Nine people were arrested in London recently under suspicion they tried to defraud European authorities of US $62 million in tax revenues owed on carbon trades. The traders are charged with buying carbon credits outside Britain without paying the value added tax ("VAT"), and then reselling the credits in Britain with the VAT tacked on. The traders then disappeared without paying the tax owed to the British government.

This type of fraud could happen in Canada based on the actual rules related to the goods and services tax ("GST") applicable to carbon credits. Effectively, for GST purposes, the purchase and disposition of a carbon credit should be considered the "taxable supply" of an "incorporeal movable property" under the Excise Tax Act ("ETA"). (This result may be different for the trading of carbon credits that are cash settled on a recognized commodities exchange).

Normally, a GST registered purchaser of such a taxable supply should be entitled to claim input tax credits to recover any cost of GST incurred on its acquisition, thus avoiding this indirect cost. In order to claim such input tax credit, the seller must provide the purchaser with a detailed invoice or document containing the information prescribed by the ETA, such as the GST registration number of the seller. With this number, it is possible to verify, on the website of the Canada Revenue Agency, if the GST registration number is valid. The seller must normally remit the GST collected on the sales of the carbon credits to the Receiver General of Canada within a prescribed time.

In practice, the purchaser of carbon credits can mitigate this risk by asking for and validating the seller's GST registration number prior to the transaction. Also, the purchase may ask for documentary evidence that the GST was in fact reported and duly remitted by the seller. Special provisions concerning the seller's obligations concerning GST should be inserted in the purchase and sale agreements.

An alternative solution to avoid such fraud would be for the government of Canada to amend the definition of "financial effect" in the ETA in order to include the emission allowances and carbon credits. A financial effect is a GST "exempted supply" under the ETA. Accordingly, any transaction involving carbon allowances and credits would be exempted from GST. Thus, if a trader purchased carbon credits outside Canada free of GST, he would not be able to charge any GST in addition to the purchase price on such an exempted supply. However, with the actual rules, this type of fraud is, in theory, possible in Canada.