Tax treatment of transactions in emissions units

The legislation deals with the income tax treatment of transactions in emissions units outside the forestry sector. The amendments ensure that the tax treatment of emissions units is clear, that income and expenditure are recognised appropriately, and that unintended distortions do not arise.

Sections CB 36, CX 51B, DB 60, DB 61, EB 2, ED 1, ED 1B, EW 5, GC 1 and YA 1 of the Income Tax Act 2007; sections 2 and 11A of the Goods and Services Tax Act 1985

Generally emissions units are treated as excepted financial arrangements which are revenue account property. Emissions units purchased will generally be deductible on acquisition, but added back at cost at year-end to the extent they are still on hand. Income from the receipt of emissions units from government is assessable on an accruals basis.

The amendments to the GST legislation ensure that emissions acquisitions and disposals of emissions units can take place across international electronic markets. The supply of emissions units is almost always zero-rated for GST purposes. Supplies made by businesses to government for the receipt of emissions units under the Permanent Forest Sink Initiative (PFSI) are now also zero rated.

These changes ensure that the tax treatment of transactions in emissions units is clear, and consistent with both the government’s objectives in introducing an emissions trading scheme and coherent tax policy.

Background

The government introduced an emissions trading scheme in the Climate Change Response (Emissions Trading) Amendment Act 2008. That Act inserts provisions into the Climate Change Response Act 2002, under which:

businesses in certain sectors will be required to surrender emission units based on their emissions; and
the government may allocate "free" emission units to businesses in certain sectors.

For more information on the emissions trading scheme see https://www.mfe.govt.nz/node/21785 .

Previously, the taxation treatment of transactions in emissions units was sometimes unclear, and inconsistent with the government’s climate change objectives or coherent tax policy.

Proposals for the tax treatment of transactions in emissions units were set out in the government discussion document Emissions Trading Tax Issues released in September 2007.

Some amendments to the tax legislation were made by the Climate Change Response (Emissions Trading) Amendment Act 2008. The Act amended tax legislation to:

provide for the income tax treatment of forestry businesses which participated in the emissions trading scheme; and
generally GST zero-rate transactions in emissions units.

An explanation of these amendments can be found in Tax Information Bulletin, Volume 20, No. 9 (November 2008).

The new rules follow on from the amendments above, and deal with the income tax treatment of businesses outside the forestry sector. They also make some further GST amendments.

In the interests of simplicity and coherency, the earlier income tax amendments have been rewritten and incorporated into the new rules.

Key features

New provisions in the Income Tax Act 2007 provide for the tax treatment of emissions trading units.

The amendments address transactions which arise under the emissions trading scheme, and other transactions in emissions units - such as the sale of emissions units by one business to another. Certain amendments also apply to "voluntary" emissions units - units which are not used in the emissions trading scheme.

Most costs of emissions trading will be tax deductible, and the government subsidy (the award of "free" emission units by government) of emissions costs will generally be taxable. The specific taxation treatment varies depending on the emissions type, of which there are four:

non-forestry - generally dealt with on an accruals basis;
post-1989 forestry - dealt with on a cash basis;
pre-1990 forestry where the land is held on capital account - outside the tax system; and
pre-1990 forestry where the land is held on revenue account - special rules apply.

There are special rules for the surrender of emission units to government.

The government subsidy is recognised on an accruals basis, by reference to the accruing costs or liability for which the subsidy is intended to compensate.

Generally emissions units are treated as excepted financial arrangements that are revenue account property. Emissions units are generally deductible upon acquisition, but added back at cost at year-end to the extent they are still on hand.

Application date

The amendments to the Income Tax Act apply from 1 January 2009.

Amendments to the GST Act relating to Kyoto-compliant and other "official" emissions units apply from the date of Royal assent, being 6 October 2009. GST amendments for "unofficial" or voluntary units take effect from 1 April 2010.

Detailed analysis

The underlying objective of the income tax amendments for the non-forestry sector is to generally treat transactions in emissions units as revenue account transactions. Emissions units are excepted financial arrangements, so are generally valued at cost with no annual revaluation and consequent gains and losses. Income and expenditure arising under the emissions trading scheme is recognised on an accruals basis, consistent with ordinary tax and accounting practice.

Except where otherwise indicated, the commentary below applies only to New Zealand units, Kyoto and other "official" units - defined in section YA 1 as "emissions units".

At the end of this section there is a comprehensive example of the income tax treatment of a non-forestry business.

Underlying basis of taxation

Emissions units are defined as trading stock in section EB 2, and as excepted financial arrangements in section EW 5. Section ED 1 contains new provisions which require businesses which hold emissions units received from more than one source (for example, units awards for carbon capture in a post-1989 forest, and units purchased on the open market) to be kept in separate "pools" for valuation purposes. This is to ensure that the correct tax treatment can be applied to each different type of unit when selling, surrendering, or valuing at the end of the year.

Certain "unofficial" units are also treated as revenue account property and excepted financial arrangements. These are emissions units which are issued by reference to greenhouse gases and which are verified to an internationally recognised standard. (See the definition in section YA 1 of "non-Kyoto greenhouse gas unit".)

Disposal of emissions units

New section CB 36 deals with the disposal, including by way of surrender, of emissions units. In general, an amount received on the disposal of an emissions unit is treated as income.

If the emissions unit is surrendered to meet an obligation relating to post-1989 forestry land or pre-1990 forestry land held on revenue account, the unit is treated as being sold for zero.

If the emissions unit is a post-1989 forest land emissions unit but is surrendered to meet a liability which does not relate to post-1989 forest land, or it is a unit granted by government outside the forestry context and which has not yet been brought into account for tax purposes, it is treated as being sold for market value.

Generally in other circumstances, surrender is treated as a sale for cost. This is because the business will have already received the deduction for the liability to surrender units on an accruals basis.

Separate provision has been made in section CX 51B for the disposal of emissions units awarded by the government in relation to pre-1990 forestry land which is not held on revenue account. Because the award of these units is to compensate for the fall in value of the land - a capital transaction - the disposal of these units gives rise to excluded income. The classification as excluded rather than exempt income is to ensure that there is no impediment to claiming interest deductions relating to this forestry land.

Deduction for emissions liabilities outside the forestry sector

There are no specific provisions providing deductions for emissions liabilities outside the forestry sector. This is because ordinary principles are sufficient to provide a deduction on an accruals basis. The year-end deduction for each business will be determined by:

calculating the business’s liability to surrender units under the emissions trading scheme which is attributable to the income year, in accordance with the methodology prescribed under the Climate Change Act (almost certainly the same calculation as will be made for financial reporting purposes);
to the extent that the business has purchased and still holds at the end of the income year any emissions units, the cost of those units (limited to the income year liability); and
to the extent the business holds fewer units than the income year liability, that shortfall multiplied by the market value of a New Zealand unit at the end of the income year (or, if a proposed price cap is implemented and applicable, the amount of the price cap).

Emissions units awarded without payment by the government are not netted off in this calculation - they are brought in as income separately under express statutory provisions.

The application of ordinary principles to post-1989 forestry land and pre-1990 forestry land held on revenue account is expressly denied by section DB 61. This is because forestry businesses obtain their deduction by way of the rule which states that emissions units surrendered for liabilities arising from this type of land are treated as being sold for zero.

Recognition of income when subsidy units are allocated by government (non-forestry)

Certain non-forestry businesses will be allocated units without payment under the emissions trading scheme. These are some of the businesses which face increased costs as a result of the introduction of the emissions trading scheme, either in the form of a new liability to surrender emissions units, or increased costs, such as higher electricity prices.

The principle behind these amendments is that income arises from the free allocation of these units, but that income should be recognised on an accruals basis. Income from the award of units is matched to the expenses for which the award compensates. The section is primarily required to deal with the fact that allocations of units will relate to an emissions year, which is a year ending 31 December, whereas many businesses do not have income years ending 31 December. Income recognition is triggered by assigning the units a market value - in the absence of a market value being assigned, the units will have a zero value.

Section ED 1B applies when emissions units have been allocated to the business by government, the emissions units do not relate to forestry, and the section has not previously valued the units at market value.

When first allocated, these units have a value of zero - see section ED 1(7B)(a).

If the emissions year to which the units relate has not started at the end of the income year, the emissions units continue to have a value of zero. If the emissions year finishes during or at the end of the income year, the emissions units have a value of the market value of those emissions units at the end of the income year.

If the emissions year has started at the end of the income year, but has not yet finished, section ED 1B applies to value some of the units received at market value, and the remainder at nil.

A simple pro-rating calculation is applied to determine the number of units which are to be given a market value.

The primary basis for the pro-rating calculation is by reference to the business’s emissions. So, if the business expects to have a total emissions liability of 1,000 units for the emissions year, and at the end of the income year emissions total 200 units, then 200/1000, or 20%, of whatever number of units have been allocated for the year are assigned a market value, with the remainder having a nil value. The remaining units will probably be assigned a market value at the end of the next income year, under the rule that all emissions units which relate to an emissions year which has finished are assigned a market value.

If the business cannot estimate its emissions liability for the emissions year or the accrued liability at the end of the income year, a pro-rating by reference to the number of days of the emission year which have elapsed in the income year can be used.

There are two important variations to the rules described above.

First, some businesses which receive subsidy emissions units will be facing indirect cost increases (such as a higher electricity price) rather than a direct liability to surrender emissions units. These businesses should use the relevant cost (such as expenditure on electricity), if they can determine it, in the pro-rating formula in place of emissions.

Secondly, some businesses might sell emissions units received before the end of the income year. The sale proceeds are brought into account under other provisions. This other income recognition is taken into account in the pro-rating formula - so if, in the scenario discussed above, the business had already sold 20% or more of its free allocation of units, no further units would be assigned a market value. If it had sold less than 20%, the difference between 20% and the number of units already sold would be assigned a market value.

Anti-avoidance rules

Because emissions units are trading stock, the anti-avoidance rule in section GC 1 applies. Transactions at less than market value are deemed to take place at market value. However, the surrender of emissions units is expressly excluded from section GC 1.

Example: Income tax calculations for a non-forestry business

On 1 January 2015, AB Co begins manufacturing product Z for export. Carbon dioxide is emitted as part of manufacturing product Z, and the provisions of the Climate Change Act require AB Co to surrender the commensurate number of emission units following the end of each emissions year.

The government issues an allocation plan under the provisions of the Climate Change Act under which businesses that make product Z for export are entitled to receive "free" emission units.

AB Co is issued 100 free units for the emissions year which runs from 1 January to 31 December 2015. AB Co’s expected emissions liability for the emissions year is 800 units. AB Co has a 30 June balance date. On 30 April 2015, AB Co buys a further 150 emissions units for $8 each. On 30 June 2015, emission units are trading at $10 each.

The following calculations are required for AB Co’s 2014-15 tax return.

Under existing law, AB Co will be entitled to a deduction on an emerging basis for its emissions obligations. AB Co produces the same amount of product Z every month in the same way, so management knows that emissions are exactly the same level every month. At the end of the 2014-15 income year, the proportion of the emissions liability to be recognised is 6/12 x 800 units = 400 units. The fraction 6/12 is simply the number of months in the 2015 emissions year which have elapsed at the end of the 2014-15 income year.

The 2014-15 income year deduction for the accrued liability to surrender 400 units will be calculated as follows:

150 units x $8 = $1,200. This is the portion of the liability matched to the 150 units which have been purchased, valued at the cost price of those units.
250 units x $10 = $2,500, which is the remaining portion of the liability, valued at the market value of those units at balance date. Any variance between the year-end market value and the eventual actual cost of the 250 units required will be brought to account in the following income year.

The 100 free units are not relevant to calculation of the deduction.

The total deduction for the liability accrued in 2014-15 to surrender 400 units is therefore $1,200 + $2,500 = $3,700.

The approach taken to recognition of the income from the 100 free units is similar. Income from the 100 allocated units will be recognised over the period to which the allocation applies, on a basis which matches the allocated units to the costs for which they are intended to compensate.

AB Co will therefore recognise as income the value of 400/800 x 100 units = 50 units at the end of its 2014-15 income year. The fraction 400/800 is the number of units of emissions actually emitted in the 2015 emissions year at the end of the 2014-15 income year, divided by the number of units of emissions expected for the entire 2015 emissions year. This is the same pro-rating formula used to determine the deduction above.

The balance date market value of the units is used to calculate the income, so this is 50 units x $10 = $500.

However, if the 100 units were sold immediately upon receipt for $8 each (and this might occur if the business does not have a direct emissions obligation, but rather is downstream from a business with emission obligations), then the sale proceeds of $800 would be income. The units sold would have no cost base.

The increase in the market value of the 150 emissions units held from $8 to $10 each is not brought into account.

GST amendments - background

As noted earlier, transactions in emissions units were generally zero-rated by amendments introduced in the Climate Change Act.

Technical amendments have been made to reflect the original policy intention of the provisions introduced in the Climate Change Act, particularly in relation to emissions units which are transferred by the government under schemes outside the Climate Change Act.

Amendments have also been made to extend zero-rating to emissions units which are not New Zealand units, Kyoto-compliant emissions units or approved overseas units (sometimes called "voluntary" or "unofficial" units).

A table showing the GST treatments of different emissions units transactions can be viewed here.

GST treatment of Permanent Forest Sink Initiative transactions in units

The Permanent Forest Sink Initiative (PFSI) is a government scheme under which landowners can establish permanent forest sinks on land that was not forested on 31 December 1989, and receive emissions units reflecting the amount of carbon sequestered in their forests. For more information, see www.maf.govt.nz/forestry/pfsi.

The zero-rating of the transfer of emissions units by the government under PFSI has been added to paragraph (s).

This change has the consequential effect of zero-rating the supply of services made by the forester in exchange for the emissions units (whether it is an actual supply or a deemed supply under section 5(6D)).

The change applies from the date of Royal assent, being 6 October 2009.

GST treatment of other transfers of emissions units by government

Section 11A(1)(v) was introduced by the Climate Change Act. It was intended to zero-rate transactions in emissions units in the private sector, and the sale of emissions units by the government. It was not intended to apply when the government transfers emissions units without payment. The section has been amended to make this clear. Accordingly, the transfer of emissions units by government under schemes such as the Project to Reduce Emissions (PRE) and Negotiated Greenhouse Agreements (NGAs) revert to being standard-rated, although any subsequent transfers of these units by recipients will be zero-rated under paragraph (v).

The change applies from the date of Royal assent, being 6 October 2009.

Zero-rating of transfers of other types of emissions units

The provisions referred to above apply to transactions in New Zealand units, Kyoto-compliant units and approved overseas units.

New provisions also zero-rate certain other emissions units which do not fall within this description - sometimes called "grey market" or "voluntary" units.

The new provisions apply to units which are:

issued by reference to the sequestration, or avoidance of emission, of human-induced greenhouse gases; and
verified to an internationally recognised standard.

Examples of the type of units which will qualify for zero-rating under the new rules are Voluntary Carbon Standard units (www.v-c-s.org) and Gold Standard units (www.cdmgoldstandard.org).

The change applies from 1 April 2010.