EU Emissions Trading Scheme

Introduction

The purpose of this note is to clarify the position in relation to certain tax issues arising from the EU Emissions Trading Scheme in the light of provisions included in the Finance Act 2012 and discussions with representatives from ITI, CCAB-I, Law Society and the Green IFSC Committee.

Emissions Trading Scheme (ETS)

The EU Emissions Trading Scheme operates by allocating greenhouse gas emission allowances to enterprises in the energy, industrial and aviation sectors and requiring these enterprises (ETS participants) to surrender sufficient allowances each year to cover their emission levels. Within an overall EU limit, enterprises can buy and sell emissions allowances depending on their current and projected needs. An emissions allowance gives the holder the right to emit one tonne of CO2 or the equivalent amount of another greenhouse gas. The Environmental Protection Agency (EPA) is the competent authority for administering the EU Scheme in Ireland and detailed information on the scope and parameters of the Scheme is available on the EPA website at www.epa.ie

Background - Establishment of Technical Group

As there is no uniform or standard accounting practice in relation to emissions trading, Revenue has taken the approach of providing an opinion, where requested, on how particular transactions would fall to be treated under general tax principles and legislation having regard to the specific facts and circumstances of the case. In May 2011 Revenue invited representatives from ITI, CCAB-I, Law Society and the Green IFSC Committee to participate in a technical group to consider the direct tax implications of emissions trading. The group set out to consider the following issues as part of the process:

• Accounting practice;
• Free allocation of allowances to ETS participants and surrender of allowances to cover emission levels in a particular year;
• Purchases of allowances and sale of surplus allowances by ETS participants;
• Treatment of brokers/traders;
• Other issues, including expenditure incurred by companies in overseas projects which generate carbon credits, derivative instruments, intra-group transfers of allowances, and the treatment of penalties under ETS.

Several meetings of the group took place between June and December 2011. Over the course of the group’s meetings presentations were made and submissions received from representative bodies.

Summary of provisions of section 44 FA 2012

In February 2012 the Finance Bill was published and it addressed the direct tax implications of transactions in emissions allowances under the EU Emissions Trading Scheme. The Bill became law on 31st March 2012.

Section 44 of the Finance Act 2012 has introduced two new sections into the Taxes Consolidation Act 1997 (TCA) to clarify the tax treatment of purchases and sales of emissions allowances issued under the Emissions Trading Scheme. Firstly, a new section 81C was inserted into the Act to confirm that a tax deduction is available for expenditure incurred on the purchase of emissions allowances for use in a company’s trade and that, where purchased allowances are subsequently sold, the sale proceeds are deemed to be a trading receipt of the trade.

Section 44 also inserted a new section 540A into the TCA which provides that where a company sells, transfers or otherwise disposes of allowances acquired free of charge from the Environmental Protection Agency under the EU Emissions Trading Scheme, or where it disposes of any interest in, or rights over, such allowances, the transaction will be treated as the disposal of an asset for capital gains tax purposes and will trigger a charge to corporation tax on the gain arising to the company on the disposal. This tax charge will also apply to the disposal of such allowances acquired by a company on transfer from another company within the same group or from another company under a business re-organisation, where the transfer was subject to the corporation tax deferral provisions of section 617, 615 or 631 of the TCA. The new section will apply to disposals made on or after 8th February 2012.

DIRECT TAX IMPLICATIONS OF TRANSACTIONS IN EMISSIONS ALLOWANCES

In the light of the Finance Act provisions, Revenue would like to clarify the position in relation to:

• transactions in emissions allowances undertaken by ETS participants,
• tax treatment of brokers, intermediaries and other persons dealing in emissions allowances, and
• other tax issues in relation to emissions trading activities.

A. ETS PARTICIPANTS

1. Allocation and surrender of Emissions Allowances

Whilst it is acknowledged that accounting practice varies in relation to the treatment of the allocation and surrender of emissions allowances under the EU Scheme, Revenue considers that these transactions, and corresponding entries in the profit and loss account or income statement, should be treated as events not subject to taxation: - the receipt of allowances from the EPA will not constitute taxable income in the hands of the ETS participant and the surrender of allowances under the Scheme will not be a deductible expense of the trade.

2. Costs arising under ETS

It is acknowledged that the management of carbon emissions is an integral part of the production process for companies participating in the ETS and, accordingly, costs incurred in the purchase of emissions allowances arising from obligations under the ETS are considered to be incurred wholly and exclusively for the purposes of the trade. Again, there can be differences in accounting treatment whereby expenditure incurred in the purchase of emission allowances may be treated as a revenue expense or it may be capitalised in the accounts as an intangible asset and amortised as allowances are used up. Notwithstanding this, there are good reasons for treating expenses incurred in the acquisition of allowances as revenue expenditure rather than capital expenditure. Expenditure will generally be of a recurring nature on an asset that can only be used once and that does not provide enduring benefit to the trade.

In the light of the above and to provide clarity on the matter, Finance Act 2012 inserted a new section 81C into the TCA to provide that expenditure incurred on the purchase of emissions allowances for use in a company’s trade will be a deductible expense of the trade. For the purposes of the section, emission allowances includes emission reduction credits issued under the Kyoto Protocol. These credits, known as certified emission reductions (CERs) and emission reduction units (ERUs), are generated by emission-saving projects undertaken in third countries subject to a verification process under the Kyoto Protocol. These credits are traded in the carbon market and can be exchanged for EU emissions allowances for the purposes of meeting a company’s compliance obligations under the EU Scheme.

3. Disposals of allowances

In considering the treatment of sales of allowances, it is appropriate to distinguish between allowances received free of charge by an ETS participant from the EPA in accordance with the allocation rules of the ETS, and those that are purchased and subsequently sold. A disposal of allowances, which were bought for the purposes of the trade and become surplus to requirements, is considered as being on trading account. Accordingly, the new section 81C of the TCA inserted by Finance Act 2012 provides that, where purchased allowances are subsequently sold, the sale proceeds are deemed to be a trading receipt of the trade.

On the other hand, where a company sells, transfers or otherwise disposes of allowances acquired free of charge from the Environmental Protection Agency under the EU Emissions Trading Scheme, or where it disposes of any interest in or rights over such allowances, the new section 540A of the TCA inserted by Finance Act 2012 provides that the transaction will be treated as the disposal of an asset for capital gains tax purposes and will trigger a charge to corporation tax on the gain arising to the company on the disposal. This tax charge will also apply to the disposal of such allowances acquired by a company on transfer from another company within the same group or from another company under a business re-organisation, where the transfer was subject to the corporation tax deferral provisions of section 617, 615 or 631 of the TCA. This will ensure that a tax charge cannot be avoided by transferring the allowances intra-group or under a scheme of reconstruction or amalgamation and subsequently disposing of the allowances on the open market.

As the allowances are acquired free of charge, no sum, apart from incidental costs to the company making the disposal, will be allowed as a deduction from the consideration for the disposal in computing the chargeable gain arising on such disposal. Also, in computing the chargeable gain, any purchased allowances will be deemed to have been disposed of before free allowances are disposed of by a company. The new section will apply to disposals made on or after 8th February 2012.

4. Intra-group transfers of allowances

Where purchased allowances are transferred within the group such transfer will be treated as a normal trading transaction subject to the transfer pricing rules provided for in Part 35A of the TCA. In the case of allowances acquired free of charge from the EPA, the corporation tax deferral provisions of section 617 will apply to any intra-group transfer of such allowances but, by virtue of the new section 540A of the TCA, a subsequent disposal of such allowances outside the group will trigger a charge to corporation tax on the gain arising on the disposal.

5. Transfer of a business

Similarly, where allowances acquired free of charge are transferred from one company to another under a company reconstruction or as part of the transfer of a trade, or the transfer of part of a trade, the corporation tax deferral provisions of section 615 or 631 of the TCA, as appropriate, will apply to such transfer. However, by virtue of section 540A, a subsequent disposal of such allowances by the acquiring company to a third party will trigger a charge to corporation tax on the gain arising on the disposal.

6. Transactions pre Finance Act 2012

Section 44 Finance Act 2012 applies to disposals of emissions allowances made on or after 8th February 2012. The tax treatment of disposals made prior to this date will depend on the facts and circumstances of the transaction and these would include, inter alia, the accounting treatment of the emissions allowances, the reason for the disposal, the nature of the business of the company disposing of the allowances and the circumstances in which the disposal was made.

It is, of course, open to a company to use the expression of doubt facility under section 955(4) of the TCA in filing its corporation tax return where it has a genuine doubt about the tax treatment of a particular transaction.

B. TRADERS/BROKERS

The position of non-ETS participants such as brokers, intermediaries and other persons dealing in emission allowances needs to be distinguished from ETS participants subject to compliance obligations under the scheme. Trading in emission allowances is carried on through various international exchanges and non-ETS participants engaged in such trading often provide other services such as providing expertise on energy efficiency, measurement of carbon footprint, investment in carbon offset projects and managing the carbon credit requirements of a group.

It is acknowledged that companies wishing to establish a business in carbon offsets or related services will need to know whether the business activity constitutes a trade, with trading income subject to the 12.5% corporation tax rate. Of course, the question whether a business activity constitutes a trade or not will depend, ultimately, on the facts and circumstances of the case. In line with current practice, Revenue is prepared to give an advance opinion, if required, on whether a particular business activity in the emissions trading area would constitute a trade, income from which would be subject to the 12.5% rate of corporation tax. To facilitate such an opinion, Revenue would require details of the nature and range of activities involved, personnel employed and their functions, risks and decisions taken and any other relevant information. This approach follows well-established practice used for other types of new business activities (e.g. IP-related activities) and, whilst it should be reasonably clear to companies setting up a new business whether the business activity constitutes a trade or not, Revenue guidance can be sought in cases where there is uncertainty. A request for an opinion should be forwarded to Marie Hurley, Corporate Business and International Division, Stamping Building, Dublin Castle, Dublin 2.

C. OTHER ISSUES

Derivatives and other financial instruments

In many respects, trading in emission allowances is similar to commodity trading where there is a range of hedging instruments used to manage risk, including forward/ fixed-price contracts, cap and floor prices and guaranteed average price. Where carbon emission-based derivatives are regarded as financial instruments and accounted for under IFRS on a fair value basis, S76B of the TCA provides that unrealised gains or losses on derivatives included in the profit and loss account are taxed under Schedule D Case I where they are trading in nature. However, where trading income treatment is not appropriate, the correct treatment will generally be Case IV or capital gains tax depending on the circumstances. In this case profits will be taxed on realisation.

CDM projects

Companies participating in the ETS can use carbon credits obtained from environment-friendly projects under the Clean Development Mechanism (CDM) or Joint Implementation (JI) programme under the Kyoto Protocol to offset their emissions. These credits - known as certified emissions reductions (CERs) or emissions reductions units (ERUs) - can be obtained by investing in such projects or by purchasing them, either directly from the project owners (e.g. through fixed/ forward price contracts) or in the open market. CERs and ERUs can be exchanged for EU emissions allowances for use under the ETS. Direct investment in a CDM/ JI project would arise, for example, where a company finances an environment-friendly project which contributes to reductions in emission levels and, in return for the investment, the company receives an agreed amount of credits over a specified period.

It is understood that CERs or ERUs are purchased from time to time by Irish companies for use under the ETS. As provided for in Section 81C of the TCA, purchases and sales of CERs or ERUs are treated on the same basis as EU emission allowances. As regards direct investment in CDM/ JI projects, given the differing circumstances that may arise in relation to such investments and the limited experience in this area to date, Revenue is not in a position to provide general guidance on tax issues arising. Revenue can, however, give an opinion on the tax treatment of specific projects, if required, and a company seeking such an opinion should provide full details of the project and outline the tax issues on which clarification is sought. Submissions should be made via the Revenue Technical Services or to the relevant unit in Revenue’s Large Cases Division.

Treatment of Penalties imposed under the EU Directive

The EU Directive provides that any enterprise subject to the ETS, which fails to surrender sufficient allowances to cover its emissions, has to pay a penalty of €100 per tonne of CO2 equivalent and still remains under the obligation to make up the shortfall. Revenue’s view is that penalties imposed under the ETS are non-deductible. The non-deductibility of penalties is a well-established principle in case law consistent with the public policy perspective that allowing a deduction for a fine would mitigate the intended purpose and deterrent effect of the measure.