March 30, 2022
This is part 2 in a series of blogs on Investment Tax Credits being released in the lead up to Budget 2022. Click here for post 1.
Investment Tax Credits (ImTCs) are one of the tax incentives that Canada plans to use to support clean technologies (cleantech) and reduce greenhouse gas emissions. As a result, it is important to understand what ImTCs can do and how they should be designed.
As SPI’s policy brief Taking the Tax System to Task explains, the ImTC allows firms to reduce their tax liability by an amount related to their expenditures on qualified equipment, in this case, cleantech equipment. Generally, the credit is a set percentage on the initial capital expenditure and is usually received by the taxpayer in the same year the expenditure is made. The following is an example of how it may work in practice.
Take for example, a firm based out of Ontario. The firm has taxable income of $500,000 and pays a 15% federal corporate tax rate and an 11.5% provincial corporate tax rate. The firm wants to invest $100,000 on cleantech equipment. This cleantech equipment is eligible for a refundable 30% Investment Tax Credit. If the firm makes a capital investment and purchases this equipment, it will reduce the firm’s tax liability by $30,000 ($100,000 x 30%). Therefore, without the tax credit, the firm’s tax liability for the year is $132,500 ($500,000 x 26.5%). However, with the credit, the firm’s tax liability reduces to $102,500 ($132,500 - $30,000).
ImTCs can be used to support firms that adopt cleantech. By providing tax credits, businesses will be incentivized to make investments in cleantech as part of their operations. For example, a cement manufacturer can invest in carbon capture equipment, which is a large capital investment. This will, first and foremost, help reduce greenhouse gas emissions, in this case the hard-to-abate industrial process emissions. By incentivizing greater adoption, it will also help overcome the real or perceived risks of firms in utilizing these technologies thus helping to expand markets. By signalling increased market demand, ImTCs can also potentially attract investors for cleantech companies.
While the case for adoption is clear, tax credits can also be designed to support manufacturing of cleantech. For example, in Canada, Manitoba’s Green Energy Equipment Tax Credit allows manufacturers of geothermal heat pumps to claim a 7.5% refundable tax credit on the cost of geothermal heat pump systems. The U.S. goes further and provides credits on a range of cleantech manufacturing. The Advanced Energy Manufacturing Tax Credit (Section 48C) provides a credit of up to 30% for investments in building new manufacturing facilities or expanding existing facilities to produce a wide range of cleantech, including clean energy, energy storage, smart grids, carbon capture and others. Tax credits for manufacturing can potentially help close the financing gap for Canadian firms which have found the product-market fit and are trying to scale up and achieve commercialization.
Whether for adoption or manufacturing, it is important to properly design these credits so that they are both effective and efficient in achieving the desired objectives. Failure to do so may create a situation where money is given away without necessarily affecting investment decisions. To do that, the federal government needs to consider the following design principles.
1) Determining credit rates and investment thresholds: The government needs to determine the credit rates for different eligible cleantech investments. They also need to properly set maximum investment sizes to put a cap on the government revenue forgone on tax incentives. Other jurisdictions such as the Netherlands use different criteria to set rates and thresholds, such as the level of additional cost that it represents against a conventional alternative; the environmental performance; and the level of technological innovation that it represents. Similar criteria needs to be developed for the Canadian ImTC.
2) Reaching smaller firms without tax liabilities: In most cases, an ImTC is valuable to a firm only if it has taxable income i.e. profits. Small and medium-sized companies which need support – a key target of the ImTC – may not be earning profits (or earn very little) and cannot use the tax credit. While tax credits can have carry-forward provisions, so that the credit can be used in the future when the firm has taxable profits, these firms typically need the financing now. A better option would be to make the ImTC refundable.
3) Considering interaction with other tax instruments and policy measures: The effect of, and subsequently the need for, an ImTC will depend on whether the equipment is eligible for other tax benefits and policies. Therefore, it is important to understand the interaction of ImTCs with other tax instruments and existing policy tools.
4) Determining implementation period and phase-out criteria: The ImTCs should have a clear implementation period, ideally one that provides extended periods of eligibility. This will provide certainty to firms making the investments and also induce more investment as stakeholders will know that credits will be provided for a limited period. Tax credits will also need a phase-out criteria for technologies that move ahead toward commercialization. Failure to do so can contribute to technology lock-in, unnecessary allocation of public funds and stifle innovation and deployment of other emerging cleantech.
5) Setting a proper monitoring & evaluation process: As with any policy measure, it is important to evaluate whether the instrument is effective and efficient. As a result, the ImTC should include a provision for monitoring & evaluation process. Notably, the Netherlands engages in a 5-year review of their tax instruments via external expert reviewers. Similar practice needs to be adopted in Canada, starting with the ImTC and for other tax instruments.
In short, ImTCs can help businesses adopt cleantech as part of their operation, reduce emissions and create markets for these technologies. They can also be designed to incentivize manufacturing of Canadian cleantech and close the financing gap for firms trying to scale up their operations. Moreover, by considering the credit rates & investment thresholds, refundability, interaction effects, implementation period, phaseout criteria and incorporation of monitoring & evaluation processes, ImTCs can be made both effective and efficient in attaining Canada’s clean growth objectives.
Want to learn more? Check back tomorrow, March 31, for the third post in our series of blogs on Investment Tax Credits!