This post is built around a letter sent by Business Europe to the European Commission this week. Despite the current focus on BEPS, this is an important issue to resolve in the short term.
“Now that the EU ETS has entered its phase 3 and cross-border activities are given more opportunity to expand through on-going initiatives such as the linking of the EU ETS to the Australian carbon market and the recently announced carbon market in PRC, business should be increasingly concerned about the negative consequences arising from an absence of consistent best practices on tax treatment of emission permits and credits.
The key issues have been well identified by the Copenhagen Economics report “Tax treatment of ETS allowances- options for improving transparency and efficiency” and published in October 2010:
First, the absence of common rules within the EU as regards to the treatment of emission allowances in direct taxation has the potential to introduce significant distortions in the internal market. ETS efficiency depends heavily on its ability for all enterprises to have the same marginal cost of emitting greenhouse gasses and the same benefits from reducing CO2 emissions. But systematic differences in post-tax costs of purchasing CO2 between Member States open up opportunities for tax arbitrage and can affect the level playing field for businesses and tax losses for Member States. This can be a serious issue given the extreme mobility of trade in allowances carried out simply by a shift between accounts in the electronic register. Differences in tax systems further increase the risk of unnecessary compliance cost for firms and authorities.
Secondly, the possibility of purchasing or creating emission credits from Clean Development Mechanism and Joint Initiative projects and the future linking of the EU ETS with other regional/national cap-and-trade schemes could further exacerbate the problems of inconsistent tax treatment in cross-border situations. The OECD Model Tax Convention does not currently deal explicitly with tradable permits (or emission allowances), and therefore the treatment of income derived from trading of allowances in bilateral tax treaties depends on their treatment in domestic law of tax jurisdictions. In this regard, the practices may vary between the countries as several possible interpretations exist. Inconsistencies in domestic law treatment could actually lead to failure in relieving double taxation, which would increase the costs to market participants.
There is an urgent need to gain agreement on a common tax treatment of emission allowances by Member States within the EU both domestically and in cross border transactions. A possible action plan could be as follows:
Take forward Copenhagen Economics conclusions as best practices stating that:
No depreciation should be allowed;
Deduction of auctioned allowances purchasing costs should be allowed at the time when they are used;
Capital gains/losses on allowances should be taxed when they are realised, for consistency with the rest of the tax system;
Regarding free allowances, a preference should be given to the solution “not taxed when received, no later deduction when used”.
OECD’s decision to expand its public discussion draft on tax treaty issues related to the trading of emissions permits to issues arising from the trading of CERs (Certified Emission Reduction credits) and ERUs (Emission Reduction Units) as well as arising from the issuance, as opposed to the trading, of emissions permits, CERs and ERUs is a positive move. I would recommend that a consultation between the Commission, Member States and Business should be launched with the aim of delivering a best practice set of guidelines in this important field.”
This obviously relates to the EUETS, but the principles are just the same for other emission trading systems as they are set up. The current focus on Beps has meant that environmental taxes and charges have taken a back seat, this is understandable. But going forward this will be a significant issue and it would be ironic if the focus on BEPS meant that the tax treatment of this new market allowed tax arbitrage which then had to be fixed by a later “environmental beps”. Attention needs to be focussed on this area to achieve a platform for tax to not be a factor in emission trading.