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HG Alert: The Carbon Pollution Reduction Scheme’s impact on taxation - 28 July 2009

Leaving aside the political and scientific aspects of climate change, the introduction of the Carbon Pollution Reduction Scheme has significant legal, commercial and taxation issues – and not just for large industrial operators such as power generators or miners.

As well as imposing costs on large carbon emitters by requiring them to pay for emissions units that reflect the greenhouse gas emissions they are responsible for, the Carbon Pollution Reduction Scheme deals with new property rights and obligations. Valuable emissions units can be created and sold in the Scheme market. Prospective land purchasers will need to take into consideration the restrictions on clearing trees attached to particular land (for example, as a result of carbon sequestration activity).

Because the taxation treatment of emission units is broadly the same whether or not an entity generates credits for themselves through activities such as reforestation, or acquires units in the market, the special taxation regime that is being introduced as part of the Carbon Pollution Reduction Scheme legislation package needs to be understood by a much wider audience than large carbon emitters alone. Farmers, forestry industry participants, purchasers of land with Scheme or other related obligations attached to it, and others with an interest in generating or dealing in valuable emission units, will need to understand the ground rules of what will be a market worth billions of dollars annually.

As well as understanding the specific taxation regime that is part of the Carbon Pollution Reduction Scheme (Division 420 of the Income Tax Assessment Act 1997), it is also important to be aware of the complex interactions with the existing taxation treatment of agricultural expenditure (including the new Division 40-J of the Income Tax Assessment Act 1997 dealing with some taxation aspects of carbon sink forests) relating to activities that generate emission units.

The Carbon Pollution Reduction Scheme provides commercial opportunities for those involved in the agricultural industry, the buyers and sellers of agricultural property and those with an eye for commercial opportunities in a new and dynamic market.

Tax treatment of emission units

The Scheme legislation introduces a new regime that specifically deals with the taxation of emission units. As with most tax legislation, the detail can be very complex, although the main principle is reasonably easy to understand.

Whether emission units are acquired by buying them in the market place or generating them by carbon sequestration activities such as planting trees, the broad tax accounting is the same and is based on a “rolling balance” approach.

The main features of the “rolling balance” tax treatment are:

  • the cost of a unit is deductible, with the effect of the deduction being deferred through the rolling balance (in the standard case where banked units are valued at cost) until the sale or surrender of the unit; 
  •  the proceeds of selling a unit are assessable income;
  • any difference in the value of units held at the beginning of an income year and at the end of that year is reflected in taxable income, with:
    -  any increase in value included in assessable income
    -  any decrease in value allowed as a deduction
  • taxpayers can elect to value all units held at the end of the first income year they hold units at either cost or market value; 
  • the choice of valuation method continues to apply but, as a transitional measure, can be changed only once before the 2016-17 income year, after which a change will only be allowed after a method has been used for four years; and
  • where an entity surrenders a unit for a purpose unrelated to producing assessable income, the deduction for the cost is effectively reversed by including in assessable income an amount equal to the amount deducted for its acquisition.

In a very simple example the rolling balance works like this:

Year one

Emissions unit cost          $10
Tax deduction for acquisition          $10

Rolling balance

Opening balance          Nil
Closing balance (Assuming election to use cost of unit, rather than market value)          $10
Added to income (Closing balance less opening balance)          $10
Year one taxable income ($10 deduction for the emissions unit acquisition cost plus $10 rolling balance adjustment)          Nil

Year two

Emissions unit surrendered

Rolling balance

Opening balance (Year one closing balance)          $10
Closing balance (As the emissions unit has been surrendered)          Nil
Deduction (Closing balance less opening balance)          $10
Year two taxable income          $10 loss

In this way the tax deduction for acquiring an emissions unit is deferred until the unit is disposed of - in this example, by being surrendered to offset carbon emissions. If an emissions unit is acquired and disposed of in the same period, this tax deduction deferral should not occur.

Free units

The rolling balance treatment becomes a little more complicated where a business has not directly purchased an emissions unit, but has been granted a unit at no cost. This could occur for a number of reasons, including the issue of free units to Emissions Intensive Trade Exposed industry participants such as aluminium smelters.

The following example outlines the Division 420 tax treatment of free emissions units issued as a result of reforestation activities.

Year one

Division 420 deduction (As no direct cost of acquiring the emissions unit a Division 420 deduction is expressly excluded)          Nil
Expenditure deductible under other non-CPRS tax rules – for example, carbon sequestration forest costs          $9
Year one taxable income          $9 loss

Year two

Emissions unit with market value of $10 acquired for no cost

Rolling balance

Opening balance          Nil
Closing balance (Market value of unit when issued)          $10
Closing balance less opening balance          $10

Less year one loss brought forward          $9

Year two taxable income          $1

Year three

Emissions unit sold for $15
Sale proceeds          $15

Rolling balance

Opening balance (Year two closing balance)          $10
Closing balance (As the emissions unit has been sold)          Nil
Division 420 rolling balance deduction (Closing balance less opening balance)          $10
Year three taxable income          $5

The overall outcome is that after accounting for $15 sale proceeds and $9 deductible expenditure, a profit of $6 is subject to tax, $1 in year two and $5 in year three. In practice, the operation of these rules will involve many more factors, including rolling balance choices about using cost or market value.

The important point for businesses that may generate emissions units is that the Carbon Pollution Reduction Scheme tax rules do not deal with the costs incurred in creating an entitlement to be granted free emissions units. The tax treatment of those expenses is to be found in the existing tax legislation, including the complex rules dealing with matters such as carbon sink forests, forestry activities, and other agricultural expenses, which will need to be carefully considered in working out the tax and cashflow costs of generating emission units.

An example of another tax rule that will impact on Carbon Pollution Reduction Scheme activities is the new Subdivision 40-J dealing with carbon sink forests. Under the previous law, the cost of planting trees was treated as capital expenditure and no immediate income tax deduction was available. The new rules mean that the costs of certain expenditure incurred in establishing trees in a carbon sink forest can be deducted upfront. These deductible costs include the costs of acquiring trees or seeds, the cost of planting, the cost of pots or potting mixtures, costs incurred in grafting trees or germinating seeds, and the costs of surveying a planted area. For the period ending 30 June 2012, the cost of establishing a carbon sink forest is 100 percent deductible in the year that the trees are established. From 1 July 2012 these costs are to be amortised over 14 years.

Expenses incurred in acquiring other plants such as trees for felling or horticultural plants are not deductible under the carbon sink rules. Neither are the costs of fencing, water facilities, roads or fire breaks, or the cost of purchasing land to be used in the establishment of a carbon sink forest. Some of these expenses may be deductible under other provisions of the taxation law.

Summary

The importance of the new Carbon Pollution Reduction Scheme regime and its new taxation rules is not limited to big players such as power generators or miners. A large market is being created, which is not limited to Australia. It will provide opportunities for farmers, generators of emission units (for example, through carbon sequestration activities) and investors, amongst others.

In order to avoid unnecessary tax costs, a careful pathway will need to be negotiated through the complexities of the new Carbon Pollution Reduction Scheme tax regime and the existing tax rules dealing with agricultural and forestry expenditure and GST, amongst other things.

For more information on how the Carbon Pollution Reduction Scheme will impact on taxation, please contact HopgoodGanim’s Climate Change specialists.