Allens

Climate Change

Increase text sizeDecrease text sizeDefault text size

Focus: Tax consequences of the Carbon Pollution Reduction Scheme

20 February 2009

In brief: Following on from our summary of the Federal Government's White Paper on its Carbon Pollution Reduction Scheme, Australia's Low Pollution Future, Partner Grant Cathro (view CV) and Lawyer Penny Alexander discuss in detail the tax consequences of the proposed Scheme. This is the eighth in a series of articles that examines in more depth the principal proposals contained in the White Paper.

How does it affect you?

  • Next financial year, liable entities and traders buying and selling carbon permits under the Carbon Pollution Reduction Scheme will need to be aware of the income tax consequences for taxpayers of dealing with carbon permits, including how expenditure on and revenue from carbon permits will be treated for tax purposes, how carbon permits will be valued, the timing of deductions and the treatment of carbon permits that are provided by way of adjustment assistance.
  • Emitters of greenhouse gases will need to carefully manage the timing of the surrender of permits if they are to obtain a tax deduction for the cost of the permit in the year in which they make the emissions for which the permits are surrendered.
  • The introduction of the Carbon Pollution Reduction Scheme also raises other tax issues, such as the application of GST, the treatment of penalties incurred under the Scheme by taxpayers who do not surrender sufficient permits, and the application of the proposed Taxation of Financial Arrangements legislation to permits (and to derivatives of permits).

Background

Under the Federal Government's proposed Carbon Pollution Reduction Scheme (CPRS), liable entities will need to acquire and surrender an Australian Emissions Unit (AEU)1 for every tonne of greenhouse gas that they emit. Liable entities may surrender AEUs at any stage during a compliance year (ie a year ending 30 June). The final date by which liable entities must surrender the required number of AEUs for a compliance year is 15 December of the following compliance year. Failure to surrender sufficient AEUs for a compliance year will result in the imposition of a penalty and an obligation to surrender AEUs in the next compliance year to make up that shortfall.

Each AEU will be stamped with a 'vintage' year. Earlier vintage year AEUs can be used to acquit a CPRS liability for a subsequent year (ie can be banked). In addition, within certain limits, AEUs with a later vintage can be used to acquit a CPRS liability for the immediately preceding year (ie can be borrowed).

Once liable entities start dealing with AEUs they will need to account for expenditure on and revenue from those AEUs in their assessable income.

While the majority of AEUs will be issued by way of auction, some entities will be allocated AEUs for free as a transitional assistance measure, namely:

  • entities undertaking emissions-intensive trade-exposed (EITE) activities will receive free annual allocations of AEUs; and
  • eligible coal-fired electricity generators will receive a once and for all allocation of free AEUs that is to be provided to them in instalments over the first five years of the CPRS.

Such entities will also need to account for these AEUs in their assessable income.

The CPRS is intended to encourage trade in AEUs so that they are channelled to the activities that value them most highly.

The principal aim of the proposed CPRS tax arrangements is to ensure that the taxation of AEUs does not compromise the objectives of the CPRS by distorting taxpayer behaviour. The arrangements are therefore designed to ensure that all taxpayers are treated in the same way and to minimise any adverse tax impact of acquiring, surrendering, banking, borrowing or selling AEUs. Treating taxpayers equally ensures that AEUs are not more or less valuable to some taxpayers than to others as a result of their tax treatment, and prevents the tax outcomes impacting decisions about whether to bank, borrow or sell AEUs.

Income tax and the CPRS: fundamentals

In its White Paper the Federal Government confirms that it intends to enact discrete legislative provisions for the income tax treatment of AEUs, rather than to use the existing income tax law. This will ensure that the income tax treatment of AEUs does not differentiate between taxpayers, which could distort the underlying market for AEUs. The capital gains tax provisions of the income tax law will not apply to transactions involving AEUs.

The core principles for the income tax treatment of AEUs are embodied in a 'rolling balance' mechanism under which:

  • the cost of an AEU will be deductible from a taxpayer's assessable income;
  • any proceeds from the sale of an AEU will be included in a taxpayer's assessable income;
  • any increase in the value of AEUs on hand at the end of the year of income, compared to the value of those on hand at the beginning of the year of income, will be brought to account in the taxpayer's assessable income;
  • any decrease in the value of AEUs on hand at the end of the year of income, compared to at the beginning of the year of income, will be allowed as a deduction;
  • acquisitions of AEUs during the year that are still on hand at the end of the year will have the effect of increasing the total value of AEUs on hand at the end of the year, adding to assessable income and effectively negating the deduction for their cost; and
  • the surrender or sale of an AEU which was on hand at the beginning of the year of income, will reduce the balance on hand at the end of the year of income, creating an effective deduction.

The CPRS tax provisions will operate in a very similar way to the trading stock provisions contained in Division 70 of the Income Tax Assessment Act 1997 (Cth).

The effect of the rolling balance mechanism is to defer recognition of the cost of purchasing AEUs, and any associated tax deduction, until they are surrendered or sold. Expenditure on AEUs will only affect the income tax liability of a taxpayer in the year the AEU is surrendered or sold because by including the value of permits on hand at the end of the year of income in assessable income, deductions for the cost of AEUs will effectively be deferred until the year in which AEUs are surrendered or sold.

In general terms, the rolling balance mechanism results in the following tax outcomes:

  • If an AEU is purchased and surrendered in the same income year, the taxpayer will be entitled to deduct the cost of the AEU in that income year.
  • If an AEU is purchased and sold in the same income year, the profit or loss arising will be recognised for income tax purposes in that income year. This is achieved by allowing the taxpayer to deduct the cost of the AEU from its assessable income, and requiring the taxpayer to include the proceeds of the sale of the AEU in its assessable income, for that income year.
  • If an AEU is purchased, banked and then surrendered or sold in a later income year, the taxpayer's deduction for the cost of the AEU is effectively deferred until the year it is surrendered or sold.

Practical implications: timing of deductions

Taxpayers who have acquired AEUs before the end of a compliance year, which they intend to surrender to meet their obligations in respect of that year, will only obtain a deduction for the cost of the AEU in that year if they surrender the AEU prior to the end of their current income year.

Example: A taxpayer has acquired a 2011 vintage AEU and makes emissions during the period up to 30 June 2012 which will require the surrender of that AEU. The taxpayer has an income year ending 30 June. If the AEU is surrendered on or before 30 June the taxpayer will effectively obtain a deduction for the AEU in their tax year ended 30 June 2012. If however they wait and surrender the AEU on the last date for surrender of AEUs for the compliance year ending 30 June 2012 (ie 15 December 2012), the deduction will effectively be postponed until the following income tax year during which the AEU is surrendered (ie the year ended 30 June 2013).

The rules determining the tax treatment of AEUs do not differentiate between AEUs of different vintages, nor do they differentiate between AEUs that are borrowed or banked. Taxation treatment is determined by reference to the time of purchase (irrespective of the vintage year of the AEUs), the number and value of AEUs on hand at the end of each income year (irrespective of the vintage year of the AEUs), and indirectly by the time at which the AEUs are surrendered or sold.

You purchase a 2012 vintage AEU at an early auction in 2010 for use in 2012.

You will receive a tax deduction when you purchase the AEU, but the deduction will effectively be postponed until you surrender or sell that AEU in 2012. While you will technically receive a tax deduction in 2010 for the value of the AEU, you will also include the value of the AEU in your rolling balance (and therefore in your assessable income) because it will still be on hand at your income year end. The value of the AEU will not be subtracted from your rolling balance until you surrender or sell it in 2012 (the effect of the deduction is delayed until then). When you value the AEU, you will need to have regard to the valuation principles set out below.

You purchase a 2012 vintage AEU at an early auction in 2010 and then borrow it for use in 2011.

The tax outcome does not change because the AEU is borrowed. The same principles apply, which look only to when the AEU is purchased and surrendered or sold. You will receive a tax deduction in 2010 when you purchase the AEU but the deduction will effectively be postponed until you surrender the AEU in 2011. While you will technically receive a tax deduction in 2010 for the value of the AEU, you will also include the value of the AEU in your rolling balance (and therefore in your assessable income). The value of the AEU will not be subtracted from your rolling balance until you surrender it in 2011 (the effect of the deduction is delayed until then). Again, when you value the AEU, you will need to have regard to the valuation principles set out below.

You purchase a 2012 vintage AEU in early December 2013 (either at a late catch-up auction or by acquiring it on the market) and surrender it on the last surrender date for the compliance year ending 30 June 2013 (ie 15 December 2013).

You will be entitled to deduct the cost of the AEU in that income year. Because you will have surrendered the AEU before the end of your income year, you will not include its value in your rolling balance and the deduction will not be postponed.

Valuation of AEUs: historical cost method and market value method

Where AEUs are held at income year end: the need for an election

Taxpayers may have AEUs on hand at the end of an income year that:

  • they intend to surrender for the current compliance year, but have not yet surrendered; or
  • have a future vintage year or they have chosen to bank for use in a subsequent year.

Taxpayers who hold AEUs at the end of an income year will be required to choose between two methods for the valuation of those AEUs for income tax purposes. They must either elect the 'historical cost method' or the 'market value method'. The choice of method affects the timing of recognition of income and deductions in respect of AEUs.
During the first five years, which are to be treated as a transitional period, a taxpayer may change its election once only. After the transitional period, taxpayers will be required to make an irrevocable election to use either the historical cost method or the market value method.

A choice to use the market value method rather than the historical cost method will alter the timing of the recognition of income and deductions. This is because taxpayers who use the market value method are required to bring to account movements in the market value of AEUs on hand at the end of each income year.

Historical cost method

Where a taxpayer elects to value its AEUs using the historical cost method, its rolling balance of banked AEUs will be valued at their original purchase cost. This means that:

  • a taxpayer will only be entitled to a deduction for the original cost of an AEU, regardless of its later value, in the year the taxpayer sells or surrenders it; and
  • no adjustment will be made for movements in the market value of an AEU while it is held by the taxpayer.

A taxpayer who elects to use the historical cost method will need to keep a record of the cost of each AEU until it is surrendered or sold.

By electing to use the historical cost method, the taxpayer avoids having to account for unrealised gains. Under the historical cost method, the taxpayer will not have to include any increases in the market value of an AEU in its assessable income unless or until the AEU is surrendered or sold. However, the White Paper does not specify whether taxpayers will be required to follow a 'first in, first out' rule if they elect to use the historical cost method of valuation, or whether they will instead be able to select which of their AEUs they are considered to surrender or sell.

Market value method

Where a taxpayer elects to value its AEUs using the market value method, movements in the value of those AEUs will affect the timing of the recognition of income and deductions. This means that:

  • any increase in the value of the AEUs on hand between the beginning of an income year and the end of that income year will be brought to account as assessable income;
  • any decrease in that value will be allowed as a deduction; and
  • the value of AEUs on hand can change through a movement in their market value, even if there is no change in the number of AEUs held.

Under the market value method:

  • if an AEU is purchased and surrendered in the same income year, the taxpayer will be entitled to deduct the cost of the AEU in that income year (an outcome which is the same as that arising under the historic cost method);
  • if an AEU is purchased and sold in the same income year, the profit or loss arising will be recognised for income tax purposes in that income year. This is measured by comparing the original cost of the AEU with the proceeds of sale (an outcome which is again consistent with the historical cost method); and
  • if an AEU is purchased, banked and then surrendered or sold in a subsequent income year, the value of the AEU at the end of each income year will be based on its market value. In the subsequent year where the AEU is surrendered or sold, the effective deduction will be equal to the opening market value of the AEU at the beginning of that income year.

Worked example

Assume that an AEU is acquired in year one at the cost of $100. It has a market value at the end of year one of $90 and is surrendered in year two.

Under the historical cost method, the deduction for the cost of the AEU is effectively deferred until year two when a deduction for $100 is available. This is achieved by allowing a deduction in year one for the $100 cost, but bringing to account as assessable income at the end of year one the value of the AEU of $100, resulting in a net position of zero (ie $100 – $100). When the AEU is surrendered in year two, the value of the AEUs on hand decreases by an amount of $100, resulting in an effective deduction in that year of $100. This position is not affected by the market value of the AEU at the end of year one.

In contrast, by using the market value method, the taxpayer obtains a deduction in year one for the movement in market value between the original acquisition cost and its value at the end of the year. This is achieved by allowing the taxpayer a deduction for the cost of the AEU and requiring the value of the AEU on hand at year end to be brought to account as part of the rolling balance (ie $100 – $90 = $10). The taxpayer obtains a lower deduction in year two when the AEU is surrendered, equal to the value of the AEU at the beginning of that year in the rolling balance (ie $90).

Had the value of the AEU increased at the end of year one to $110, a taxpayer using the market value method would be required to bring the increase in value to account at the end of year one (ie $110 - $100 = $10). The deduction then allowed in year two when the AEU is surrendered would be equal to the value of the AEU at the beginning of the year (ie $110).

Income tax treatment of government assistance

As stated above, entities undertaking EITE activities and some coal-fired electricity generators will be provided with adjustment assistance in the form of annual allocations of free AEUs.

Given the nature of free AEUs, taxpayers who acquire them will not be able to claim a deduction at the time of acquisition. However, the value of such AEUs must be included in the taxpayer's rolling balance (and therefore assessable income) in the year in which they are received.

In some circumstances a special 'no disadvantage rule' will deem this value to be an amount of zero. In other cases, taxpayers will simply adopt the historic cost or market value method that they have otherwise elected. Those using historic cost will value the AEU at an amount equal to its value on the date on which the AEU was issued.

Under the 'no disadvantage rule', where a taxpayer undertakes an EITE activity and receives free AEUs, those AEUs will be valued at zero in the rolling balance (and therefore zero in the taxpayer's assessable income) if they are held at the end of an income year that ends before the last surrender date (15 December) for the year in respect of which those AEUs were issued.

For example, if a taxpayer is allocated 2010 vintage AEUs, but the taxpayer's income year ends before the final surrender date for the 2010 compliance year (ie 15 December 2011) such of those 2010 vintage AEUs as are still on hand at the end of the taxpayer's income year (ie 30 June 2011) would be valued at zero in the rolling balance and therefore cause no increase in the taxpayer's assessable income.

The no disadvantage rule ensures that taxpayers who undertake EITE activities and receive AEUs which they still hold at the end of an income year before the last surrender date for the year in respect of which the AEUs were issued, will not be assessed on their value in that income year. Where, however, AEUs are banked for use in a year that is later than the year in respect of which those AEUs were issued, their value will be brought to account.

In summary:

  • If a taxpayer undertaking an EITE activity receives free AEUs and surrenders them in the same income year, there will be no impact on the taxpayer's assessable income because none of the AEUs were held at the start of the income year and so are not included in the taxpayer's rolling balance.
  • If a taxpayer undertaking an EITE activity receives free AEUs and sells them in the same income year, the amount for which those AEUs are sold will be included in the taxpayer's assessable income. No deduction will be available.
  • If a taxpayer undertaking an EITE activity receives free AEUs and holds them at the end of an income year that is before the last surrender date for the year in respect of which those AEUs were issued, the AEUs will be valued at zero under the 'no disadvantage rule' and there will be no effect on the taxpayer's assessable income (because there will be a zero amount to include in the rolling balance).
  • If a taxpayer undertaking an EITE activity receives free AEUs, banks them, and continues to hold them in an income year after the last surrender date for the year in respect of which those AEUs were issued, the taxpayer will be assessed on the value of those AEUs. The value of the AEUs will be included in the taxpayer's rolling balance, calculated by either the historical cost method or the market value method (whichever the taxpayer has chosen). The historical cost of an AEU will be the market value of the AEU on the date on which it was issued.
  • If a taxpayer surrenders or sells an AEU received as part of a free allocation that was included in the rolling balance at the beginning of the income year, the sale or surrender will reduce the value of the rolling balance at income year end, effectively providing a deduction equal to the value of that AEU at the beginning of the year.

Taxpayers who are coal-fired electricity generators and receive free AEUs will be treated the same way as described above, but without the benefit of the 'no disadvantage rule'. If those free AEUs are still on hand for coal-fired electricity generators at the end of an income year, they will be included in the generator's assessable income (at whichever valuation method the taxpayer has elected), and treated in the same way as AEUs that have been allocated by way of EITE assistance that are still on hand after the last surrender date.

Decision to emit or abate – not tax neutral

While the White Paper recognises that the tax treatment of expenditure can also affect decisions that businesses make about whether to emit or abate, as yet little attention has been given to the timing of the deductions for tax purposes of expenditure incurred to reduce emissions. Businesses will consider the tax cost of each option open to them. A truly tax neutral tax system would not affect a business's choice to:

  • acquire and surrender AEUs;
  • emit less greenhouse gases by reducing or altering production processes; or
  • sequester greenhouse gases to reduce net emissions.

Given that much of the expenditure required to reduce emissions is likely to be capital in nature and deductible over a number of years, it is far from clear that the existing tax system achieves this neutral outcome.

Other tax issues

AEUs surrendered by taxpayers for non-commercial purposes

It is possible for entities to acquire AEUs for private or domestic purposes (ie to voluntarily offset their carbon footprint), but this expenditure will not be deductible. The original cost of the AEU will be deductible, but the amount equal to the cost of the AEU will be re-included in the taxpayer's assessable income in the year the taxpayer surrenders it. This provides little incentive for taxpayers to voluntarily acquire and surrender AEUs.

AEUs created from reforestation and destruction of synthetic greenhouse gases

Taxpayers who undertake eligible reforestation or synthetic greenhouse gas destruction activities will be issued with AEUs. These AEUs will be known as 'created permits' and for tax purposes will be treated similarly to AEUs that are allocated for free by way of adjustment assistance, without the benefit of the no disadvantage rule.

Expenditure on certain reforestation and environmental protection activities is already deductible under specific provisions of the income tax law (see the carbon sink forest provisions in Subdivision 40-J and the environmental protection activities provisions in Subdivision 40-H of the Income Tax Assessment Act 1997).

Tax treatment of penalties incurred for failure to surrender sufficient AEUs

There will be no tax deduction available for the cost of penalties incurred by taxpayers for a failure to surrender sufficient AEUs by the final surrender date for a compliance year. AEUs which a taxpayer is required to purchase to make up such a shortfall will be deductible in the same way as other AEUs.

Tax treatment of eligible international units

The rolling balance mechanism will only apply to eligible international units that have been registered in Australia on the national registry. The normal income tax rules will apply to international units that are not registered in Australia.

If an entity decides to register an eligible international unit on the Australian registry, the entity will be treated as though it:

  • sold the unit for its market value just before it is registered in Australia; and
  • then immediately re-purchased it for the same value.

Conversely, if the entity decides to remove the eligible international unit from the Australian registry, the entity will be treated as though it:

  • sold the unit for its market value just before it ceased to be held in Australia; and
  • then immediately re-purchased it for the same value.

The rolling balance mechanism will apply from the time the eligible international unit is registered on the national registry, and the entity will be entitled to a deduction for the cost of 'purchasing' the eligible international unit and must include the value of the eligible international unit in its rolling balance and assessable income. The rolling balance mechanism will cease to apply if the unit is removed from the national registry.

Application of proposed Taxation of Financial Arrangements legislation

The Federal Government has indicated that the proposed Taxation of Financial Arrangements (TOFA) provisions will not apply to the acquisition, holding and disposal of AEUs. However, it has indicated that derivatives of AEUs may be subject to the proposed TOFA provisions where they are within the meaning of 'cash settlable' and therefore may be 'financial arrangements'.

Effect of consolidation (entities joining or leaving consolidated groups)

The White Paper does not explain how an entity holding AEUs that joins or leaves a consolidated group is to be treated. These details will be available once the exposure draft of the proposed CPRS legislation is released.

International tax: controlled foreign companies, foreign investment funds and foreign residents

The White Paper does not explain how the rules in respect of controlled foreign companies and foreign investment funds will interact with the tax treatment of AEUs. The Board of Taxation has reviewed the rules and provided a report to the Federal Government, but the Government has yet to decide on a response.

However, the Government has indicated that the proceeds from the sale of AEUs and increases to rolling balances would be treated as income with an Australian source, and as part of the assessable income of foreign residents. Australia's right to tax may be subject to international treaties.

Public trading trusts

The White Paper does not explain whether managed investment trusts will be able to trade in AEUs without the public trading trusts provisions applying. The Board of Taxation is considering this issue as part of its review of tax arrangements applying to managed investment trusts, and will provide a report to the Federal Government in mid-2009. The Government will confirm its position once it has received the report.

PAYG

The White Paper does not explain how the PAYG instalment provisions will apply to the sale of AEUs. These details will be available once the exposure draft of the proposed CPRS legislation is released.

Petroleum Resource Rent Tax

The White Paper does not set out the Federal Government's position on the interaction between the CPRS and petroleum resource rent tax. These details will be available once the exposure draft of the proposed CPRS legislation is released. The Federal Government is continuing to consult stakeholders about this issue.

GST

In the White Paper, the Federal Government confirms that, to promote certainty, it will amend the GST law to characterise AEUs (and eligible international units) as personal property rights and not real property rights for GST purposes. The Federal Government has also confirmed that the normal GST rules will apply to transactions involving AEUs, including input taxed treatment of supplies of financial derivatives of AEUs.

State taxes

There has been uncertainty about whether, in some states, taxes will be levied on allocations and transfers of AEUs. In the White Paper, the Federal Government states that it has written to the states seeking their agreement not to levy these taxes.

The next step

The Federal Government is proposing to release an exposure draft of the CPRS legislation for public comment in early March 2009 (delayed from late February 2009). If you would like further information in regard to the White Paper proposals that will form the basis of this draft legislation, or any other information, please contact any of the people below.

Footnotes
  1. Alternatively, liable entities may surrender eligible international units. However, for the sake of simplicity, this article refers only to AEUs.

For further information, please contact:

Share or Save for later

What are these?

 

To save this publication on your smartphone or
tablet for off-line reading (eg on a plane flight),
we recommend Pocket.

 

 

You can leave a comment on this publication below. Please note, we are not able to provide specific legal advice in this forum. If you would like advice relating to this topic, please contact one of the authors directly.

Comment Box is loading comments...