Beware ‘hidden’ taxes around voluntary carbon credit trading

We are seeing several tax authorities around the world – particularly those in countries where climate projects are proliferating – exploring whether, and if so how, they might apply local taxes to derive additional tax income from investment in climate projects and the voluntary carbon credits generated from them.

It is an emerging issue but, as a recent policy change in the UK shows, one that can emerge almost overnight to alter the value of investment returns. It is a risk that we expect to grow in substance and significance amidst a complicated global tax environment and pressures on businesses, investment funds and other finance providers to demonstrate their ‘ESG’ credentials.

Decarbonisation, ESG, and the secondary market for voluntary carbon credits

Against the backdrop of international efforts to limit the effects of climate change, reflected in global accords like the 2015 Paris Agreement, businesses have been grappling with how to align with global climate objectives. For many, decarbonisation strategies, policies and practices are being shaped by national laws and regulation that seek to deliver on the international climate commitments governments have made. Others’ action is being driven by increased shareholder, activist and wider public scrutiny that associates with the need to transition towards a greener economy.

Entire industries are changing the way they operate. In the energy sector, there has been a shift towards renewable energy generation, while in the automotive sector, the market is responding to increased demand for electric vehicles – in part, in some countries, driven by regulatory change. Lenders, investment funds, and other funders of businesses and projects are also ‘greening’ their financing and investment strategies.

The move to decarbonise is, in some cases, seeing demand rise for natural resources – lithium and cobalt are needed to make batteries for electric vehicles, for example. Businesses and financiers right across the mining value chain are increasingly under pressure to demonstrate their environmental – and social and governance (ESG) – credentials. Those that cannot do so risk falling foul of regulatory requirements, becoming targets of climate litigation, and/or being negatively perceived by prospective investors, funders, and customers.

One way that businesses, investment funds and lenders are seeking to demonstrate their ESG credentials is through investment in, or financing of, environmental projects. One example in the UK might be investing in unused farmland to enable reforestation, but there is a myriad of different climate projects we have seen globally in places like Indonesia and Ghana where, for example, one project is concerned with restoring mangrove swamps.

Enhancing or conserving of carbon stocks in ecosystems can, under a system of certification, generate voluntary carbon credits – assets that attribute a greenhouse gas emissions reductions value to climate-positive activity. These credits can then be used by businesses to offset greenhouse gas emissions deriving from their operations.

Increasingly, it is not just the environmental value of voluntary carbon credits that is being recognised. A secondary market has emerged in which businesses have been trading in those credits. At a basic level, it allows businesses with spare voluntary carbon credits to sell them to those that need or want to offset their own emissions. The trading of voluntary carbon credits is controversial as some critics believe the carbon offsetting they facilitate detracts from investment in decarbonisation. However, the market is growing – and the financial value of the credits is increasingly being recognised in the investment and funding arrangements for environmental projects. Against this backdrop, new tax risks are emerging.

The global tax context and action to-date

Related to the rise of new tax risks is slow progress towards the recalibration of the global tax system.

For years, through efforts coordinated by the OECD, countries have been engaged in negotiations over the implementation of a new two-pillar global tax system which is designed to achieve a more even distribution of global tax revenues.

‘Pillar one’ is focused on redistributing taxation rights so that some countries – particularly in the developing world, in theory – would be allocated rights to a greater proportion of the tax paid by multinational companies. However, progress with that initiative has stalled and is causing frustration among countries that are seeking a greater share of global tax wealth.

This slow progress in transforming the global tax system is relevant in the context of voluntary carbon credits because, in the absence of the promised global agreed mechanism for tax wealth redistribution, individual countries are unilaterally exploring their options for increasing their tax take from international business and investment activities. For countries where climate projects are proliferating, the growth of the secondary market for the sale of voluntary carbon credits generated from such projects is coming onto the tax radar.

In Indonesia, for example, the issuance of new carbon credits was temporarily put on hold as the country deliberated over a new regulatory and tax regime, which remains a developing area where continued instability is expected, while in the UK, HM Revenue and Customs (HMRC) in May announced a change in VAT policy pertaining to the sale of voluntary carbon credits. Currently, VAT does not need to be applied to the sale of voluntary carbon credits in the UK, but that will change in September this year when such sales become subject to VAT.

‘Hidden’ tax risks

Over time, we expect policymakers and tax authorities to develop individualised approaches to the local taxation of the trading of voluntary carbon credits. There are several different tax levers countries could decide to pull.

For example, like the UK, some countries may decide to subject such trading to VAT. Other countries could consider taxing the underlying interest that is being sold – therefore, where the trade of voluntary carbon credits involves land, they could decide that the transaction constitutes a trade of a land interest and apply local real estate transfer taxes. Another option some might favour is to apply local capital gains taxes to what those countries might consider the sale of local property assets.

Whatever option countries pursue, a risk for investors in and financiers of environmental projects – and holders of and investors in voluntary carbon credits – is that the tax position changes overnight. Not every country will take the UK’s approach of applying a grace period before implementation. This matters in the context of environmental projects as these are often conducted in phases and result in the generation of voluntary carbon credits in stages. The value attributable to projects and the credits they generate could therefore change over time and affect the returns that can be achieved by investors.

A further risk that could arise from the introduction of new local taxes pertaining to voluntary carbon credits is that those taxes could be outside the scope of bilateral or multilateral double taxation treaties. Those treaties protect businesses from being taxed twice on the same profits. However, property taxes, for example, are commonly excluded from the scope of such treaties, meaning investors could find that they face local taxation in the country where voluntary carbon credits are generated and a further tax on related profits in other jurisdictions too.

This is a new issue that businesses, investment funds and other finance providers need to consider around their involvement with environmental projects and the trading of voluntary carbon credits. The tax position across most jurisdictions has yet to be settled, but it is prudent to account for hidden taxation when considering investment in environmental projects and/or the trading of voluntary carbon credits as we expect to see more countries develop a tax position that enables them to derive value from the increased activity in this largely unregulated market.