Updated: Mar 8
22 February 2022
Sustainable development always encourages us to conserve and enhance our resources, by changing the manners in which we develop business and use technologies. Carbon credits have become a popular way to fight climate change. The carbon offsetting market is growing rapidly as more and more companies pledge net zero, but the proper place for carbon offsets in their strategies remains unclear. Effective organizational management is key to managing carbon credits and carbon pricing risks in the face of shifting climate change regulation and government policy.
This white paper gives and overview of the taxation of ‘Carbon Credits’. To learn more, download a copy now
Carbon dioxide (“СO2”) has the same impact on the climate no matter where it is emitted and what the source. CO2 emissions are the primary driver of global climate change. If one party cannot stop emitting CO2, it can ask another to emit less so that, even as the first carries on producing CO2, the total amount of carbon in the atmosphere is reduced. To reduce emissions across all sectors of the economy, businesses all over the world will need to explore carbon offsetting.
The term carbon credit (“carbon offset” or “carbon offset credit”) broadly refers to a reduction in emissions or an increase in carbon storage aiming to compensate for emissions that occur elsewhere.
A carbon credit is a transferrable instrument certified by governments or independent certification bodies to represent an emission reduction of one metric tonne of CO2.
Carbon credits allow businesses to compensate for their Greenhouse gas emissions (GHG emissions). Individuals or companies looking to offset their own GHG emissions can buy those credits through a middleman or those directly capturing the carbon. It can be purchased to make up for CO2 emissions that come from industrial production, delivery vehicles or travel.
Carbon Credits: Schemes and Categories
There are three types of schemes available to offset carbon emissions:
Reduced emissions. Reduction schemes cut emissions by improving processes and providing energy efficiency measures (windfarms, installing solar cooking stoves, LED lights, etc.)
Removed emissions. Removal projects absorb or eliminate greenhouse gases. They are either nature-based (for example, re-forestation) or technology-based such as carbon capture
Avoided emissions. A good example of such scheme is refraining from cutting down rainforests
Carbon credits fall into two categories:
Compliance market credits, which derive from the Kyoto Protocol and the EU (European Union) Emissions Trading System (“EUETS”)
Non-compliance credits, of which the most common example is the Verified Emission Reduction (VER)
The important distinction, for Value Additional Tax (“VAT”) purposes, between compliance market credits and non-compliance credits such as VERs is that the former are capable of consumption of the type envisaged by the VAT system, and the latter are not. It means that compliance market credits are subject to VAT, whilst VERs are outside the scope of VAT.
Carbon Credits in the UK: Direct Taxation
Although carbon credits are regularly traded in the UK, there is currently no speciﬁc guidance from HMRC on the direct taxation of carbon credits.
Where an asset is only sold once, and is thereafter never again available for the original owner, it is likely to be a capital disposal, and subject to capital gains tax (CGT).
Standing timber is exempt from CGT and so where there is a sale of trees whose value is inﬂated due to the available carbon credit thereon, that will fall to be part of the tree value, and therefore also be exempt. Conversely, when the unit is sold without any underlying tree, then the value traded is subject to CGT.
If the credit is not a single sale, but a regular income stream, then this is not generally a disposal of the right, but rather an exploitation of this for proﬁt, and thus subject to income tax rules.
If the carbon credit is income, it may be taxed under many parts of the tax code. The detail will depend on whether this is deemed farming, commercial land management, woodland or simply a by-product of holding land.
If the regular receipt of income is linked to the commercial management of woodland then it could be exempt. This includes payments under the Woodland Carbon Code which guarantees the price of units being sold to the government every ﬁve or 10 years, and is speciﬁcally noted by the government to be tax free as related to woodland management.
If income is linked to commercial management of land with a view to a proﬁt, it will form part of the taxable proﬁts from that trade. This may include peatland management schemes where the management of the land is commercial and proﬁtable.
Otherwise, any regular income from a land based carbon credit will be property income, and subject to Inheritance Tax but not to national insurance contributions.
Carbon Credits in the UK: Reverse Charge
According to HMRC (HM Revenue & Customs) guidance only those compliance market credits which can be used to meet obligations under the EUETS are subject to the UK domestic reverse charge mechanism. These currently comprise of EU Allowances, as defined in Directive 2003/87/EC (as amended)(“Directive”). EU Allowances such as Certified Emission Reductions (CERs) and some Emission Reduction Units (ERUs), as defined in the Directive, were subject to the UK domestic reverse charge. From 1 May 2021 the CERs and ERUs are no longer within the scope of the UK domestic reverse charge, as the UK is no longer a member of the EU and is no longer part of the above schemes.
At the beginning of 2021, a new UK Emissions Trading Scheme (UKETS) was introduced. This broadly follows the EUETS and an amendment was made to the scope of the UK domestic reverse charge so that it applies to UK allowances from 1 May 2021.
The reverse charge applies to UK supplies of the following: A transfer of:
an allowance, as defined in the Directive, Article 3 (concerning the EU emissions trading scheme) or, with effect in relation to supplies made on or after 1 May 2021, in article 4 of the Greenhouse Gas Emissions Trading Scheme Order 2020
In relation to supplies made prior to 1 May 2021 it were also a transfer of
an emission reduction unit which can be used by an operator for compliance with the scheme established by the Directive
a certified emission reduction which can be used by an operator for compliance with the scheme established by the Directive
The reverse charge will only apply to transactions made between a UK VAT registered supplier and a UK customer who is VAT registered, or legally required to be VAT registered in the UK. VAT reverse charge means that customers are able to charge themselves VAT and pay it directly to HMRC rather than the supplier sending them an invoice at a later date, which in return stops suppliers from avoiding paying HMRC, also known as missing trader fraud. In the UK, you need to register your business for VAT if:
- you expect your VAT taxable turnover to be more than £85,000 in the next 30-day period - your business had a VAT taxable turnover of more than £85,000 over the last 12 months
It might also need to register in some other cases, depending on the kinds of goods or services you sell and where you sell them.
The supplier should implement a system to check that the customer is VAT-registered and that the number provided is valid before using the reverse charge. The UK supplier will need to continue to charge UK VAT on supplies to customers who are not VAT registered, or required to be VAT registered, in the UK.
In the meantime, not all transactions involving greenhouse emissions are treated as supplies for VAT purposes and are therefore not subject to the reverse charge provisions. For example, Verified Emission Reduction (VER)4 is essentially a promise that carbon has been or may be reduced somewhere in the world. There may be a general benefit to the reputation of a business (good PR, marketing and corporate responsibility) in paying for a VER, but no particular service is rendered which can be identified as a cost component of the business. There is therefore no consumption. No service is being provided to an identifiable consumer and no benefit is being provided which is capable of forming a cost component of the activity of another person in the commercial chain. Members of the general public cannot constitute a specific recipient of the kind which must exist in order to give rise to a transaction chargeable to VAT.
Applying the reverse charge is possible with the accounting systems and software that can handle the reverse charge. Care should be given to the fact that VAT is not charged on supplies that are liable to the reverse charge. Customers must identify which purchases are liable to the reverse charge, ensure that these are coded correctly in the accounting systems and that the reverse charge is correctly applied, and VAT accounted for to HMRC. If VAT is incorrectly accounted for, the customer would be issued with an assessment for under-declared VAT and the supplier could be liable to a penalty if the error is careless or deliberate.
Carbon Offset Programs: VAT issues
A carbon offset is an intangible commodity representing a reduction in GHG emissions, sold in units of carbon dioxide-equivalent (CO2). In the voluntary market, it is purchased to negate or diminish the impact of the recipient’s own GHG emissions. Reductions occur at projects located away from the source of emissions being offset.
Projects may be evaluated and reductions verified according to various offset project standards in the market. The programs administering these standards will certify verified reductions from qualified projects as carbon credits. Once issued, these credits are often bought wholesale by offset sellers or retailers that repackage the reductions into carbon products (offsets), which they then sell on to end-use businesses and individuals seeking to make an offset claim. Retail carbon offset certification standards, such as Green-e Climate, verify transparency and ownership in sales to end-use customers.
Consumers purchasing Green-e Climate certified offsets are guaranteed complete and exclusive ownership of their emission reductions and receive clear and comprehensive information on the projects their offsets are sourced from. The program also verifies that all GHG emissions reduction projects are independently certified through a high-quality project-level standard body such as Climate Action Reserve (CAR), American Carbon Registry (ACR), Verified Carbon Standard (VCS), and the Gold Standard.
A lot of businesses are providing carbon offset programs. The VAT treatment of any individual transaction will depend on the arrangements.
In many situations, when a member of the public makes a payment to a carbon offset provider, there is no supply for VAT purposes. This is because there is no identifiable, direct benefit to the person making the payment in return for their money. For example, an airline offers its passengers the facility to offset the carbon emissions generated by their flights, via a third-party carbon offset provider. So, the passenger pays across an amount, calculated to be the cost of offsetting the resulting emissions, but receives no identifiable, direct benefit in return.
In other situations, a carbon offset provider might make taxable supplies of carbon credits, or of the purchase and “retirement” of compliance market credits, or a general advice on how an individual or a business can improve its energy efficiency.
The place of supply of cross-border carbon credit trading falls under the general rule so the place of supply of B2B supplies is where the customer belongs as it will be treated as a reverse charge service. For B2C supplies, VAT will be due in the country where the supplier belongs.
The place of supply of intermediary services is determined separately. The intermediary’s supply will be treated as taking place where the intermediary’s customer belongs.
Carbon Credits in Shipping
In terms of using carbon credits to help meet certain regulatory carbon targets – shipping companies and vessels are not currently required to adhere to any specific CO2 caps. However, there are indications that the EU, as well as the UK, may bring shipping within their emissions trading schemes (ETSs) over the coming years.
At the end of June 2021, the European Commission as declining to comment on reports that a draft proposal had been circulated to expand the carbon market to cover shipping emissions within the EU, international voyages to the bloc and those at berth in an EU port. This would force owners to buy permits from the ETS when their ships pollute.
In April 2021 the UK announced that shipping be included in its new Carbon Budget, which enshrines in law the government’s commitment to cutting emissions by 78% by 2035 compared to 1990 levels.
ETS caps the total amount of certain greenhouse gases that may be emitted annually by individuals and companies covered by the scheme. This cap could be applied to the shipping industry in any number of ways, e.g. a ship-owning company may face a cap on the total emissions for its fleet or each vessel may have a cap on its annual emissions. For example, UK ETS may be applied to UK-flagged vessels; or it may apply to UK-based ship-owning entities, or to any vessel entering UK ports or sailing in UK waters.
However, there are some practical considerations which can make ETSs unsuitable for an industry as international as shipping. For example, credits issued by certain hydroelectric projects exceeding 20 MW of installed capacity are not currently eligible for exchange with EU ETS-compliant credits.
Without proper communication and cohesion between ETSs, shipowners could find themselves unfairly penalized by multiple schemes in different jurisdictions.
Global concern about Climate Change has provided transitioning to a low carbon economy. It will require significant changes to policy, the way markets operate, tackling the value chain emissions and technology advancement for all the countries. The question is, if the businesses have effective management systems in place to measure, monitor and respond to carbon pricing impacts on their business and supply chains as these changes unfold.
The participants to the Paris Agreement could revise their Nationally Determined Contributions (NDCs) to reduce greenhouse gas emissions every five years.
Carbon prices are increasing in response to government announcements, impacting sectors with direct exposure as well as downstream supply chains.
One of the most significant carbon pricing policies currently being debated is the EU Carbon Border Adjustment Mechanism (“CBAM”) that forms part of the European Green Deal. It is anticipated that some form of CBAM may be implemented no later than 2023, which aims to prevent ‘carbon leakage’ as the cost of EU ETSs allowances rise.
Carbon leakage is the risk of consumers switching to products produced outside of regulated carbon markets, to avoid high carbon costs, or else businesses relocating outside of the EU and the developed countries to avoid carbon prices imposed directly on their production emissions. The EU CBAM initiative aims to resolve this concern by adjusting the price of goods from selected industries imported into the EU to align to carbon costs levied on goods produced in those domestic markets.
Companies should ensure that they understand the geographical composition of their emissions to enable them to undertake a supply chain review where required, to analyze carbon pricing risks, and ensure their pricing models are in line with the proposed changes.
A thorough review will be needed of any new and developing regulations to avoid the costs associated with carbon pricing and remain competitive. With the world moving to a global low carbon economy, for businesses it is important to act now to be prepared for tomorrow, including more companies will need to use carbon offsetting more effectively.
If you have any questions regarding the carbon credits, our team at LEXeFISCAL is ready assist with any queries, please contact:
Kseniya Devlekanova at: email@example.com , or
Dr Frank J Clifford at: firstname.lastname@example.org.
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