Multinational groups are increasingly likely to use voluntary carbon credits as part of their efforts to decarbonize their businesses and achieve their climate goals. There are a number of tax complexities and risks depending on how voluntary carbon credits are going to be acquired and used by companies and further guidance from HMRC would be welcomed, particularly as the market grows and becomes more regulated. Where multinational groups are taking a strategic approach to their offset activity, tax functions should play an active role in design and implementing structured arrangements.
This article was first published in the 11 November 2022 edition of Tax Journal. The article can be accessed here.
As world leaders gather in Sharm el-Sheik, Egypt for the 2022 United Nations Climate Change Conference known as COP27, attention is refocusing on the urgent need to reduce greenhouse gas (“GHG“) emissions and limit global warming. At COP26 last year many countries committed to achieve net zero GHG emissions by 2050 and the latest gathering intends to bring governments together to accelerate efforts to reach this target.
Multinational groups around the world, across different industry sectors, are setting voluntary objectives to reduce their carbon emissions and achieve net zero, including more than four fifths of FTSE 100 companies. This is being pursued by eliminating emissions, either by moving to greener operations and supply chains or by ceasing or divesting polluting parts of their businesses. However, groups that are eager to reach targets sooner may decide to offset emissions that they currently find impossible or very costly to eliminate.
Multinational groups can voluntarily offset their emissions by reducing the amount of GHG in the atmosphere outside their businesses, such as by planting trees to absorb and remove carbon dioxide or by promoting alternative energy use, such as clean cook stoves in rural areas, to avoid GHG emissions that would otherwise occur. This decarbonization typically occurs indirectly by acquiring voluntary carbon credits (“VCCs“) rather than companies directly engaging in those activities.
What are voluntary carbon credits?
VCCs are intangible instruments recorded in an electronic registry that each represent one metric ton of carbon dioxide equivalent (“MTCO2e“) reduced, avoided or removed from the atmosphere. VCCs are issued by bodies that are independent non-governmental organizations, such as Verra, Gold Standard, the Climate Action Reserve and the American Carbon Registry. These standard-setting bodies certify the carbon-related objectives of the underlying projects and the amount of carbon being reduced, avoided or removed. These are voluntary arrangements and are separate from those connected with certain regulated industries and regimes, such as the EU Emissions Trading Scheme (often described as “compliance market credits”).
VCCs allow the environmental benefits of project activities to be transferred from the projects ultimately to businesses or individuals wishing to offset their emissions. The transfer of VCCs occurs either directly from the person undertaking that activity or via intermediaries, including developers, brokers or marketplaces. Credits have a specific year of creation or “vintage”, which refers to the year when the emission reductions or removals occurred. When a holder “retires” a credit, which involves the irrevocable cancellation of a credit via a registry process, it can claim to have reduced its carbon footprint by one MTCO2e as the retired credit is no longer tradeable. So, a company with hard-to-abate emissions, such as those engaged in air transportation or steelmaking, can claim to have reduced environmental impact by purchasing and retiring VCCs.
The market for VCCs is global and highly fluid and demand for VCCs has been growing rapidly. According to consultancy McKinsey, USD 1 billion was estimated to have been spent on offsets in 2021 and the market could expand to USD 15 billion 2030 and USD 100 billion by 2050. There are various voluntary initiatives to establish common design principles relating to VCCs. The objective of these is to increase standardization and thereby widen the market. Currently the market (and the sector more generally) is lightly regulated but if the market continues to expand, it is likely that there will be increasing calls to regulate it in a similar manner to other commodity markets.
How do companies acquire voluntary carbon credits?
There are a wide variety of ways that companies may get access to carbon credits. They may simply purchase VCCs from the market and retire them against their own emissions. Alternatively, they may seek to enter into agreements directly or indirectly with the operator of an offset project to secure a future flow of VCCs. Such “emission reduction purchase agreements” involve an agreement to transfer credits arising from the project in the future on terms agreed upfront. For instance, companies may enter into long term contracts to acquire or “offtake” a share of the credits generated by a particular project over a period of time at pre-agreed prices. This may be in combination with investment funding in the form of equity or debt to get the project established.
How are voluntary carbon credits taxed?
There are a number of tax complexities and uncertainties that UK companies may face when using VCCs. These are derived, in part, by uncertainties about the legal nature and accounting treatment of these credits and transactions in them.
The VAT treatment varies for different types of carbon credits and in different countries. Transactions with carbon credits will only be subject to UK VAT if there is an identifiable supply, performed by a business, for which consideration is paid. HMRC distinguishes VCCs and compliance market credits, providing that the purchase of a VCC does not amount to an identifiable consumable supply and is therefore outside the scope of VAT, while the purchase of compliance market credits is a supply of services subject to VAT. HMRC justifies the difference on the basis that compliance market credits are regulated, verifiable, with attached subjective value to the credit unit and traded on national and international markets. (VATSC06584), while VCCs do not have identifiable consumers or genuine secondary trading markets.
Whilst it is helpful that HMRC has drawn a clear line in its view of the VAT treatment of carbon credits there are two potential issues. Firstly, we are aware that in most other European jurisdictions there is no clear guidance on this topic and in some countries, such as France, the tax authorities have expressed a view that voluntary carbon credits should be subject to VAT in the same ways as compliance market credits. So, there is international inconsistency, despite a common framework in Europe. Secondly, HMRC’s commentary implies that, as regulation of VCCs is tightened and the international voluntary carbon market develops, VCCs may in future be regarded as a consumable supply by the purchaser and therefore be subject to VAT. A change in the VAT treatment triggers legal uncertainty and could lead to irrecoverable VAT costs for a purchaser in some circumstances.
The starting point for determining the corporation tax treatment of VCCs is the accounting treatment. However, the accounting is not clear-cut due to lack of definitive guidance from accounting standards boards. In the absence of guidance, management of companies must use their judgement, which can give rise to differences in treatment of the same credit.
However, broadly speaking, the accounting treatment depends on future use: VCC acquisition costs may be treated as: (a) an expense if the VCC is immediately retired; (b) an intangible fixed asset if the VCC is held for use in a future period; or (c) as inventory if the VCC is held for trading.
The deductibility of any expense is not certain, partly because there is no specific published guidance from HMRC on VCCs. In particular trading companies must consider whether such expenses are “wholly and exclusively for the purposes of the trade” (CTA 2009 s 54). This depends on the facts and circumstances: if expenditure on the VCCs is incurred by the company solely in the interests of its own trade then it should meet this test (even if there are incidental benefits that accrue to others); if, however, the expenditure is borne by the trading company solely or partly in the interests of its affiliates or other stakeholders then it may be difficult to argue the expenditure is deductible. So, it will be important for the company incurring the VCC expenditure to have an identifiable and legitimate purpose for doing so (for instance, to promote particular products and services or to recruit and retain staff).
As indicated above, there are more complex investment structures, covering longer periods and having different terms. These can also result in uncertain accounting and tax implications. For instance, if a VCC offtake arrangement represents a forward contract to purchase credits at a pre-defined time and price, this may be a derivative contract for accounting purposes. If the arrangement is accounted for as a derivative, then it may be that fair value movements in the value of the contract go through profit and loss. It would then be necessary to consider whether such unrealized gains and losses would be brought into account for corporation tax purposes or would be disregarded. Clearly it is important that accounting and tax analysis is undertaken to understand the implications of entering into more complex VCC contracts.
Transfer pricing and international aspects
Multinationals are taking an increasingly strategic approach to the acquisition and use of VCCs on their path to net zero. Such an approach is likely to involve some centralization of procurement activity for VCCs given that VCCs have a global context in their creation and trading and are fungible in their use across a multinational group. Such centralization may involve transactions between group companies that would need to be on arm’s length terms to comply with transfer pricing rules. Given the variety of potential transactions that the group as a whole might enter into there are similarly multiple transactions that might occur between group companies that are engaged in strategic carbon activities on the one hand and those that might need to use VCCs to offset their own emissions on the other.
Given the nature of the markets for VCCs and uncertainties associated with their valuations, there may be consequent difficulties in determining appropriate and defensible arm’s length terms for transactions in VCCs between group companies. There are also questions about who benefits from expenditure incurred by the group. For instance, if there is a benefit to the group as a whole from marketing a specific product as carbon-neutral should the related costs be shared between relevant operating companies in the product’s internal supply chain on the basis of emissions offset or on the basis of sales made?
The pricing of externally acquired VCCs could also be used as a basis for establishing carbon pricing arrangements between group companies and for making investment and other financial decisions. Making polluting companies in the group pay a fee for their emissions in the form of actual or notional offset should provide a strong incentive for business units to reduce the carbon intensity of their operations and help them prioritize business model changes to reduce or eliminate emissions. However, if actual fees are charged to group companies making emissions, such fees will need to be on supportable arm’s length terms to comply with transfer pricing rules.
The overseas tax treatment in respect of VCC transactions could also have tax implications for multinational groups. The tax treatment of VCCs may be uncertain in jurisdictions where projects are being undertaken, which may have tax implications for the company acquiring the credits or incremental tax costs to the overall arrangement. For instance, the delivery of credits may be subject to withholding taxes or indirect taxes, depending on the jurisdiction. There may also be a risk that the investor in a carbon project could create a taxable presence in the project jurisdiction, depending on the nature of the contractual arrangements and local tax code. Any such tax costs or risks should be factored into the evaluation of options.
Multinational groups are increasingly likely to use carbon credits as part of their efforts to decarbonize their businesses and achieve their climate goals. There are a number of tax complexities and risks depending on how VCCs are going to be acquired and used by multinational groups and further guidance from HMRC would be welcomed, particularly as the sector grows and becomes more regulated. Where multinational groups are taking a strategic approach to their offset activity, tax functions should play an active role in the design and implementation of structured arrangements.