Before discussing accelerated capital cost allowance (CCA) deductions, I need to discuss operating costs and capital expenditures. This topic was covered in the royalty and tax discussions earlier. To make my explanations easier to understand, I am going to use a corner grocery example, and then move back to an oil sands example later.
Assume that an entrepreneur is the owner and operator of a small corner grocery store. After he pays his staff, heating, lighting, insurance and the cost of his goods—all of which are operating expenses—he has some cash remaining. This cash could be reinvested back into the store. He might purchase additional shelving. Or, perhaps he might purchase a better store sign or cash register. All of these options are capital expenditures. The significant difference between an operating cost and a capital expenditure is that operating costs are consumed within a year typically and capital expenditures last for several years.
When a business is simple, this differentiation is reasonably clear and easy to understand. But as businesses become more complex, it is more difficult. For example, employee training often has benefits that last many years, yet training is typically an operating cost. Same applies to advertising. If a company buys computer software for a personal computer that lasts for several years, that too is an operating cost. So our earlier one year benefit rule is not a hard and fast rule.
Why does it matter whether or not a cost is an operating cost or capital expenditure? The difference is taxation. When an operating cost is incurred, the company is assumed to have spent all the money and earned all the benefits. The heat and air conditioning costs ensure that the store remained at the proper temperature. All heating and air conditioning operating expenses and benefits are complete at year end. Thus, on the tax return, the owner deducts from his income all his operating costs, which serves to reduce his taxes. If his heating and air conditioning were $2,000 and tax rate were 20%, then his taxes were reduced $400 (=$2,000 times 20%).
When a grocery storeowner purchases a new neon store sign, the neon sign lasts for several years. Thus, a grocery storeowner has merely exchanged cash, an asset, for a neon sign, a different asset. Only as the sign depreciates is the storeowner able to deduct the depreciation expense against his income. The depreciation rates are prescribed by the tax code. Ignoring all the complexities of the half year rule and double declining balances and such, let us assume that the depreciation rate is ten percent per year. So, if a storeowner spent $2,000 on a new neon sign, then he could claim only $200 worth of expenses in the first year. Next year, he could claim $180 (=10% times (2000 - 200)). And so on. In this example, the storeowner's taxes are reduced by $40 (=$200 times 20%) in year one and $36 (=$180 times 20%) in year two and so on.
Note that in our operating expense example, tax savings were $400 in year one. There are no more tax savings. In the capital expenditure example, the tax savings is $40 in year one and $36; in year two. If were to continue for several more years, eventually the total savings would equal $400. The storeowner wants his tax savings realized as soon as possible. From a taxation and cash flow perspective, an operating expense is less painful than a capital expenditure of equal value because an operating cost can be completely deducted against income in the current year.
In the oil sands fiscal regime, all capital expenditures associated with new projects, expansions where production is increased equal to or greater than 25%, and capital expenditures of greater than 5% of gross revenue were deemed CCA Class 41A and were eligible for immediate capital write-off. The 5% of gross revenue rule is meant to capture efficiency projects where a developer spends capital to reduce costs. These capital expenditures were, in essence, transformed into operating costs. Note, this is not completely true because of project ringfencing rules, but close enough for our purposes. During a normal environment where an oil sands company is moderately profitable, this immediate capital write-off capability provides a tremendous boost the developer's bottom line.
On pages 85 and 86 of the Panel's Report, they state:
Corporate Income Tax (CIT) and Accelerated Capital Cost Allowance (ACCA) -
It its 2007 Budget, the federal government announced that it was phasing out the ACCA for oil sands in the federal corporate tax system.
As part of its mandate, the Panel was asked to examine the provincial portion of the ACCA.
In the federal budget, the decision to eliminate the federal ACCA was justified on the following grounds:
"This incentive [the ACCA] helped to offset some of the risk associated with the early investment in the oil sands and contributed to the development of this strategic resource. Over time, however, technological developments and changing economic conditions have led to major investments that have moved the sector to a point where the majority of Canada's oil production will soon come from oil sands. As a result, this preferential treatment is no longer required."
The Panel agrees with this assessment. Accordingly, the Panel supports the elimination of the provincial ACCA for oil sands projects.
Both the federal government and the Panel got it wrong.
While it is true that this
Let us engage in another thought experiment. Suppose that a developer could address a project requirement by increasing its operating costs by $200 million dollars by burning more natural gas or by building a new facility for $200 million. In this thought experiment, I arbitrarily have all the money spent in one year to eliminate cash costs timing differences. Under this scenario, this developer would burn valuable non-renewable natural gas because it is more tax efficient. The developer is always biased toward operating expenses. That is the reason why I dislike the elimination of ACCA. Without the ACCA, plant engineers often forego the most technical and cost effective solution to implement a more tax efficient solution. With ACCA, plant engineers and others can ignore the tax code and simply focus on the actual costs and technical efficiency. In other words, they can design and implement solutions that cost the least amount of cash while satisfying the technical criteria.
Moreover, they are more likely to invest in capital equipment that will serve to reduce the project's ongoing operating costs as opposed to spending money on operating costs. A lower operating cost helps to reduce risk and helps to ensure that the project can withstand a prolonged period in an adverse oil price environment. In summary, the ACCA promotes efficient design and decision making.
These oil sands projects are unbelievably large and complex. If you have never set foot near an oil sands project, you should. You will marvel at their size and complexity. Because these projects are so large and complex, it is even more important that public policy encourage these projects to use all resources in the most efficient manner possible. Elimination of the ACCA distorts good design practices, sound decision making, and wastes resources.
Edmonton model Nikki G is featured in the photograph, which is hosted at Flickr. If you click on the picture of Nikki, you will be taken to where you can view a larger version and see even more pictures of her.
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