With the development of cap-and-trade regimes and the recent attention given to them in North America and abroad, the issues arising in this context have come under careful consideration by environmental and commercial lawyers for some time. However, the national and international tax consequences of trading in emission allowances (or tradable permits) have been largely ignored in the analysis and the political developments that have preceded the United Nations Conference on Climate Change in Copenhagen from December 7 - 18, 2009. The importance of these consequences should not be underestimated, since any tax regime that results in "tax friction" costs may impede the efficacy of a domestic cap-and-trade system and negate the natural flow of such instruments across international borders. These issues and others were recently identified and addressed in submissions made by the Business and Industry Advisory Council (BIAC) of the Organisation for Economic Co-operation and Development (OECD).
Trading in emission allowances creates numerous tax issues encompassing a variety of matters, including: (i) the national and international tax consequences of trading, surrendering and disposing of tradable permits; (ii) the application of value-added taxes to transactions involving tradable permits; (iii) the treatment of offset arrangements; and (iv) the consequences of tradable permits being treated as financial instruments. For example, when a tradable permit is acquired, does it matter whether the permit was freely allocated or purchased? Is the acquisition of a permit on income or capital account? If the acquisition of the permit is on capital account, is the permit depreciable property or intangible property? Even if the nature of the permit can be determined, what is the timing in respect of income realized and expenses incurred by a permit-holder? In the event that these issues differ between jurisdictions, the possibility of double taxation or tax arbitrage may exist.
Characterization of tradable permits
In order to provide a coherent and comprehensive explanation of the many tax issues arising from the acquisition and disposition of tradable permits, it is necessary to determine the characterization of a tradable permit. However, characterizing a permit will depend, in large part, on the principles used in the analysis. The choices articulated to date include using: (i) international accounting standards; (ii) existing domestic law; or (iii) existing domestic law combined with selected statutory amendments and clarifications where appropriate.
In those jurisdictions where accounting standards have been used to deal with the taxation of tradable permits, the results are mixed, and issues have arisen in areas not limited to the characterization of the tradable permits. Indeed, since accounting standards are used to measure income for financial reporting purposes, it has long been the case in Canada that such standards have been considered incapable of conclusively determining the taxable income of a taxpayer. Similar concerns arise in the context of tradable permits, and therefore it is unlikely that accounting standards will be widely adopted, either to determine the nature of a tradable permit or the treatment of expenses incurred or gains realized in respect of a tradable permit.
Most jurisdictions would prefer to use existing tax principles to determine the nature of a tradable permit and that could well be the widely adopted approach. However, even under existing law the characterization of a permit is far from certain. In some instances, the cost of acquiring a permit will be considered a deductible business expense if the permit is held for surrender and no property is acquired (e.g., Australia and New Zealand). In other circumstances, the permit is treated as intangible property, the cost of which is on account of capital, on the basis that it has a benefit beyond the current year. In many jurisdictions (such as Canada and the United States) the cost of intangible capital property that is not depreciable property is amortized over a period of years.
The U.S. has characterized tradable permits as intangible property in the context of their regime for taxing the passive income of controlled foreign corporations. In a recently issued advance tax ruling, the Internal Revenue Service considered a situation where an affiliate of a U.S. taxpayer was granted allowances under the European Union Emissions Trading Scheme and sold its surplus allowances. The Internal Revenue Service ruled that the taxpayer did not have to treat the income from those sales as subject to current taxation under the rules applicable to U.S. shareholders of controlled foreign corporations, on the basis that the allowances were intangible property held for use in a trade or business. The Internal Revenue Service was careful to limit the characterization of the permit to the facts of the ruling and therefore, it is unclear whether a similar characterization would be applied to taxpayers whose participation in the carbon markets arises for different business reasons.
Recognition of income and expenditures
One of the more controversial issues in a cap-and-trade system is how to deal with freely allocated permits. Although many jurisdictions want to move to an auction system for allocating permits, at the moment many permits either have been, or will be, freely allocated. For instance, the European Union, New Zealand, Australia and certain industry groups in the U.S. have provided permits at no cost to participants. Although the U.S. has excluded the value of these permits from gross income, preferring to realize income on the surrender or disposition of the permit, other jurisdictions treat the allocation as being akin to a government subsidy. In Canada, a freely allocated permit would appear to create an immediate income inclusion, which raises the possibility of "phantom income" - that is, taxable income without a corresponding amount of cash to pay the tax liability in respect of the income. This issue is alleviated in part by permitting a taxpayer to elect to reduce the amount of an outlay or the cost of property acquired. Although late-filed elections are permitted in some circumstances, failure to file an election in a timely manner will result in an immediate income inclusion. This is especially problematic if the freely allocated permit is treated as intangible capital property. In these circumstances the value of the permit may be included in income immediately, even though the cost of the permit would be amortized over a period of years at an effective rate of 5.25% per annum on a declining-balance basis.
The issuance of freely allocated permits also raises questions with respect to the measurement of income. For example, let's assume that a taxpayer receives 100 freely allocated permits on January 1 of a particular year, the cost of which is not included in income because the taxpayer has elected to reduce the cost of the permits. On March 1, the taxpayer purchases an additional 100 permits for $5 per permit in circumstances where the purchase price is included in the cost of property. If the taxpayer disposes of 100 permits on July 1 for $10, what is the taxpayer's income inclusion? Although the Canada Revenue Agency has not issued any definitive statement in this context, some jurisdictions allocate the cost of freely allocated permits over the course of the year on the basis that the cost relates to emissions throughout the year. This approach results in fifty freely allocated permits and fifty permits acquired at a cost of $5 being treated as the cost of the permits sold (i.e., an income inclusion of $1000 $250 = $750). The outstanding issue is the treatment of the remaining 100 permits held at year end. For instance, if the permits are considered financial instruments, there may be an issue as to whether they should be subject to mark-to-market reporting for either accounting or tax purposes.
Climate change funds and penalties
The treatment of contributions to climate-change funds will also need to be considered. In the case of a climate-change fund in Alberta or otherwise, the issue will be whether these payments are merely remedial payments or whether they constitute non-deductible punitive payments. Generally, remedial payments will restore property to the condition it was in, prior to any work being undertaken on the property. Payments over and above a remedial payment could be considered a non-deductible punitive payment. Although contributions to climate-change funds are generally based on excess omissions, computed by reference to emissions in excess of permissible levels, and stated in $/ton, the difficulty is determining whether those costs are remedial or punitive. For instance, what is the remedial cost of an excess emission where the cost is not referable with respect to remediation of any specific property? It is our understanding that the Department of Finance has been prepared to allow a deduction for contributions to the Alberta Climate Change Fund, in part on the basis that the Alberta legislation contains other specific provisions that are intended to be punitive in nature.
International issues and intragroup transfers
While the preceding discussion has focused principally on the domestic tax issues that taxpayers will need to confront, a similar number of issues arise where trading and other activities occur across international borders. Questions that arise in the international context include the following:
- Will a tradable permit constitute an interest in real property in the relevant jurisdiction?
- How will income and gain from the disposition of a tradable permit be characterized for tax-treaty purposes?
- What are the withholding-tax implications in the case of payments that cross national borders?
- Is there a risk of double taxation where transactions involve two or more jurisdictions?
- Will work undertaken in a foreign jurisdiction by one entity for a related party create either permanent establishment or transfer pricing issues?
- Will profits that arise in a foreign subsidiary be attributed to a Canadian parent company?
- What treatment will be accorded to permit trading under the value-added tax regimes in various countries?
This bulletin discussed some of the key tax issues that arise with respect to tradable permits under a cap-and-trade system. As cap-and-trade regimes are developed both domestically and internationally, all taxpayers will need to deal with the multitude of tax issues in this area, particularly publicly traded corporations that must address these and other issues for financial reporting and disclosure purposes.