It is time to revisit the income tax treatment of forestry-generated carbon credits to ensure that the tax policy settings are not creating an impediment to investment in this important sector for New Zealand's climate change obligations.
Emissions Trading Scheme and carbon pricing
Climate change and addressing New Zealand's emissions targets are frequent topics of discussion in the media, with a lot of the commentary centred around the New Zealand Emissions Trading Scheme (ETS). The ETS establishes the trading market for carbon credits in New Zealand (NZUs). Businesses that carry out activities subject to the ETS are required to buy and surrender NZUs to the Government depending on the amount of emissions they produce.
NZUs are, however, finite and can be acquired by anyone who wants to invest in NZUs without necessarily having a surrender obligation as part of their business – any investor can open an account and acquire NZUs via secondary market trading platforms. NZUs have accordingly become a potential target for various investors and it is no surprise that the price of NZUs has increased from around $20 in March 2020 to over $70 in the most recent closing spot prices. The introduction of quarterly government auctions of NZUs has also influenced recent increases in prices.
As legal advisors we have seen the interest in carbon credits from both domestic and international investors increase markedly, given the eye-catching returns. Often those investment arrangements involve co-investment typically using a company, limited partnership, or a 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 when contrasted with the tax implications for conventional capital investment.
What's the tax issue under the current rules?
The income tax rules relating to NZUs were originally introduced in 2008, being the year that the ETS was enacted as part of the Climate Change Response (Emissions Trading) Amendment Act 2008. While there has been some tinkering over the years, the tax rules have largely been retained on the same principled basis since their introduction.
At the outset, it is important to note we have a stark demarcation from a tax perspective between pre-1990 NZUs and post-1989 NZUs. Pre-1990 NZUs are treated as capital account assets in recognition of the impact that the introduction of the ETS had on historical land values and the costs that would arise for those landowners if they changed their land use from forestry. Post-1989 NZUs, on the other hand, are treated as revenue account property on the basis that growing trees for harvest is generally regarded as a revenue account activity for income tax purposes.
Putting pre-1990 NZUs aside for the moment, "emissions units" are deemed to be "revenue account property" for income tax purposes. The effect of that position, and other relevant tax rules, is that the sale or disposal of an NZU in the market generally gives rise to taxable income and, if an NZU is transferred at other than market value, 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 accrued and are then historically surrendered to the Government on harvest of the standing timber. However, since those rules were introduced in 2008, the landscape has changed dramatically. There are many investors across the spectrum seeking to invest in this sector. Investing in carbon, not necessarily trees or timber, is now seen as an option that very much stands on its own two feet.
However, if a taxpayer has an accrued store of NZUs through investment in forestry or otherwise, any change in the legal ownership of those credits will give rise to a taxable event. This frequently arises as an issue to be managed in:
Carbon credit "lending", "leasing" or repurchase transactions – similar to securities lending or repurchase transactions involving debt or equity, these transactions involve an actual sale and purchase of the NZUs from a legal perspective (notwithstanding being in substance secured "loans").
Security arrangements for corporate finance facilities involving a transfer of credits to a designated account.
Co-investment arrangements in forestry and carbon, using vehicles such as companies or limited partnerships, where carbon credits are distributed to investors in accordance with their investment proportions as part of the agreed capital return.
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 for securities lending generally for financial institutions and others holding securities on revenue account. A key element of those rules was to tax qualifying securities lending transactions on the basis of economic substance (as secured loans) rather than legal form (as a sale and purchase).
In a similar manner, the introduction of specific tax rules for transactions in post-1989 forestry NZUs would be beneficial for the New Zealand economy and provide greater certainty in this area. In addition, it would allow taxpayers with accrued stores of NZUs to generate income from the credits rather than the NZUs being dormant balance sheet assets.
In particular, for co-investment arrangements in companies or limited partnerships where NZUs are distributed proportionately to investors, some consideration should be given to providing "roll-over 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 potential for no corresponding cash flow. "Roll-over relief" would allow the NZUs to be transferred to investors without triggering a taxable event.
The principles are identical to the most recent tax law changes for pre-1990 credits which are treated as capital account assets. Concessionary rules were introduced to ensure that the "securitisation" of those credits did not jeopardise their one-off capital treatment. It is understood Inland Revenue may be considering extending those concessions to post-1989 NZUs or whether the issues could be addressed via an alternative law reform avenue.
Given the significant and increasing investment in this sector, the revisions to rules of carbon accounting to include "averaging" and the revised targets for New Zealand's emissions, it would seem timely to revisit the policy settings here as a priority and consider a revised set of rules for post-1989 carbon credits generated from New Zealand forestry.