Marquette Universitye-Publications@Marquette

Accounting Faculty Research and Publications Business Administration, College of

1-1-2009

Trading in CO2Credits: Tax Issues to ConsiderMaureen MaschaMarquette University, maureen.mascha@marquette.edu

J. William HardenUniversity of North Carolina at Greensboro

James TrebbyMarquette University, james.trebby@marquette.edu

Published version. The CPA Journal, Vol. 79, No. 1 ( January 2009): 44-49. Publisher Link. Reprintedfrom The CPA Journal, January 2009, © 2009, with permission from the New York State Society ofCertified Public Accountants.

The issue of limiting carbon emissions has recently com-manded international attention. Starting with the 1997 KyotoProtocol, world markets have begun to coalesce around thenotion that carbon dioxide (CO2) emissions should be con-

trolled or capped. There are three generally accepted methodsfor limiting the emission of CO2: 1) a carbon tax that chargesproducers a fee for emissions that exceed a prespecified amount;2) an auction, in which organizations bid on credits that are thenused to offset the amount of actual CO2 emitted; and 3) a “capand trade” system.

The cap and trade system proposed at Kyoto envisioned thata limit (i.e., cap) would be imposed by the government on theamount of CO2 emissions allowed in a given period. Organizationswith emissions that do not exceed the limit are free to trade thedifference between the cap and their expected amount of emis-sions as “CO2 credits.” Likewise, organizations that anticipateexceeding the limit may purchase these credits in order toexceed the cap amount. The economics of purchasing the cred-its make sense when their cost is less than the cost required toreduce emissions below the cap.

Trading in CO2 Credits: Tax Issues to Consider

T A X A T I O N

c o r p o r a t e t a x a t i o n

JANUARY 2009 / THE CPA JOURNAL42

By Maureen Francis Mascha, J. William Harden, and James Trebby

In essence, an auction and cap and tradesystem are similar in that entities can pur-chase credits outright, with a governmentusually controlling the number of creditsauctioned. They are dissimilar in that theauction is not a secondary market wherefirms can trade previously purchased cred-its. Unfortunately, the cap and trade sys-tem is not optimal in the long term froma pollution control perspective, in the sensethat each player in the economy is notforced to lower emissions. It is, however,practical for many businesses and offers amore palatable transition toward eventuallower emissions overall. Because themost prevalent method used today is thecap and trade system, this article will focuson that methodology.

Most of the cap and trade activity hasoccurred in Europe, but carbon trading isemerging as a very real possibility in theUnited States, particularly with global warm-ing moving up in the political agenda. Whileaction at the federal level had been stagnantunder the Bush administration, individualstates started to take action to reduce emis-sions (e.g., California’s promoting the useof carbon credits for reducing emissions).While there is no regulatory guidance in theevolving CO2 area, the U.S. Treasury hasissued regulations dealing with the similarcap and trade system for sulfur dioxide(SO2) emissions.

What follows is a review of the feder-al tax precedent established for SO2 cred-its. The authors believe these rules mayeventually be applied to CO2 credits.Familiarity with current practice will behelpful until the IRS specifically clarifiesif rules governing SO2 credits will beapplied to CO2 credits.

Sulfur Dioxide Credits While the focus on carbon emissions is

relatively new, the issue of controllingemissions is not. Title IV of the Clean AirAct Amendments of 1990 charged theEnvironmental Protection Agency (EPA)with regulation of SO2 emissions. A majorprovision specified that the EPA wouldcontrol compliance through the regularissuance of credits which could be usedto offset actual emissions. The credits,issued at no cost to the recipient (usuallya utility), limited the amount of allowableemissions by setting a de facto ceiling (i.e.,the sum of the credits). The EPA moni-

tored actual emissions, providing regula-tory enforcement. In response to theissuance of SO2 credits, the IRS issuedRevenue Procedure 92-91, which providesguidance on how the credits should betreated from a tax standpoint.

Because the practice of carbon tradingloosely follows the parameters establishedunder the Clean Air Act, it is expected

that the tax issues surrounding the pur-chase, sale, and exchange of CO2 creditswill fit within the framework adopted forthe treatment of SO2 credits found inRevenue Procedure 92-91. The IRS hasnot issued similar guidance for CO2 cred-its, but given the economic similaritybetween SO2 and CO2 credit trading sys-tems, it is likely the IRS would recom-mend similar tax treatment.

Regulation Procedure 92-91 provides thefollowing:■ Credits issued by the EPA to utilitieshave a zero basis rather than a fair marketvalue basis because they were allocated,not purchased. If costs are incurred toacquire or hold the credit, then these costsmust be capitalized. ■ Credits purchased, rather than grant-ed, are to be recorded at cost (includingtransaction costs), and this cost should becapitalized.■ Credits are generally treated as capitalassets. If the taxpayer holds this type ofcredit as inventory, then the gain upon saleis ordinary.

■ Credits are not depreciable becausethey do not have a set useful life. Thetaxpayer claims a deduction in the year thatoffset SO2 is emitted.■ Credits can be sold or exchanged.■ If credits are sold, the gain or loss iscapital in nature unless the seller is engagedin the sale of these credits as a regular busi-ness, in which case the gain or loss is ordi-nary in nature.■ The exchange of credits qualifies asa like-kind exchange under IRC section1031, resulting in no gain recognition atthe time of the exchange. In this case,basis is carried over in accordance withsection 1031.■ The withholding and sale of creditsby the EPA is treated as an involuntaryconversion. The purchase of replacementcredits is treated as similar-use property forIRC section 1033 purposes.■ In the case of persons acting asinvestors or traders of SO2 credits, the samerules apply where applicable.

Differences Between CO2and SO2 Credits

While similarities exist between SO2 andCO2 credits, there are also differences inthe business arena and in the underlyingrights that could create distinct tax rulesin trading credits. The key differences areas follows: ■ CO2 credits are purchased. They arenot allocated by the EPA and, therefore,should always have a starting basis equalto what was paid for them, which cannotbe zero.■ There is generally an expiration datefor carbon credits, so amortization must beconsidered.■ Active markets exist for the trading of car-bon credits [e.g., Clean DevelopmentMechanism (CDM), Chicago ClimateExchange, and the European market for thetrading of carbon credits. See www.cdm.organd www.chicagoclimateexchange.com formore information]. The market value of car-bon credits is volatile, making gains or loss-es from the trading of such credits likely. ■ No single regulatory body is currentlyresponsible for monitoring compliance inthe United States (i.e., setting carbon lim-its and measuring actual emissions). Whilethe Chicago Climate Exchange offers whatis presumed to be an efficient market thatshould detect and “punish” rogue firms

43JANUARY 2009 / THE CPA JOURNAL

While similarities exist between

SO2 and CO2 credits, there are also

differences in the business arena

and in the underlying rights

that could create distinct tax

rules in trading credits.

JANUARY 2009 / THE CPA JOURNAL44

STATE TAX INITIATIVES

Many states have enacted or proposed legislation regulat-ing the emission of carbon dioxide. The majority of thislegislation sets limits on the amount of CO2 that can beemitted in a given amount of time (e.g., 40 tons per year).

Some limits are voluntary and some are mandated, but the generalgoal is to lower CO2 emissions. The following are summaries of ini-tiatives in states invoking cap and trade systems or imposing a car-bon tax in their legislation. Also included are summaries of initiativesderived by regional associations formed by a consortium of morethan one state, as well as other current issues affecting state regu-lation of CO2 credits.

New YorkEnacted 2005. On December 20, 2005, New York State entered

into a regional agreement to reduce greenhouse gas (GHG) emis-sions from power plants. Under the agreement, New York joined10 other northeast and mid-Atlantic states to propose the Region-al Greenhouse Gas Initiative (RGGI). The initiative, originally estab-lished in 2003 (see below), seeks to voluntarily cap and reduce car-bon dioxide (CO2) emissions from power plants in the region by 10%by 2019.

Enacted 2001. Executive Order 111, signed by Governor GeorgePataki, referred to as the “Green and Clean” state buildings andvehicles guidelines, mandates a reduction in greenhouse emis-sions for all state-operated buildings and vehicles. The order con-tains numerous directives designed to reduce energy use and thecarbon impact caused by the state government.

Enacted 2000. In May 2000, New York State enacted the GreenBuilding Tax Credit (GBTC) for owners and tenants of buildings thatmeet energy, indoor air quality, materials, and water conservationgoals, among other criteria. The GBTC is prospective in nature inthat it provides a tax incentive for ongoing maintenance, as wellas an incentive for the initial cost of compliance. The GBTC allowslicensed architects and engineers to certify compliance.

Proposed. In order to execute New York’s commitment to theRGGI, the Department of Environmental Conservation has proposedstatute 6 NYCRR Part 242 and Part 507. Part 242 establishes the CO2Budget Trading Program designed to allocate CO2 emissionsallowances to an Energy Efficiency and Clean Energy TechnologyAccount, while Part 507 allows the trading of these allowancesthrough auctions overseen by the New York State Energy Researchand Development Authority (NYSERDA). Revenue from the sale ofthese allowances will fund programs promoting energy efficiency,renewable or non–carbon-emitting technologies, and innovativecarbon-emissions technologies with significant carbon-reductionpotential.

CaliforniaEnacted 2006. The Global Warming Solutions Act of 2006 (AB 32)

is the most comprehensive legislation addressing greenhouse gasemissions in the United States to date. AB 32 mandates that carbonemissions be tracked, sets predefined limits as to the amount of CO2that can be legally emitted, reduces this limit beginning in 2010 andthereafter, imposes penalties and fines if those limits are not met,and specifically mentions a cap and trade system as an alternativeto fines and penalties. Additionally, AB 32 segments organizations into

“projects” (i.e., similar types of organizations): forestry, building energy, landfills, manure management, and SFG. Emissions are afunction of which type of project is applicable to the organization,meaning that one organization may find itself in more than one segment.

ColoradoEnacted 2007. Boulder, Colo., began taxing the use of carbon

energy (i.e., use of any nonrenewable energy source).Proposed. Colorado is considering a tax on any consumption of

nonrenewable energy.

IllinoisEnacted 1997. Illinois passed the Volatile Organic Compound Act

which aims to reduce the emission of 100 sources of pollution with-in an eight-county area. Participants trade credits for not only CO2,but other organic polluters as well. Participation is voluntary.

KansasEnacted. Kansas has enacted an income tax credit for the pur-

chase of alternative fuel vehicles.

OregonEnacted. Oregon requires that new power plants (and other

large energy facilities) offset a significant portion of their carbondioxide emissions. There are two ways to comply: through the useof offset projects (where renewable energy is produced to offsetcarbon-based energy) or the “monetary path.” The latter optioninvolves payment of a fee (sometimes referred to as a “tax”) equalto $0.85 per short ton of excess CO2 emission beyond the presetlimit. If the actual emissions exceed the projected emissions pro-rated for a five-year period, the energy producer must offset theexcess emissions using the monetary path. If the energy produc-er has not emitted CO2 equal to the prorated amount in previousfive-year periods, the state will credit it with the “unused” emis-sions to determine the net amount of excess emissions the certifi-cate holder may have to offset in future reporting periods. It is antic-ipated that credits for emissions under the limit can be traded.

WashingtonProposed. Washington is considering investigating the feasibil-

ity of a cap and trade system for reducing gas emissions. Underthe proposed legislation, power plants are required to reduce theirCO2 emissions by 20% over a period of 30 years. The CO2 may bemitigated by payment to an independent qualified organization; bydirect purchase of permanent carbon credits from real, perma-nent, verifiable CO2 mitigation not otherwise required or used forother CO2 mitigation projects; or by direct investment in CO2 miti-gation projects. Direct investments are limited in amount to nomore than the cost of a lump-sum payment option.

West VirginiaEnacted. West Virginia has enacted lower property and business

and occupation (B&O) taxes for utility-owned wind turbines.

(Continues on page 46)

trading worthless credits, it is not regula-tory in nature. Any actions it takes maybe limited to civil, not criminal, remediesfor injured parties.

Questions About the Tax Treatment of Carbon Credits

In light of the differences noted above,these distinctions are addressed by refer-ence to the eight items provided in thequestion-and-answer framework articulat-ed in Revenue Procedure 92-91.

Question one: cost basis. Essentially nodifferences should exist because RevenueProcedure 92-91states that the costs relat-ed to the acquisition and holding of thecredits are capitalized.

Question two: depreciation. No depre-ciation is allowed under RevenueProcedure 92-91. While this seems appro-priate for credits that do not expire, it pre-sents an issue for carbon credits that doexpire. Because the market for carbon cred-its is relatively unregulated, carbon cred-

its (as well as other credits for gas emis-sions) can take virtually any shape or form,

and their useful life varies significantly.Short-term credits are considered tempo-rary, as are longer-lived credits that areleased or rented. Even renewable creditsare risky, in that the underlying event that

allows for renewal may cease to exist andthe credit may be deemed worthless. Thekey issue for depreciating the basis of thecredit appears to hinge on the certainty ofthe useful life of the credit.

Question three: the use of creditsagainst emissions. Revenue Procedure 92-91 states that credits applied to emissionsshould be charged to expense in the peri-od in which they were used. This impliesthat purchasers of carbon credits wouldreduce taxable income by the amount ofthe credit used during a period. The costis usually measured in tons, so firms wouldcalculate how many tons were used andreduce their capital asset by the numberof credits used to offset that tonnage. It isanticipated that CO2 credits in the UnitedStates will be traded rather than used tooffset emissions. In such cases, the costwill be recovered at the time of sale, asdescribed below.

Question four: sale of credits. WhileRevenue Procedure 92-91 states that

JANUARY 2009 / THE CPA JOURNAL 45

The key issue for depreciating

the basis of the credit appears to

hinge on the certainty of the

useful life of the credit.

gains and losses arising from the sale ofSO2 credits are capital in nature as longas the entity selling the credit is not“holding a credit primarily for sale to cus-tomers in the ordinary course of trade orbusiness of dealing in allowances,” it isunclear whether frequent trading by busi-nesses whose primary purpose is not thesale or exchange of credits (e.g., utilities)still qualifies for capital gain treatment iftheir sales activity rises to a recurring

nature. Specifically, concerns exist withregard to the following issues: ■ The point at which a companybecomes classified as a “trader.” The aboveexcerpt from Revenue Procedure 92-91suggests that the intent of the firm (i.e.,principal business) is the defining criteri-on, but numerous examples from caselaw indicate that frequency of trading isalso a criterion, leaving the determinationan open issue.

■ The depreciation treatment of carboncredits. If carbon credits have a limited lifeand are depreciated, then the gain or losson the subsequent sale of those creditscould be subject to recapture.■ The sale of credits that were anticipat-ed to be used by the taxpayer to offsetemissions (if such a system eventuallyappears in the United States). The con-cern is whether certain issues could causethe credits to be ordinary rather than cap-ital in nature. This occurred, for example,in the case of Corn Products Refining Co.v. Comm’r, [350 US 46 (1955)]. TheSupreme Court found that selling futurescontracts related to purchasing raw mate-rials caused ordinary income instead ofcapital gain. The company bought thefutures to ensure adequate supply. If thecontracts were not needed, they were thensold. The Court focused on the relationshipof the futures to the ordinary operationsof the business.

Question five: tax treatment ofexchanges. Because SO2 credits are uni-

JANUARY 2009 / THE CPA JOURNAL46

REGIONAL INITIATIVES

Northeastern United StatesConnecticut, Delaware, Maine, Maryland, Massachusetts, New

Hampshire, New Jersey, New York, Rhode Island, and Vermont aremembers of the Regional Greenhouse Gas Initiative (RGGI).Observers in the process of joining include Washington, D.C.; Penn-sylvania; the eastern Canadian provinces; and New Brunswick.

Enacted 2003. A consortium of 10 northeastern states whose goalis to lower the amount of CO2 emissions in their area formed theRGGI. The initiative begins capping emissions across the region onJanuary 1, 2009, based on current levels, and calls for the lower-ing of the cap beginning in 2014 for the next four years. Unlike otherinitiatives, the RGGI mandates a cap and trade system. Under thissystem, each state is given “allowances” for its emissions, similarto the system for SO2 credits. Each state has discretion for dis-tributing these allowances. It can allocate them for free, sell themby auction, or use a combination of the two. The exception is thatthe RGGI stipulates that at least 25% of allowances be allocated“for a consumer benefit or strategic energy purpose.”

Western Regional Climate Action InitiativeEnacted 2007. This initiative is a collaboration between several U.S.

states and Canadian provinces. It calls for a cap on emission levelsand encourages a cap and trade system for voluntary compliance.

Additional AssociationsPowering the Plains (PTP), Western Governors’ Association

(WGA), and the New England Governors’ Conference, Inc. (NEG)have initiatives similar to those noted above.

Other TrendsWhile not unique to any one state, the use of “green tags” is

gaining popularity. Green tags are certificates awarded by stateand local governments to utilities for every 1,000 kilowatt-hoursof noncarbon energy production; benefits include revenue derivedfrom the sale of energy to the grid, as well as additional revenueearned through auctioning the certificates.

Even if no legislation currently exists, most states will beaffected by efforts to limit carbon dioxide emissions, eitherdirectly at the state or federal level, or indirectly in the form ofregional initiatives. One common theme that appears in recent-ly enacted legislative initiatives is that CO2 limits will be reducedover time, implying that compliance is transient and subject tochange at any given point. As a result, the cost of reducing car-bon emissions, in whatever form, is only likely to increase.

(Continued from page 44)

Carbon credits come in many different types, with a multitude of terms,

conditions, and expiration dates. It is therefore uncertain whether

the provision in Revenue Procedure 92-91 for like-kind

treatment would extend to CO2 credits.

JANUARY 2009 / THE CPA JOURNAL 47

form in nature, exchanges of one credit foranother do not trigger a taxable gain orloss; instead, they are treated as like-kindexchanges under IRC section 1031. Carboncredits, however, come in many differenttypes, with a multitude of terms, condi-tions, and expiration dates. It is thereforeuncertain whether the provision in RevenueProcedure 92-91 that SO2 credits are eli-gible for like-kind treatment wouldextend to CO2 credits. While one mightinitially assume that SO2 and CO2 creditsshould receive identical treatment, the mar-ket for CO2 credits makes them appearmuch more like a security-type instrument.Because the like-kind provisions of IRCsection 1031 do not apply to stock sales,it is uncertain whether the IRS wouldextend the like-kind provisions to CO2

credits in the same manner as for SO2 cred-

its. If U.S. taxpayers were required to useCO2 credits to offset their emissions, thenlike-kind conversion rules should be appli-cable in those scenarios as they are cur-rently for SO2 credits.

Question six: involuntary conversions.Revenue Procedure 92-91 states that theinvoluntary conversion of SO2 creditsallows for the purchase of replacementcredits which may be eligible for non-recognition treatment under IRC section1033. Because this issue was intended asa remedy for any credit withholding by theEPA, it is unclear whether involuntary con-versions in general would apply. While theinvoluntary conversion rules are stricterin terms of replacement property require-ments, this case of CO2 credits is one inwhich involuntary conversion treatment

may be clearer than like-kind treatment. Inthe case of a trader, the involuntary provi-sion rules will not apply, as noted inRevenue Procedure 92-91, for traders ofSO2 credits. If, in the future, U.S. taxpay-ers are required to use CO2 credits to off-set their emissions, then involuntary con-version rules should be applicable.

Question seven: penalties paid. The EPAcan impose fines for noncompliance withthe Clean Air Act. In the case of SO2 cred-its, the monetary penalty is punitive andtherefore not deductible. The reduction offuture emissions allowances imposed on thetaxpayer, however, is not considered sucha penalty. Currently, these issues do not existin the United States for CO2 credits.

Question eight: traders and investors.Revenue Procedure 92-91 describes the taxconsequences for traders and investors inSO2 credits. They are generally the sameas for entities that are not traders orinvestors, with the exception of deprecia-tion, involuntary conversion, and penalties,which do not apply to traders and investors.The issues affecting traders have beendetailed in the discussion above.

CO2 Credit Concerns and Future Regulation

A comparison of CO2 credits with SO2

credits reveals significant similarities anddifferences that may affect the tax treat-ment of CO2 credits. As noted above,many issues related to CO2 credits shouldbe reportable in a manner similar to SO2

credits. There, are, however, someissues for CO2 credits that may not beeasily explained by the SO2 credit guid-ance. In terms of these differences, thereare several key concerns:■ Is IRC section 1031 nonrecognitiontreatment for like-kind exchanges appli-cable in the case of CO2 credits?■ Will there be a provision for record-ing depreciation in cases involving cred-its with a definite useful life?■ What constitutes a “trader” (i.e., fre-quency of trades, monetary amount oftrades)? Is there a frequency thresholdof trading that affects tax treatment, oris the treatment entirely based on intent?■ In the case of credits expiring prior totheir use, is this event treated as an ordi-nary or capital loss? The guidance forSO2 credits indicates that they are gen-erally capital in nature. Currently, CO2

credits are traded but not used by tax-payers, which should lead to capital treat-ment. If the United States adopts a capand trade system in the future, thenature of the asset to users of the creditswill not be as clear.

Guidance from the IRS in theseambiguous areas for users and tradersof CO2 credi ts would clar ify theextent to which the rules of RevenueProcedure 92-91 may be applied inthese cases. ❑

Maureen Francis Mascha, PhD, is anassistant professor of accounting atMarquette University, Milwaukee,Wis.; J. William Harden, PhD, isan associate professor of accountingat the University of North Carolina atGreensboro; and James Trebby, PhD,is an associate professor of account-ing, also at Marquette University.

Guidance from the IRS for users and

traders of CO2 credits would clarify

the extent to which the rules of

Revenue Procedure 92-91

may be applied.