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Focus: Taxing the Carbon Pricing Scheme

12 August 2011

In brief: The Federal Government has released draft legislation containing the tax implications of its proposed carbon pricing scheme. Partner Martin Fry (view CV) reports on the key income tax implications for entities when acquiring, holding, surrendering and trading in carbon units.

How does it affect you?

  • The carbon pricing scheme will operate in two phases: a three-year, fixed price phase from 1 July 2012 to 30 June 2015; moving to a floating price phase on 1 July 2015. In both phases, liable entities will be required to acquire and surrender carbon units equivalent to their annual emissions from activities covered by the scheme.
  • In the fixed price phase, the carbon price will commence at $23/tCO2-e. In this phase, the Government will sell to liable entities an uncapped number of units at the applicable fixed price, which will then be automatically surrendered by liable entities to meet their liability (ie these units cannot be traded or banked for future use). An entity will be able to acquit up to 5 per cent of its annual liability during this phase by surrendering Kyoto-compliant carbon credits generated under the proposed Carbon Farming Initiative.
  • In the floating price phase, the Government will set annual caps on the number of carbon units to be issued in each year and the price of those units will be determined by the market (subject to a floor and ceiling in the first three years of this phase). In addition to surrendering carbon units, liable entities will be able to acquit their annual liability using Kyoto-compliant Carbon Farming Initiative carbon credits and approved kinds of international permits. While there will be no limit on the number of Carbon Farming Initiative carbon credits that may be used for this purpose, the number of international permits that may be used will be limited to 50 per cent of an entity's annual liability. Carbon units issued for the floating price phase will be able to be banked without limit, and liable entities will be able to 'borrow' such carbon units from one vintage year (up to 5 per cent of their liability) in order to meet their liability for the immediately preceding vintage year.
  • Free carbon units will be allocated to 'emissions-intensive trade-exposed' activities under a Jobs and Competitiveness Program. Under this program, the highest emissions-intensive activities (such as aluminium smelting) will receive free units to cover 94.5 per cent of their average emissions in the first year, and moderate emissions-intensive activities (such as LNG production) will receive free units sufficient to cover 66 per cent of their average emissions in the first year, in each case decreasing at the rate of 1.3 per cent per annum.
  • Also, $5.5 billion worth of assistance will be provided to emissions-intensive coal-fired electricity generators in the form of cash in the first year (2012-13) and free carbon units over the next four years. Entities covered by the carbon pricing scheme (whether being liable entities or entities in receipt of free units under the industry assistance measures) will need to understand the tax implications of acquiring, holding, surrendering and trading in carbon units. The key tax implications are summarised below.

Deductions

Expenditure incurred in acquiring carbon units will be tax deductible (subject to the discussion of free units below). The deduction is recognised in the income year in which the acquiring entity becomes the 'holder' of the carbon unit – this is the income year in which there is an entry for the unit in the entity's Registry account.

Expenditure incurred in disposing of carbon units will also be tax deductible. The deduction is recognised in the income year in which the carbon unit is disposed of. The fact that the deduction for such expenditure is not recognised until the income year in which the carbon unit is disposed of will be of no consequence for carbon units that are issued to liable entities for a fixed price, because the liable entity is taken to immediately surrender such fixed price units.

Assessable income

Any amount entitled to be received on the disposal of carbon units will be assessable and deemed to have an Australian source. The assessable amount will generally be treated on revenue account (however, there are certain circumstances in which the CGT provisions can apply).

Carbon units that are issued to liable entities for a fixed price cannot be traded, so there can be no assessable receipts arising from the sale of such units. Units that are issued for free under either the Jobs and Competitiveness Program or the coal-fired electricity generation assistance program can be traded and amounts received from the sale of such units will be assessable.

Gross basis

The deduction for expenditure incurred in acquiring or disposing of carbon units, and amounts included in assessable income for the sale of carbon units, are brought to account on a gross basis (a net profit from the sale of units is not calculated).

Rolling balance account

Each income year an entity must compare the value of all carbon units held by it at the beginning and end of the income year. An increase in value at the end of the year is included in assessable income and a reduction in value at the end of the year is an allowable deduction.

There are three valuation methods available, being the FIFO cost method, the actual cost method, and the market value method. In relation to the FIFO cost method and the actual cost method, the 'cost' is that amount of expenditure incurred in acquiring the unit that is an allowable deduction (ie the amount of the deduction for the expenditure incurred is built into the year end value to ensure the deduction is not available twice). There are particular rules governing changes to the valuation method adopted by an entity.

Special tax rules for Free Carbon Units

Carbon units can be issued for free:

  • to an eligible entity under the Jobs and Competitiveness Program; and
  • to the owner, operator or controller of a generation complex under the coal-fired electricity generation assistance program.

The benefit of having valuable units issued for free will not be assessed for tax to the entity (on an income or CGT basis) when the free unit is issued.

During the fixed-price phase, free units can be sold back to the Clean Energy Regulator and, if so, the price received from the sale will be assessed for tax.

Jobs and Competitiveness Program

Where the free unit is issued to an eligible entity under the Jobs and Competitiveness Program, a nil value for the free unit is included in the year-end rolling balance (and, therefore, the eligible entity is not assessed for tax on the value of the unit) if the unit is held at the end of the income year that ends before 1 February in the year following the end of the vintage year. For example, if the free unit is issued on 5 July 2017 with a 2018 vintage year (ie the vintage year being the year ended 30 June 2018), the free unit will have a nil value in the year-end rolling balance if it is held at the end of the income year occurring before 1 February 2019 – for a taxpayer with a 30 June income year, this means that it will have a nil value in the rolling balance if it is held as at 30 June 2018. This regime will have unique consequences for entities having income years ending on a date other than 30 June (such as a 31 December year end).

Coal-fired electricity generation assistance program

Where the free unit is issued under the coal-fired electricity generation assistance program, the market value of the free unit is included in the year end rolling balance if the unit is still held at the end of the income year. As such, tax is assessed on the value of the unit if the unit has not been disposed of by year end.

Free units with a vintage year in the fixed price phase will be automatically cancelled if they are still held on 1 February in the year following the end of the vintage year – for example, a free unit with a 2014 vintage year would be cancelled on 1 February 2015. The recipients of free carbon units will therefore be motivated to either utilise the free units by surrendering them to discharge a liability under the scheme, or to sell them back to the Clean Energy Regulator.

Free units issued with a vintage year in the flexible price phase are able to be banked. In this phase, if a free unit is issued then the unit will have a nil value in the rolling balance if the unit is held at the end of the income year that ends before 1 February in the year following the end of the vintage year. The unit will not have a nil value in the rolling balance (and therefore the value of the unit will be assessed for tax) if it is held at the end of a later income year.

Quarantine expenditure relating to Free Carbon Units

An entity may not claim a deduction under the proposed Division 420 of the Tax Act 1997 (Cth) for expenditure incurred in becoming a holder of free units issued under either the Jobs and Competitiveness Program or the coal-fired electricity generation assistance program.

As there will no direct price payable to acquire free units, this rule will apply to expenditure incurred in the process of establishing the entity's entitlement to free units, ie the cost of administration and any registration fees.

Because this rule precludes a deduction under proposed Division 420, the question that arises is whether such expenditure may be deductible under other provisions such as section 8-1 of the Tax Act 1997. There is a risk that it will not be so deductible. If that is correct, entities will need to establish systems to capture and quarantine such expenditure.

Interaction with tax consolidated groups

Where the relevant entity is a member of a tax consolidated group, the deductions and assessable income that arise from dealing with carbon units will generally be appropriately treated as deductions and assessable income of the head entity of the group. Existing tax funding and tax sharing arrangements should be reviewed to ensure that the appropriate tax and accounting outcomes are achieved.

Corporate groups may wish to establish a special purpose entity within the group to acquire carbon units for the group, in which case that entity will need to transfer such units to the liable members of the group for them to be surrendered to acquit liabilities under the carbon pricing scheme. The single entity rule should assist with the tax implications of any transfers which arise from such arrangements (although stamp duty implications will need to be considered).

There are tax cost setting rules that apply when acquiring companies that hold carbon units.

30 June year end

The obligations arising for liable entities under the carbon pricing scheme are determined by reference to financial years ending 30 June. As there are no provisions allowing liable entities to apply a substituted account period, entities with income tax years ending on a date other than 30 June will need to establish systems to capture expenditure, liabilities and receipts arising from the scheme throughout each 30 June financial year.

Other tax issues to note

  • There are deemed market value rules applying to dealings in units that are not on arm's length terms.
  • There are complex CGT and income tax rules that apply where an entity transfers units between its foreign account and its 'domestic' Registry account, which will be relevant during the flexible price phase.
  • Where a Federal Government grant is made under an industry assistance program, such as the proposed clean tecnology grant schemes, the value of the grant will generally be assessed for tax.
  • Entities should consider any stamp duty implications that may arise from any dealings in carbon units.
  • The taxation of derivatives entered into to hedge an entity's carbon price exposure will be governed by the existing TOFA provisions.
  • The draft legislation provides for the transfer of liability under the carbon pricing scheme from one entity to another in certain circumstances. Entities will need to carefully consider the tax consequences that may arise when transferring liability to entities that do not sit within the tax consolidated group, as may occur in a joint venture context.

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