Are Carbon Credit Exchanges Taxable?

Carbon Credit Exchanges Taxable

Carbon credit exchanges have grown in popularity as an alternative to carbon taxes, especially among those countries aiming to reduce their emissions footprints. However, the question of whether these exchanges are taxable remains unanswered. The answer to this question depends on how the carbon credit exchange in question are created and how they are sold, and whether they are viewed as an intangible or tangible asset.

In an effort to encourage investment in carbon capture and storage (CCS), the Bipartisan Budget Act of 2018 instituted changes to Section 45Q, the tax credit that aims to offset the cost of CCS projects. Specifically, it eliminated limits on the total number of credits available and reduced project minimum requirements. Additionally, it made credits available for 12 years after the taxpayer’s carbon capture equipment is placed in service.

The credits are awarded to the owner of carbon capture equipment that contractually ensures the sequestration of captured carbon dioxide and carbon oxide. A taxpayer may enter into contracts with multiple counterparties, each assuming a different portion of the responsibility for ensuring that the carbon oxide is captured, injected and/or utilized in connection with the underlying oil or natural gas production process. In this manner, the taxpayer may pass a portion of its Section 45Q credits to each such contracting party on an annual basis.

Are Carbon Credit Exchanges Taxable?

Because the credits are passed through to each counterparty in this way, they are not considered to be owned by the taxpayer who captures the carbon dioxide or carbon oxide. As a result, the holder’s cost basis in the credits is not recognized, and thus they are not treated as capital assets for federal income tax purposes.

Aside from the Section 45Q credits, there are a variety of other mechanisms for reducing the amount of carbon in the atmosphere, including “cap-and-trade” Emissions Trading Schemes and carbon border adjustment levies, or CBAMs. The latter are proposals that would impose a levy on imports based on the amount of carbon embodied in their manufacture. The levy could be returned to consumers as a form of carbon pricing or used to offset a carbon tax.

As these policies begin to gain momentum, the issue of whether they should be viewed as a tax is becoming increasingly important. If they are seen as a tax, the revenue generated will be included in gross profit under the head of ‘Profits and Gains from Business and Profession’, potentially subjecting them to both payroll and corporate taxes. If they are seen as a climate policy tool and not a tax, they will be exempt from these taxes and may have greater appeal for investors. A potential disadvantage of not viewing the carbon credit as a tax, however, is that it may be more difficult to gain approval for such an initiative from important trade partners like China and Russia, who could argue that it violates World Trade Organization rules. This could delay or even derail the implementation of such a measure.