth thinking about:

Tax Credit

This is typically the most valuable energy and environmental efficiency incentive. Generally speaking, these run at a 10-30% rate on the capital expenditure (there are many state tax credits that are functions of qualifying square footage, kWh produced etc) and are used to directly offset tax liabilities, i.e. dollar for dollar value. These tend to be served up in the US for investments in renewable energy sources, such as solar and wind power. These are less prevalent in Canada, where to date they are more likely to show up at the provincial level.

Accelerated Deduction

These are a favourite for all governments. They simply accelerate the time line over which capital can be depreciated for tax purposes over its real economic timeline. Presumably these have appeal for government in that they tend to gain more in public relations value than they give up on the fiscal front. While there is clearly an economic advantage in getting this “front-end loaded” deduction, the real value for these incentives is diluted by the realities of present value. The net result on $100 in spending typically yields $5 for alternative energy equipment and a high of over $20 for the US energy efficient commercial building.

Exemption from Taxable income

Some jurisdictions have elected to provide tax breaks by simply removing certain amounts of income out of the taxable income computation. Examples include the removal of energy rebates received from utilities and incomes derived from the exploitation of energy conservation patents. While simple in concept, this approach is not yet widely applicable or available.

What should companies be building into their financial models and planning?

At the federal level in the US there are currently two tax credits that could apply. The Business Energy Tax Credit delivers 30% on qualified spending on solar, solar hybrid lighting and fuel cell installations, 10% on geothermal and microturbine installations. For those closer to the production end of the spectrum, the Renewable Electricity Production Tax Credit provides various scale tax credits for such sources of electricity as landfill gas, wind, biomass and geothermal. A number of states also provide tax credits ranging from 5% to 75% to encourage the use of renewable energy.

In Canada, there are currently no significant tax credits available for energy and environmental efficiency. Instead, many levels of government have bypassed the tax system and are prepared to provide incentives, including, for example, direct funding for up to 25% of the cost of energy retrofits for small and medium-sized companies.

In terms of accelerated deductions, the US has provided for accelerated tax depreciation (the “MACRS” system) for a number of configurations, including solar, wind, geothermal, fuel cell, microturbine and solar hybrid lighting, typically a 5-year write-off. However, the deduction that is getting the most attention is the “energy efficient commercial building” deduction. This is acceleration from 39 years to 1year for qualifying expenditures related to improvements in interior lighting, heating, cooling, ventilation and hot water systems and the building envelope itself. The tax measures developed this summer by both the House and Senate propose extension of this well-received tax incentive beyond the current 2008 expiration date to 2013.

Canada has put most of its emphasis on the accelerated deduction methodology, offering up 30-50% (i.e. 3 and 2 year) tax depreciation rates for equipment expenditures on wind and tidal energy, active solar, small photovoltaic and fixed-location fuel cell systems, biogas, pulp and paper waste fuel cogeneration systems, and biomass drying systems. Recognizing that not everyone carrying out business initiatives on this front is in a tax-paying mode, the Canadian federal government has gone one step further. It has specifically legislated provisions that allow losses incurred in these activities to be passed out to investor shareholders through what are referred to as “flow-through shares”.

We are increasingly seeing one other set of tax incentives intersecting with these energy and environmental efficiency initiatives: the US federal and state R&D tax credit and the Canadian federal and provincial SR&ED tax credit. Many companies are incurring expenditures to assess and implement energy and environmental efficiency savings that in turn qualify for these other credits.

In this regard, Canada is substantially ahead of the US in terms of the value delivered by the credit (20-35% credit at the federal level, more at the provincial level). Given the relative complexity of the traditional two US R&D credit methodologies, it has effectively been ignored to date. However, with the newly created Alternative Simplified Credit (essentially delivering a 6% federal credit) and an increasing number of states with R&D tax incentives, we anticipate a significant increase in the number of businesses that find this a cost-effective credit to pursue.

And finally, it has to be noted that state, provincial and local governments have a vast and constantly evolving array of sales, excise, franchise, sales & use, real and property tax incentives as well, too numerous to list.

To recap, tax credits affect ROI’s, effective tax rates, cash flows and earnings, as do amounts of income not subject to tax. Accelerated deductions do not affect tax rates or earnings – they are simply a cash flow and net present value item, but are nevertheless still critical to ROI calculations. However, you can only take full advantage of these various tax incentives if you know enough about them.

Tom Routley is a Chartered Accountant with an undergraduate degree in engineering. He has over 25 years of extensive experience in both the Canadian & US income tax rules related to energy tax incentives, tax-efficient financing and R&D tax incentives. He works at Energy Advantage Inc as an independent consultant with a focus on tax incentives.