It is time to review the tax treatment of carbon credits generated by forestry to ensure that tax policy settings do not create a barrier to investment in this important sector for New Zealand’s of climate change.
Climate change and meeting New Zealand’s emissions targets are frequent topics of discussion in the media, with much of the commentary centering on New Zealand’s Emissions Trading Scheme (ETS) -Zealand. The ETS establishes the New Zealand (NZU) carbon credit trading market. Companies carrying out activities subject to the ETS are required to purchase and return NZUs to the government based on the amount of emissions they produce.
NZUs are however limited and can be acquired by anyone wishing to invest in NZUs without necessarily having a redemption obligation as part of their business – any investor can open an account and acquire NZUs through secondary market trading platforms. NZUs have therefore become a potential target for various investors and it is no surprise that the price of NZUs rose from around $20 in March 2020 to over $70 in the latest closing spot prices. The introduction of quarterly NZU public auctions has also influenced recent price increases.
As legal advisors, we have seen interest in carbon credits from domestic and international investors increase dramatically, given the eye-catching returns. Often these investment agreements involve co-investment usually using a corporation, limited partnership or joint venture, and often with an international tax aspect. The tax implications for investing in forestry and NZUs, however, are often complicated and can be counter-intuitive to the tax implications for conventional capital investments.
The income tax rules relating to NZUs were originally introduced in 2008, the year the ETS was enacted as part of the Climate Change Response Amendment Act 2008 (Exchange of emissions). Although there have been some tweaks over the years, the tax rules have largely retained on the same principle basis since their introduction.
At the outset, it is important to note that we have a clear demarcation from a tax perspective between pre-1990 NZUs and post-1989 NZUs. Pre-1990 NZUs are treated as capital given the impact that the introduction of ETS has had on historical land values and the resulting costs to these landowners if they change their land use from forestry. Post-1989 NZUs, on the other hand, are treated as revenue account property on the grounds that growing trees for harvesting is generally considered a revenue account activity for income tax purposes.
Aside from pre-1990 NZUs at this time, “emissions units” are deemed to be “revenue account property” for income tax purposes. The effect of this position, and other relevant tax rules, is that the sale or disposal of an NZU in the market will generally give rise to taxable income and, if an NZU is transferred at a value other than the value market, there will be a deemed disposal at market value for income tax purposes.
The current tax rules generally work well in a scenario where trees grow, NZUs are accumulated and then historically are returned to the government upon harvesting of stumpage. However, since the introduction of these rules in 2008, the landscape has changed dramatically. There are many investors across the spectrum looking to invest in this sector. Investing in carbon, not necessarily in trees or wood, is now seen as a self-sufficient option.
However, if a taxpayer has an accumulated stock of NZUs through investments in forestry or otherwise, any change in the legal ownership of those credits will give rise to a taxable event. This frequently arises as a problem to be managed in:
Carbon credit “lending”, “letting” or repurchase transactions – similar to securities lending or repurchase transactions involving debt or equity, these transactions involve the actual sale and purchase of NZUs from a point of exchange. legal view (although in essence these are secured “loans”) .
Security agreements for corporate finance facilities involving transfer of credits to a designated account.
Forestry and carbon co-investment agreements, using vehicles such as corporations or limited partnerships, where carbon credits are distributed to investors based on their investment proportions within the agreed return on capital.
Should we introduce special rules or roll-over relief for certain transactions?
In the mid-2000s, new tax rules were introduced to address the tax position of securities lending generally for financial institutions and others holding securities as income. A key element of these rules was to tax qualifying securities lending transactions on the basis of economic substance (as secured lending) rather than legal form (as sale and purchase).
Similarly, the introduction of specific tax rules for transactions in post-1989 forestry NZUs would benefit the New Zealand economy and provide greater certainty in this area. In addition, it would allow taxpayers with accumulated reserves of NZU to generate income from credits rather than NZU being dormant assets on the balance sheet.
In particular, for co-investment arrangements in corporations or limited partnerships in which NZUs are distributed proportionately to investors, consideration should be given to providing “rollover relief” for such distributions. In principle, taxing a gain on the ultimate sale of carbon is not particularly controversial. However, investors should have the ability to extract credits from co-investment vehicles without triggering deemed taxable income with the possibility of no corresponding cash flow. “Rollover relief” would allow NZUs to be rolled over to investors without triggering a taxable event.
The principles are identical to the most recent changes in tax law for pre-1990 credits that are treated as capital account assets. Concessional rules have been introduced to ensure that the “securitization” of these credits does not compromise their one-time capital treatment. It is understood that the Inland Revenue may consider extending these concessions to post-1989 NZUs or if the issues could be resolved through another avenue of legislative reform.
Given the large and growing investment in this sector, revisions to carbon accounting rules to include the “average” and revised targets for New Zealand’s emissions, it would seem appropriate to revisit the policy parameters here in priority and consider a revised set of rules for post-1989 carbon credits generated by New Zealand forestry.