Are Carbon Credit Exchanges Taxable?

Carbon Credit Exchanges Taxable

Carbon credit exchanges provide an opportunity for businesses to offset their emissions through investments in projects outside their operating facilities. These projects may be in compliance with an existing emissions control or reduction program or part of a voluntary market. These investments have important tax implications, particularly for businesses that operate in multiple geographies where different environmental, social and governance (ESG) initiatives are implemented. The question of whether the purchase of carbon credits is taxable raises important questions about the business context in which these investments are made and how their tax treatment should be determined.

The taxation of carbon credit exchange transactions depends on whether the carbon credits are purchased in a compliance or voluntary marketplace. Carbon credits in compliance markets are used to meet a legal obligation to reduce net emissions. Purchases of these credits are deductible under Section 162(a) as trade or business expenses. However, purchases of carbon credits in the voluntary market may be treated as charitable contributions. The purchase of VCOs is not a trade or business expense, but the purchase may be eligible to be claimed under Section 162(c) if the business can demonstrate that the expense was “ordinary and necessary.”

In 2008, Congress introduced Section 45Q to the Internal Revenue Code, which provides a credit against income tax for each metric ton of carbon dioxide captured, sequestered or disposed of in secure geological storage or used as a tertiary injectant for oil and natural gas recovery processes. The credits are only available for projects that capture and sequester at least 75 million metric tons of carbon dioxide.

Are Carbon Credit Exchanges Taxable?

Because of the unique nature of the carbon capture and storage credit, many investors are hesitant to enter into contracts that have the potential to be adversely impacted by changes in federal or state law. Contracts should be drafted to ensure that the rights and obligations of all parties are clearly defined and to make clear that a change in legislation could result in the termination or amendment of the contracts.

A number of tax professionals have suggested that, even though the IRS has not yet ruled on this matter, carbon credits should be considered to be real property for tax purposes and should thus be eligible for like-kind exchange treatment under Section 1031. This option should be explored in the context of individual circumstances, since it will depend on how the carbon credits are classified for legal purposes and the nature of any investment in the project that has resulted in the generation of these credits.

The issuance, transfer or sale of carbon credits (including a digital representation of the carbon credit) in exchange for a consideration is a supply of services and is therefore GST-taxable unless it qualifies for zero-rating under section 21(3)(j) of the GST Act (no longer applicable after 23 Nov 2022). Service fees such as carbon exchange service charges, brokering charges and legal fees incurred in connection with the acquisition or disposition of carbon credits to offset your business’s emissions are also GST-taxable. This input tax is then apportioned according to the residual input tax recovery formula applicable to your business.