This article is the first in a series of two articles in which we will address certain tax considerations related to the trading of carbon credits which we have split into two defined categories set out below. In this installment, we will comment on the tax consequences of the initial allocation of emission allowances for free and will address certain tax considerations for the buyer and seller of emission allowances and offset credits. In the second installment, we will discuss the treatment of allowances purchased at auction from the government and the taxation of financial transactions involving carbon credits and related commodities.
In both Canada and the United States, markets for project based greenhouse gas ("GHG") emission reductions or offsets ("Offsets") and emission allowances issued under, or created through compliance in, regulated systems ("Allowances") have already been established and more and broader markets will emerge with the creation of federal and/or multi state markets created through federal, state and provincial legislation. Although relatively unknown to the general public at the present time, these markets will take on an increased level of importance in the months and years to come.
This series of articles will deal specifically with the tax consequences of receiving, buying and selling Allowances and Offsets. Obviously other tax consequences may attach to the emission reduction efforts that a company must undertake in order to generate an Allowance or Offset and this is an issue that needs to be followed closely. Also, we have not addressed other tax considerations related to certain "green" initiatives, such as investment in plants, equipment and research and development.
The Government Just Gave Me an Allowance: Will I Get Taxed?
Tax Treatment of the Initial Allocation of an Allowance
An Allowance is a right analogous to a permit or a quota that is issued by the regulating authority and which bestows on the holder the right to emit a certain quantity of GHGs. In a capped emissions setting, a GHG emitter having emissions which exceed its regulatory threshold will have to either reduce its emissions to the allocated level or buy additional Allowances to cover the emissions in excess of the threshold.
In our view, the value of Allowances granted may 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.
For income tax purposes, to the extent the allocations are not auctioned, the initial allocation of an Allowance would 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.
For goods and services tax ("GST") and Québec sales tax ("QST") purposes, the allocation of Allowances should be characterized as an exempt supply as the Allowances will be granted by a federal or provincial government for no consideration.
Purchase of Allowances and Offset Credits: Capital or Current Expenditure?
Income 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 with Allowances and Offsets generating different tax consequences.
The purchase of additional Allowances in the secondary market will have an identifiable purchase price and acquisition cost which will be set out in a contract for the purchase and sale of the Allowances along with the purchase volume and the timing and method of delivery.
With respect to Offsets, they can be acquired in the secondary market from various dealers or in the primary market, directly from offset project developers. Their characterization is usually readily identifiable in a review of the relevant contracts, which will set out the number of Offsets being purchased, the delivery schedule and the price per credit.
From an income tax perspective, the expenditure to acquire an Allowance or Offset 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.
Conversely, the purchase price of an Offset or Allowance 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 the GHG emissions relating to their operations.
The CRA is of the view that expenditure is on account of capital where the benefit from the expenditure will last longer than one year or an operating cycle (which may be the case if the Allowances or Offsets are banked). In practice, if the Allowance or Offset is retired within the year it is purchased the benefit is received within the year after it is purchased and cannot be used more than once. In such a case, the benefits received from these credits do not last longer than one year or an operating cycle.
Companies have been and will be purchasing Allowances or Offsets either as required by regulation or voluntarily in response to pressures to make corporations 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 compete in the marketplace or operate at its pre-regulation capacity, something which it could not do without acquiring the Offsets or Allowances. In our view, such expenditures can be seen as being in respect of the ongoing operations of a business and not an addition to the basic structure of the business.
This leads to the situation where the same Allowance or Offset, 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, may become an expense on account of capital.
If the facts of a particular situation support the position that a capital asset has been acquired, the classification of the capital asset must be determined. In brief, Allowances or Offsets could be included in Class 14 as a "license for a limited period". A license is a right that enables the holder to carry its business and should include Allowances and Offsets, provided that the Allowance is in respect of a company and qualifies for Class 14 treatment. If the eventual provincial and federal emissions trading systems provide that Allowances and Offsets will be bankable for long periods of time, the price of the license can be deducted proportionally over the life of the property. Alternatively, expenses for Allowances or Offsets that would not meet the Class 14 conditions would be considered "eligible capital expenditures". These particularities are very technical and could be discussed in a subsequent article.
Income Tax Treatment for the Seller
For a seller, the tax treatment will generally depend on two factors: (i) the tax treatment that was given to the initial cost of acquiring the Allowance or Offset; and (ii) whether the seller makes it his business to sell Allowances or Offsets. In addition, the CRA has acknowledged the scenario whereby the tax treatment of the purchase and sale of Allowances or Offsets 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 account of capital, then the disposition may be considered to be in practice taxable at 50% as the disposition of a eligible capital property. If the acquisition cost for an Allowance or Offset is (or would be) considered to be a current expenditure, the income will constitute general business income fully taxable for the seller.
GST and QST Treatment
For GST and QST purposes, the supply of an Allowance or Offset should be characterized as a fully taxable supply of intangible personal property under the Excise Tax Act ("ETA") or incorporeal movable property under An Act respecting the Québec sales tax ("QSTA").
Accordingly, the supplier of the Allowance or Offset should be required to collect GST and, depending on the place of supply, QST on the supply of the Allowance or Offset. A GST and QST registered recipient of an Allowance or Offset should be entitled to claim input tax credits and input tax refunds to recover the cost of the GST and QST incurred on the acquisition to the extent the recipient is acquiring the Allowance or Offset for use or supply in the course of making GST or QST taxable supplies.