In this series of three articles, we will address certain tax considerations related to the trading of carbon credits. First we will address general comments on the Carbon Credit Market and the tax consequences of the initial allocation of emission allowances.
Introduction: What is the Carbon Credit Market?
In both Canada and the United States, markets for green house gas emission reductions or offset credits ("Carbon Credits") and emission allowances are emerging. Although relatively unknown to the general public at the present time, these markets may take on an increased level of importance in the months to come.
In April 2007, the Canadian federal government announced a regulatory framework that will require certain companies to reduce their green house gas ("GHG") emissions over a ten year period beginning on January 1st, 2010. The framework also introduces an intensity based "Cap and Trade system". Thus, companies that are able to reduce their GHG emissions below the required standards, or which voluntarily reduce when they have no obligation to do so, will be able to sell the additional GHG emissions avoided or offset to companies who are unable to meet their required GHG targets in the given period. In this way, there would be a system-wide intensity cap on GHG emissions with different market players trading Carbon Credits to offset others’ reduction shortfalls.
Unlike other "Cap and Trade" systems developed and in application around the world, Canada has, for the time being, decided to use an intensity based cap on emissions as opposed to an absolute cap or "hard cap". Under Canada’s proposed intensity based cap, regulated entities are required to reduce their emissions per unit of production. For example, if, in its baseline year (2006) the Acme Pen Co. produces 1 ton of GHG per pen, then by January 1, 2010, that company will have to have demonstrated an 18% reduction in the amount of GHG emissions per pen. In other words, it must, by January 1, 2010, emit only .82 tons of GHG per pen. Many have been critical of this system since it permits total GHG emissions to rise in absolute terms if industrial production increases, so long as emissions are produced more efficiently. Proponents of this system argue that in times of economic slowdown, an intensity system works better since it continues to require reductions from regulated entities, whereas a "hard cap" can be met through reduced commercial output.
As a signatory to the multilateral Western Climate Initiative, Quebec is likewise expected to put in place limits on GHG emissions by the year 2012. These limits will eventually affect an even broader spectrum of companies than those currently being targeted by the federal framework.
One does not however have to wait for these measures to come into force to see Carbon Credits being traded; already a market has been developing for such products. More specifically, standards are in place to validate the emission reduction results of voluntary efforts by companies, following which the company can sell the Carbon Credit in the primary market. Although, different certification standards and prices exist Carbon Credits certified at the same standard as will be required by the proposed federal framework have sold recently for $6 to $10 a tonne in over the counter forward contracts transacted in Canada.
If it is not already the case, most companies will soon seriously consider their own emissions and upcoming emissions reduction requirements and look to the Carbon Credit markets for both opportunities to capitalize on their emission reductions and to make up for any possible shortfalls. At that time, it is important that they also keep in mind the possible tax consequences of trading in Carbon Credits as they may have an important impact on the profitability or cost, as the case may be, of GHG emission reduction efforts.
This text will deal specifically with the tax consequences of buying or selling emission allowances and Carbon Credits. Obviously other tax consequences may attach to the emission-reduction efforts that a company must undertake in order to generate that credit and this is also an issue that needs to be followed closely. Also, we did not address the other tax considerations related to certain "green" initiatives, such as investment in plants, equipment and research and development.
Tax Treatment of the Initial Allocation of an Emission Allowance
An emission allowance is a permit or a quota issued by the regulating authority that conveys to the holder the right to pollute. It is anticipated that Canada will allocate a portion of the allowances to existing emitters and keep a portion to offer for sale at an auction. In result, a GHG emitter having emissions which exceed its allowances will have to either reduce its emissions to the allocated level or buy additional allowances on the Carbon Credit markets to cover the emissions in excess of the allocated level.
For income tax purposes, the initial allocation of an emission allowance would likely not have any direct acquisition cost, but may have indirect costs that would be considered to form part of the cost of the allowance. Certain of these indirect costs may be fully deductible under subsection 20(1)(cc) of the ITA as representing the costs of obtaining a permit, license, and so forth.
However, the value of the allowances granted (if any) might be required to be included in income for tax purposes under paragraph 12(1)(x) of the Income Tax Act ("ITA") as an amount received from a government, municipality, or other public authority.
The allocation of emission allowances should be an exempted supply for sales tax purposes since it should be made by a public sector body for a nil consideration.