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Ian Fleming, FIIT, author of The Environmental Taxes Handbook, provides an overview of carbon credits, and outlines the tax treatment of carbon trading. 
 

Overview

The majority of the international scientific community now accept that global warming is a fact that we have to face. There is predicted to be no snow on Mt Kilimanjaro by 2020 and no ice at the North Pole by 2080, and many scientists attribute the increase in extremes of weather, from hurricanes to droughts, to global warming.

The burning of fossil fuels, whether in transport, power generation or heating produces large quantities of carbon dioxide as a side effect which builds up in the earth’s atmosphere to create what is known as the “greenhouse effect”, as it traps the heat created in our planet and increases the average temperature.

At the Kyoto earth summit, the majority of developed countries, but not the USA and China, agreed to reduce their carbon emissions to 5.2% below their 1990 levels. The UK Government, in fact, took a lead, and agreed to a reduction in British emissions of 20% by 2010.

Crucially, Kyoto also defined a market-based mechanism whereby officially certified carbon emissions and credits can be traded. As a result, a new market has been created whereby those who can generate carbon credits (and companies that have not used up their emission allowances) can sell these to carbon emitting industries. Currently, carbon emission allowances are trading at around €22 per
tonne.

Carbon Credit Creation

One example, and it is only that, of how to acquire carbon credits is to reforest areas of land that have been devastated by the “cut and burn” techniques used in the rain forests of Brazil and elsewhere.

To meet Kyoto’s stringent certification requirements, the business has to be able to demonstrate that the project will provide measurable, long-term carbonreducing benefits, and that it will do so following specific guidelines such as community integration, sustainability and biodiversity.

The carbon credits trading system involves the issue of carbon credits by the government of the country in which the reforestation or growing of other plants takes place, and these can then be sold on the carbon trading markets that currently exist in many of the financial centres of the world.

Carbon Credits Partnerships

Partnerships are effectively transparent for UK direct tax purposes, as is a Limited Liability Partnership, in that each partner, or member of the LLP, is usually treated for tax purposes as if he incurred his proportionate share of any partnership trading profit or loss himself. A member of a trading partnership which incurs a loss would usually be able to relieve his share of the trading losses against his income or capital gains.

Carbon Credits Partnerships can generally be seen as a variety of a research and development partnership. Their objectives are to create environmental credits with a view to trading them for profit. Growing environmental crops for the production of biodiesel as well as reforestation projects require feasibility studies preparatory to the crops being sown or planted. It should be noted, however, that access to such schemes is not guaranteed, and most are marketed by tax specialist businesses towards the end of each financial year as they are, to some extent, used as tax mitigation devices.

Expenditure in the first year will almost inevitably give rise to losses which will be, with most partnerships, close to 100% of the investor’s subscription.

Investors

Investors in Carbon Credits Partnerships are generally likely to be persons with substantial income or capital gains that they wish to shelter from tax - Premiership footballers, investment bankers and directors of the top 100 companies are prime candidates. The potential savings in any example are calculated on the taxpayer being liable at the 40% tax rate.

Illustrated example of potential benefits for the investor

It should be made clear at the outset, that this is simply an illustrative example. Any person considering investing in a Carbon Credits Scheme MUST take appropriate professional advice from competent tax and financial advisors. In this example, the following assumptions are made:

• The investor makes a capital contribution to a partnership of £200,000 by way of an initial capital contribution of £40,000 and a capital loan (which can be arranged by the partnership or borrowed directly from a third party) of £160,000.
• 80% of the partnership’s first-year expenditure may be written off by the investor against taxable income from other sources.
• The investor is a UK resident taxpayer paying higher rate tax, with sufficient income from other sources so that the entire loss can be written off at the 40% tax rate.

On this basis, the investor should receive a tax rebate of £64,000 being 80% of £200,000 (£160,000) at a tax rate of 40%.

It should be noted that the actual effective rate of tax relief obtained will depend on both the capital contribution raised by the partnership, and on the amount and timing of expenditures made. It may, therefore, be more or less than the 80% figure used in the illustration.

In the event that the initial trading activity is unsuccessful, and the partnership trades at a loss, the trading loss thereby incurred would also attract relief. In the worst case scenario, of a partnership being unable to sell any of its initial portfolio of carbon credits, this expenditure would be written off and up to 100% of the partnership’s expenditure would be available for relief in the first three years. In the illustration above, the investor paying tax at 40% would receive additional relief of £16,000 (£40,000 @ 40%) thereby bringing the full relief up to £80,000 and the net cash flow benefit achieved in the first three years would be £40,000. It is not unreasonable to suggest, however, that if the scheme was not expected to be profitable in the long term, it is unlikely to receive a recommendation from an independent financial advisor.

Obviously, if the partnership operation were to be successful, the investor would obtain dividend income and, of course, his loan would be repayable subject to any conditions entered into as a result of taking it out.

Carbon trading partnership tax

It is beyond the scope of this article to discuss the taxation position of the trading partnership. It should be appreciated that, for example, reforestation is a long term venture – perhaps taking up to 50 years, and tax legislation will not remain constant over such a time span, neither will environmental rules, nor interest rates.

Ian Fleming FIIT is the author of 'The Environmental Taxes Handbook', published by Spiramus Press. For further information and to order a copy of this title, click here.