On 20 September 2007, the government published the framework of a proposed emissions trading scheme in New Zealand (the Scheme). Three days later Inland Revenue released a paper entitled "Emissions Trading Tax Issues", which sets out an initial discussion of the core tax issues arising from the Scheme (the Issues Paper).
The design and implementation of the Scheme has occupied the attention of most businesses and commentators, which is understandable given the controversial nature of certain aspects of the Scheme. However, as tax can have a significant impact on financial performance and behaviour, it is important that the proposed tax treatment is not overlooked.
The purpose of this article is to briefly outline the Scheme and to examine the tax issues raised in the Issues Paper.
Outline Of The Scheme
The Scheme will introduce a price for greenhouse gas emissions into the New Zealand economy. The desired outcome is a change in investment and consumption behaviours as a result of changes in the relative prices of high-emission and low-emission goods and services.
Integrating the price of emissions into the economy will happen by placing an obligation on some entities that emit greenhouse gases, or supply products that create emissions when used by consumers, to monitor, report and pay (in emissions units) for actual emissions, or emission equivalents. These entities are referred to as "points of obligation". Points of obligation will not always be entities that emit greenhouse gases. For example, petroleum companies will be a point of obligation notwithstanding that the emissions arise when their product is on-sold and used by motorists.
The New Zealand Unit (NZU) will be the primary domestic unit of trade. Persons who are a point of obligation must surrender to the government one NZU to cover each metric tonne of carbon dioxide equivalent emissions.
The Scheme will operate on an annual period of 1 January to 31 December. Each year the government will allocate NZUs, either free of charge or by selling them by auction. NZUs can also be purchased on the secondary market.
Persons who acquire or receive NZUs will be able to:
- Hold them to meet the expected level of future emissions obligations, which will minimise any risk associated with adverse price movements between the date acquired and settlement
- Sell some or all of them in the expectation of later buying NZUs equal to the quantity of emissions in the compliance period or, if not a person with obligations, sell NZUs to offset increased input costs
- Sell some or all of them to make a profit (e.g. a person who simply trades in NZUs in a similar manner to other instruments such as shares).
At the end of the compliance period a person who is a point of obligation must surrender NZUs equal to its reported emissions.
Implementation of the Scheme will be through a transitional pathway that provides for gradual adjustment to emissions pricing across the economy. As a result, the Scheme will apply to forestry from 1 January 2008, to liquid fossil fuels from 1 January 2009, and to stationary energy (e.g. coal, gas, geothermal) from 1 January 2010.
In addition, it is expected that the government will allocate "free" emissions units to businesses who it perceives will need further assistance to mitigate the impact of the Scheme in the initial years.
The Issues Paper
The Issues Paper addresses a range of tax issues that are expected to arise from the Scheme. In particular, it examines the tax treatment of the free NZUs and the income tax treatment of costs which are incurred by businesses to meet their emissions obligations.
The Issues Paper adopts the approach that the consequences of the Scheme should be taxed in accordance with the existing taxation laws, with statutory intervention only being provided when needed for clarification. Such an approach is to be applauded as our tax system is sufficiently complex without adding another new regime.
That said, it is anticipated that there will be a change in market behaviour and possibly new structures and business opportunities will arise under the Scheme which may require specific statutory intervention from a tax perspective. There is some recognition of this possibility in the Issues Paper.
The relatively short timeframe that was set for submissions on forestry related tax matters (28 October, as compared to 30 November for non-forestry matters) has been criticised. Given the wide reaching impact that the Scheme will have on foresters, we expected more than 1 month might have been given for foresters to fully understand the Scheme, the Issues Paper and prepare submissions – rushed submissions can only undermine the robustness of the tax system. However, to be fair, the shortened timetable is primarily due to the haste with which the Scheme is being introduced by the government.
Tax Treatment Proposed (Non-Forestry Taxpayers)
For non-forestry taxpayers, the Issues Paper proposes that:
- Emissions related expenditure should be deductible on the basis that such expenditure is incurred in the ordinary course of carrying on the taxpayer's business. This outcome is expected to apply regardless of whether the expenditure is a direct result of the Scheme (e.g. a petroleum company which purchases NZUs) or is an indirect result of the Scheme (e.g. a transport company which pays more for fuel).
- Free NZUs allocated to taxpayers by the government should be treated as taxable income on the basis that those units are intended to compensate the affected taxpayers for their reduced profits. In effect this is similar to taxing a government subsidy.
- The annual compliance period for the Scheme will not usually coincide with a taxpayer's financial or tax year end. As a result, it is proposed that the expenditure incurred in acquiring NZUs and/or any income derived from the allocation of free NZUs should be recognised on an emerging or accruals basis over time.
- Taxpayers who acquire NZUs prior to their tax year end will be required to recognise (and pay tax) on any appreciation in value on those NZUs notwithstanding that such gains are unrealised and will inevitably be extinguished at a later date when those NZUs are surrendered to the government. Therefore a tax leakage is likely to arise for those who buy NZUs early in an appreciating market.
Tax Treatment Proposed (Forestry)
The forestry sector is unique in the sense that it has the ability to "store" carbon emissions (i.e. to act as a carbon sink until such time as the forest is harvested). The treatment of the forestry sector under the Scheme correspondingly reflects this uniqueness.
The distinction that the Kyoto Protocol makes between pre‑1990 and post‑1989 forests is reflected in the Scheme and in the Issues Paper:
- Owners of pre-1990 forests will generally be required to account for carbon released upon deforestation (i.e. when the forests are converted to non-forest land). No issues will arise when a pre-1990 forest is harvested and replanted, or if such a forest is simply allowed to regenerate.
- As NZUs will need to be acquired (and surrendered) for emissions that arise upon deforestation, the Scheme effectively imposes an additional cost on owners who change the use of their land. It is considered that this additional cost will result in a reduction in the land values of pre-1990 forests. To reflect this, the government has proposed that some NZUs be allocated to pre-1990 forests as partial compensation for this loss in land value.
- The Issues Paper proposes that the receipt of free NZUs be treated as a capital receipt, and not subject to tax. On that basis, any subsequent liabilities arising from a change in land use should then be treated as a non-deductible capital expense associated with preparing the land for a new use.
- Owners of post-1989 forests will have the opportunity to elect to participate in the Scheme. Owners who make such an election will be allocated NZUs for increases in carbon stored in their forests from 1 January 2008. However, they will also be required to account for the associated emission liabilities that arise should the carbon stored in their forests reduce.
- Post-1989 forest owners that stay out of the Scheme should not have any emissions consequences.
- The Issues Paper proposes to treat the allocated NZUs as a new taxable income stream to forest owners, as the allocation of NZUs for post-1989 forests arises directly from the growing of trees, which are typically treated as a revenue item. For the same reason, emissions obligations that arise when there is a net decline in carbon stocks stored in a forest (e.g. from harvesting) will then be treated as a deductible expense.
- As there is generally flexibility around the decision and timing to harvest a forest (and therefore flexibility around when a forestry owner is required to account for emissions), the Issues Paper acknowledges that there may be difficulty in recognising income and expenditure on an accrual basis. Options suggested in the Issues Paper to deal with this include:
- recognising income from the NZUs as they are received, and allowing a deduction for expenditure on an emerging basis, provided there is a definite intention to harvest or
- deferring recognition of income and expenditure on NZUs until a NZU is actually realised, or used to settle an obligation arising from the Scheme.
Finally, the Issues Paper specifically provides that the NZUs (being a chose in action) should be treated as a supply of services that is subject to GST. In particular:
- GST will apply when NZUs are traded by a registered person in a secondary market or sold through auction by the Crown through a public authority
- Input tax may be claimed if NZUs are acquired for the principal purpose of making taxable supplies
- NZUs acquired from non-residents will be treated as an imported service (and may give rise to a GST liability on the importer under the reverse charge rules)
- NZUs sold by registered persons to non-residents will generally be zero-rated as exported services
- NZUs gifted by a registered person will be treated as a supply for no consideration.
Overall the Issues Paper appears to have been largely non-controversial. This is due possibly to the fact that it does not appear to examine the issues or outline any alternative treatment in any particular detail – an instance of the "less is more" adage.
One issue which has generated some debate is the prospect of taxpayers who acquire NZUs early in an income year being subject to tax on unrealised gains arising from those NZUs even though the NZUs are then subsequently surrendered to the government in the next income year. It does seem distortionary for the tax system to impose a liability on an unrealised gain which will, in all expectation, be matched by an identical deduction in the next income year when the NZU is surrendered (although this criticism has been levelled at other tax reforms without success). It would also appear to be out of line with the general approach applicable to trading stock which is to apply a lower of cost or market value approach at tax year end.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.