Simplifying Tax for C.A's and Taxpayers
Learn About Carbon Credits

Learn About Carbon Credits

Income from transfer of carbon credit shall be taxable at concessional rate of 10% plus applicable surcharge and cess.” (Budget 2017-18)

Though I have read this term “carbon credit” many times, but since it was never a subject of significance to me, I never attempted to understand them. But while reading the proposed tax amendments in Budget 2017-18, proposal to tax income from carbon credits at 10% as mentioned above, ignited in me a curiosity to learn about them. Yes, it is time to unveil them.

I read many articles and felt like sharing my understanding with my readers.

Background

We have grown up studying about greenhouse gases and global warming in our academic curriculum. In last few years, we heard about the rising concerns as to climate change resulting on account of emission of harmful greenhouse gases (GHG). The topics such as melting glaciers, stranded polar bears etc. have become issues to discuss.

Considering the danger alarmed by the global warming statistics, countries came together and signed an agreement called Kyoto Protocol to reduce emissions. Hope you recollect the recent term “Paris Agreement” starting in 2020, post Kyoto Protocol.

The protocol grouped parties to the treaty and listed developed countries in the Annexure I for which emission targets were made mandatory. It laid down various mechanisms by which such parties can reduce their emissions. 

Now, what is a carbon credit?

Carbon credit is like placing a monetary value on the cost of polluting the air.

These are units issued under Kyoto Protocol for reducing emission of greenhouse gases. One carbon credit is equivalent to one ton of carbon dioxide or an equivalent amount of other GHGs mitigated.

Let’s discuss an example to understand it better.

Suppose a business that owns a factory emitting 50,000 tonnes of greenhouse gases in a year. Its government is an Annexure I country that enacts a law to limit the emissions that the business can produce. So the factory is given a quota of say 40,000 tonnes per year.

In accordance with the mechanisms specified under Kyoto Protocol, the factory has two ways to meet the new norms of emissions:

  1. It can reduce emissions by adopting new technology or improving existing technology and earn carbon credits for achieving standard set. In many cases, achieving these emission norms require massive upgradation or revamping of facilities, implying incurring costs too huge to justify the investment.
  1. Second option is to continue with existing technology, releasing carbon in excess of their limits and offset the excess that is 10,000 tonnes (Equivalent to 10,000 carbon credits) by paying for the same.

This forms the basis of carbon credits. If you emit 1 ton less carbon, you earn 1 carbon credit. The businesses that meet the emission targets laid down, earn carbon credits to the extent of GHG mitigated. Such carbon credits could be sold to those units which do not meet the targets.

You must be thinking that carbon credits provide an escape route for polluters allowing them to emit carbon and get away with it by buying credits.

Certainly not!!

As per the norms, the businesses cannot buy 100 % of the carbon credits they are required to reduce. Reductions have to be met through local measures up to a specified percentage.

Types of carbon credit

There are three types of carbon credits to serve three different purposes:

  1. Assigned Amount Units or AAU

As per Kyoto Protocol, each Annex I country is allotted a fixed amount of AAUs by the United Nations Framework Convention on Climate Change (UNFCCC). This represents the maximum GHGs the Annex I Country can emit into the atmosphere. The Annex I Country in turn will distribute AAUs to industrial organizations in its country who want to emit carbon into the atmosphere.

  1. Emission Reduction Unit or ERU

Apart from the AAUs allotted by the UNFCCC, a developed country can set up projects that reduce carbon emission in another developed country, to earn carbon credits from UNFCCC. The carbon credits so earned are called Emission Reduction Unit or ERU. ERUs can be used by the developed country to set off against its own emissions.

  1. Certified Emission Reduction or CER

This type of carbon credit involves the developing and least developed countries which are not parties to the carbon reduction commitment. The process of obtaining these CERs is known as Clean Development Mechanism or CDM. The projects undertaken by the developing countries which reduce carbon emission are allotted CERs by the UNFCCC. 

We have prepared a chart to provide a picture of the Kyoto protocol and the mechanisms thereunder.

Kyoto protocol and the mechanisms

Price of carbon credit

The ultimate buyers of credits are often individual companies that expect emissions to exceed their emission targets. Typically carbon credits are purchased either through CER purchase agreements, trading on the stock exchanges or even by bidding for tenders floated by several governments.

Some examples of exchanges trading in UNFCCC related carbon credits:

  • Chicago Climate Exchange (until 2010),
  • European Climate Exchange,
  • NASDAQ OMX Commodities Europe,
  • European Energy Exchange.

Since allowances and carbon credits are tradable instruments with a transparent price, financial investors can buy them on the spot market for speculation purposes, or link them to futures contracts.

Carbon credit prices are normally quoted in euros per ton of carbon dioxide or its equivalent (CO2e). 

India and Carbon credits

India is a signatory to the Kyoto Protocol. However, it is not an Annexure I country which means it is not binding on it to achieve emission targets.

On a positive note, it implies that the benefit can be earned in form of technology transfer and foreign investments by way of clean development mechanism (CDM) and earn carbon credits.

In India, National Clean Development Mechanism (CDM) Authority (NCDMA) is the designated national authority that evaluates and approves CDM Projects. To know more about it, you can refer the link: http://www.cdmindia.gov.in

It is worth appreciating that the CDM and other market mechanisms have supported development and implementation of about 3,000 projects from India till December 2012, out of which about 40% have been registered with UNFCCC. These registered projects represent an investment of over INR 1.6 trillion and have generated over 170 million carbon credits that can be used by developed countries to meet their compliance requirements under the Kyoto Protocol.

However, in the existing times, price of carbon credits has slashed to less than Euro 0.50. Further, since 2012, new applications for grant of credit have not been entertained under the UN framework. However, companies in renewable energy sector, including wind farms, or those who adopted green technology, which had applied for it before this date, continue to accumulate credits.

Trading of Carbon Credits

Carbon, like any other commodity, has begun to be traded in India.

With a view to launch carbon credits, Multi Commodity Exchange of India limited (MCX) entered into a strategic alliance with the Chicago Climate Exchange (CCX) in September 2005. It launched carbon credit futures trade in 2008.

Now we move on to the accounting and taxation aspects of carbon credits.

Accounting practices    

The following image provides the status of accounting under the different accounting frameworks:

accounting for carbon credits

As we can see from the above table, there is no specific authoritative literature for accounting of carbon credits. This has resulted in divergent schools of thought for accounting carbon credits.

Direct Taxation aspects with respect to India

  1. Whether taxability arises at the time of entitlement or sale of CERs?
  2. Whether receipt on sale is a capital receipt or business income?
  • If it is a capital receipt, whether there is a capital gain?

These questions still remained unanswered.

Income-tax Department has been treating the income on transfer of carbon credits as business income which is subject to tax at the rate of 30%. However, divergent decisions have been given by the courts on the issue as to whether the income received or receivable on transfer of carbon credit is a revenue receipt or capital receipt.

Here we would like to mention that the Direct Taxes Code Bill, 2010 and 2013 explicitly provided that money received or receivable from transfer of carbon credits will be treated as business income. However, Income Tax Act was not amended to incorporate the DTC provision with respect to receipts for transfer of carbon credits. This implies the intention of the law not to tax such sale of carbon credits.

Finally, there is a tax proposal in Budget 2017-18 to tax income from transfer of carbon credit at concessional rate of 10% plus applicable surcharge and cess. But that also failed to provide clarity on the controversy as to nature of receipt from transfer of carbon credits.

Highlights of Budget 2017-18 tax proposal on carbon credits:

budget 2017-18 on carbon credtis

Indirect taxation aspects

In 2010, Government of National Capital Territory of Delhi concluded vide notification No. 256/CDVAT/2009/43 dated 13.01.2010 that Certified Emission Rights (Carbon Credits) are taxable under DVAT Act, 2004 and the rate applicable is 4% as the said item is covered under Entry No.3 of Schedule III appended to the DVAT Act, 2004 Intangible goods. The basis for such conclusion is:

  • It is a certificate having market value.
  • There are people/entities who are willing to sell and others who are willing to purchase such certificates.
  • The intrinsic nature and value of carbon credits coupled with their free transferability makes the said product a marketable commodity.

The said product is therefore covered under the definition of the term “goods” as it figures in subsection (1) of Section 2 of DVAT Act, 2004.

In the same year, Bangalore Chamber of Commerce and Industry (BCIC) mentioned that carbon credits should be treated as services and taxed as such. In its note for submission to the Union Government, BCIC has argued that CERs are intangible in nature and it is either exported to industrialized countries or tradable as securities on specified exchanges. Hence CERs should attract only services tax, not goods tax. The taxability of the CERs should depend on the place where they are generated and the place where they are registered. It said in case the place of generation is in India and the place of registration is outside India, they should be regarded as exported.

In nutshell, even the indirect aspect of taxation is not free from divergent views.

Hope this article provides a good idea to you all about carbon credits.  Carbon credits are just one way towards sustainable development. All of us are responsible human beings and must effort to keep the environment clean. GO GREEN!!

Sources:

  1. Wikipedia
  2. Guidance Note on Accounting for Self-Generated Certified Emission Reduction
  3. Finance Bill 2017, India
  4. Direct Tax Code, 2010
  5. cdmindia.gov.in
  6. iasplus.com
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