How does the carbon price fit within the Tax Act?

There has been a lot of talk about the Government’s carbon pricing mechanism (CPM), including how this new scheme fits within the broader tax agenda. Reform aside, what are the real tax consequences of Australia’s adoption of a CPM?

The first step in understanding the impact of the CPM is to appreciate the mechanics of the proposed system. This is set out in the Government’s plan. I’m not going to provide a detailed description here (many other commentators have already done so, see useful links below). But if you just want the very basics, here is my attempt to explain it in a nutshell.

From 1 July 2012, major polluters will be required to purchase “carbon permits” for every tonne of emissions they produce. In the initial phase, the carbon permits will have a fixed price that is set by the government; after three years, there will be an emissions trading system, where the price of carbon permits will (generally) be determined by market forces. Certain industries are exempt. Some heavy polluters will receive assistance by receiving a number of free permits. In the emissions trading scheme, participants can buy and trade permits. At the end of each period, emitters are required to surrender permits equal to the emissions they produce. If an emitter does not have sufficient carbon permits, a shortfall emissions charge will apply (which is effectively an inflated charge for carbon permits).

I must stress, this is a very short form of the mechanics, and it is worthwhile reading the Government’s materials to completely understand the scheme. Keen observers will note that the CPM is not terribly different to the former Carbon Pollution Reduction Scheme (CPRS), though the politicians will certainly tell you otherwise.

It is worthwhile noting that whilst many, including the Government itself, describe the CPM as a “carbon tax” or “like a tax”, it is not, in the legal sense, a tax. Carbon permits are a form of assignable personal property that will be created under a statute. It is useful to think of them like a license.

The holding, trading and surrendering of carbon permits will have tax consequences. The Government has given some high level guidance on the tax treatment of permits (refer to the Government’s factsheet and page 109 of the Government’s plan).

I have set out below the Government’s intended tax treatment of carbon permits, as well as The Tax Institute’s initial reactions.

Overall design: specific provisions will be enacted in the tax legislation to deal with the treatment of carbon permits. This is a good approach, as it should avoid uncertainties (provided the law is drafted clearly!). This is a similar approach to what was adopted under the CPRS – you can check out the ill-fated CPRS tax legislation to get an idea of what the CPM tax legislation might look like (refer to Schedule 2 of the Bill).

Tax treatment of permits: broadly, carbon permits will be treated like an item of trading stock under a rolling balance method, with gains/losses on revenue account. The approach is sound because it removes the complex capital/revenue characterisation issues.

Tax treatment of penalties: the Government proposes that penalties will not be tax deductible. Though not set out in the announcement, this presumably extends to the emissions charge (which is charged when an entity does not have sufficient permits on hand to meet its emissions liability). We consider that the emissions charge should be deductible, as it is akin to the acquisition of additional permits.

Tax treatment of freely allocated permits: the Government proposes that freely allocated permits will be assessable (that is, to take the view that they are akin to a non-cash benefit, which would usually be assessable). Our view is that freely allocated permits are like a form of compensation; by applying TR 95/35 principles, they should not be included in assessable as income.

Supplies of carbon permits under GST provisions: in a welcome move, the Government has announced that the supply of carbon permits will be GST-free (this is contrast to the position under the former CPRS, where buying and selling a permit would have been a taxable supply). Making the supply of carbon permits GST-free will ensure that significant GST costs (including financing costs and compliance costs) are not incurred by taxpayers.

Supplies of carbon permit derivatives: the Government has announced that he normal GST rules will apply to transactions in financial derivatives of carbon permits. We are continuing our analysis of the impact of this planned treatment, particularly in light of the existing treatment of derivatives.

The Government’s climate change policy contains a range of programs to encourage emissions abatement, including grants to support the development of clean energy. It is interesting that the Government has not tinkered with the existing R&D tax concessions in order to offer more support for innovative clean energy projects. We have made a number of suggestions to the Government on how the tax system can be used to support investment in clean energy technology, and we look forward to exploring these possibilities with them.

The Tax Institute’s Climate Change Committee is standing by to review the draft legislation, which is due to be released by 31 July 2011. Although the interaction with the tax system is not the primary policy driver, it is still crucial that the CPM does not create unnecessary compliance costs, which would ultimately reduce the scheme’s efficiency.
I’m interested to hear your thoughts on the CPM – are there any areas of tax uncertainty that you think the Government should address?

I have listed a few helpful resources and sources of analysis on the CPM. If you have any suggested reading materials, please note them in your comments.

Useful links
Parliamentary Library’s comparison of the CPRS and the CPM
KPMG's guide
Allens Arthur Robinson’s Climate Change Blog and tax consequences analysis
Freehills’ Brief and a tailored brief for the mining industry
Greenwoods & Freehills' Tax Brief

POST SCRIPT: the draft legislation was released on 28 July 2011 for public comment. You will find the tax amendments in Schedule 2 of the Clean Energy (Consequential Amendments) Bill 2011. Ready, set, review!