In this second article of a series of three we will address certain tax considerations for a buyer and seller of emission allowances and Carbon Credits.
Purchase of Emission Allowances and Carbon Credits: Capital or Current Expenditure?
Tax Treatment for the Buyer
In order to determine the tax treatment afforded to the buyer, one must determine the nature of the assets being purchased. Generally, the type of assets being traded would be emission allowances and Carbon Credits, with each type generating different tax consequences.
From an income tax perspective, an expenditure to acquire an emission allowance or Carbon Credit is on account of capital where such expenditure is made once and for all and with a view to bringing into existence an asset of enduring benefit to the business.
The purchase of additional allowances in the market will have an identifiable purchase price and acquisition cost which will be set out in a standard contract for the purchase and sale of yearly emission allowances, along with the purchase volume and the timing, and delivery method.
With respect to Carbon Credits, they can be acquired in the secondary market from various dealers, or in the primary market, directly from emission-offset developers. Their characterization is usually readily identifiable in a review of the relevant contracts, which will clearly set out the tonnes of Carbon Credits being purchased, the delivery schedule, and the price per tonne of credit.
Conversely, the purchase price of a Carbon Credit and emission allowances is considered to be a current expense if it is incurred for the purpose of gaining or producing income from the business. The CRA considers that this would usually be the case for companies that are required to reduce their GHG emissions relating to their operations.
The CRA is of the view that an expenditure is on account of capital where the benefit from the expenditure will last longer than one year or an operating cycle. In practice, the benefit from an emission allowance or Carbon Credit is usually received only in the year it is applied and cannot be used more than once, and thus the benefits received from these credits cannot last longer than one year or operating cycle.
However, one could argue that they are on account of capital in certain circumstances. For instance, certain credits can be banked for use in future compliance periods. Although other systems work differently, the Canadian system will require a percentage reduction in intensity. If at the time the evaluation of the compliance report takes place, a company is determined to have exceeded its reduction obligations, it will be issued credits into a registry account that it can then hold for future compliance or sell.
For the most part, companies have been and will be making emission expenditures either as required by regulation or voluntarily in response to pressures to make corporations be more responsible towards the environment. In either case, the expense is necessary to continue the day-to-day business operations of the company; namely, to allow the company to operate at its pre-regulation capacity, something which it could not do without acquiring the credits and allowances. Clearly, such credit and allowance expenditures are in respect of the ongoing operations of a business and not an addition to the basic structure of the business.
In other systems, the emission allowances purchased or allotted in advance of the compliance year, must be surrendered for that year, and thus would likely be consumed in large part in the compliance year for which they were intended and be on account of income. Alternatively, they can usually also be banked for future compliance and may thus be on account of capital.
This leads to the situation where the same allowance, if retired within a year is an expense on account of income, and if banked or carried forward to a subsequent year to cover emissions for that year, the cost may become an expense on account of capital.
If the fact of a particular situation supports the position that a capital asset has been acquired, the classification of the capital asset must be determined. Summarily, emission allowances that have a limited life are an intangible expenditure and could be considered to be a "license for a limited period". In the proposed US and Canadian systems it is provided that allowances will be bankable for long periods of time. The price of the license can, therefore, be deducted proportionally over the life of the property. A license is a right that enables the holder to carry on his or her business, which should include emission allowances, provided that the allowance is in respect of a company and qualifies for class 14 treatment. In turn, Carbons Credits would be considered eligible capital expenditures.
Sales Tax Treatment of Purchasing Credits
For sales tax purposes, the purchase and disposition of an allowance should be considered the “taxable supply” of an “incorporeal movable property” under the Excise Tax Act (“ETA”) and An Act respecting the Quebec sales tax (“QSTA”). Thus, a registered purchaser of such taxable supply should be entitled to claim input tax credits and refunds to recover any cost of goods and services tax (“GST”) and Quebec sales tax (“QST”) incurred on its acquisition, thus avoiding this indirect cost.
Tax Treatment for the Seller
For a seller, the tax treatment would generally depend on two factors: (i) the tax treatment that was given to the initial cost of acquiring the emission allowances or Carbons Credits; and (ii) whether the seller makes it his business to sell Carbon Credits. In addition, the CRA acknowledged the scenario whereby the tax treatment of the purchase and sale of emission allowances or Carbons Credits may not be mirrored i.e. a current deductible business expense for the purchaser and a gain on capital account for the seller. The factual based analysis will thus be important in every transaction to properly determine the tax consequences for each party.
If the seller’s cost of acquisition is considered to be on capital account, then the disposition may be considered to be in practice taxable at 50% as the disposition of a capital eligible property. If the acquisition cost for a Carbon Credit or allowance was (or would be) considered to be a current expenditure, the income would constitute general business income fully taxable for the seller.
For sales tax purposes, the seller should be required to collect the GST and the QST on the disposition of incorporeal movable property, which should constitute a taxable supply under the ETA and the QSTA.
In the next article, we will address the taxation of financial transactions involving Carbon Credits and related commodities.