International corporations are more likely to employ voluntary carbon offsets as part of their initiatives to decarbonize their operations and meet their environmental objectives. Further information from HMRC would be appreciated, particularly as the market grows and becomes more regulated, as there are a lot of tax complications and hazards depending on how voluntary carbon offsets are going to be obtained and utilized by businesses. When multinational corporations approach their offset activities strategically, tax departments should be actively involved in the design and implementation of structured arrangements.
More than 4/5 of the FTSE 100 businesses are among the multinational corporations declaring voluntary goals to cut their carbon emissions and reach net zero across a variety of industry sectors. This is being done through reducing emissions, either by switching to more environmentally friendly operations and supply chains, or by stopping or selling off the most polluting aspects of their enterprises. However, parties who are keen to meet their goals earlier might decide to compensate for emissions that they currently believe would be exceedingly expensive or difficult to get rid of.
International corporations can voluntarily reduce their emissions by doing things like planting trees to absorb and remove carbon dioxide or encouraging the use of alternative energy sources, such clean cook stoves in rural areas, to prevent GHG emissions that would otherwise happen. Instead of businesses carrying out those actions directly, this decarbonization often takes place indirectly through the purchase of voluntary carbon offsets (“VCOs”).
Voluntary carbon offsets: what are they?
VCOs are intangible objects that are listed in a computer registry and each represent one metric ton of atmospheric carbon dioxide equivalent (“MTCO2e”). Independent non-governmental organizations including Verra, Gold Standard, the Climate Action Reserve, and the American Carbon Registry are among of the organizations that issue VCOs. The carbon-related goals of the underlying projects and the quantity of carbon being cut, avoided, or removed are certified by these standard-setting organizations. These agreements are voluntary and distinct from those related to some regulated sectors and systems, such the EU Emissions Trading Scheme (commonly referred to as “compliance market offsets”).
Voluntary carbon offsets enable the environmental advantages of project activities to be finally passed from the projects to companies or people looking to reduce their emissions. VCOs are sent either directly from the person doing the activity or through middlemen like developers, brokers, or marketplaces. The “vintage” of an offset, which designates the year in which the emission reductions or removals took place, is a specific year. A credit holder can claim to have reduced its carbon footprint by one MTCO2e when they “retire” an offset, which entails the irrevocable cancellation of a credit through a registry process. As a result, a business that produces emissions that are difficult to eliminate, such those from the steel industry or aviation, can say that by purchasing and retiring VCOs, its environmental impact has been lessened.
Dynamic market
The demand for VCOs has been rising quickly, and the market for them is international and quite dynamic. The market for offsets might grow to USD 15 billion in 2030 and USD 100 billion by 2050, according to consulting firm McKinsey, which anticipated that USD 1 billion will have been spent on offsets in 2021. There are a number of volunteer projects to create uniform design guidelines for VCOs. These are intended to broaden the market by increasing standardization. The market (and the industry more broadly) are currently only lightly regulated, but if the market grows further, there will likely be more calls for regulation along the lines of other commodity markets.
How do businesses obtain voluntary carbon offsets?
There are several different options for businesses to obtain voluntary carbon offsets. Simply put, they may buy VCOs off the market and retire them to offset their own emissions. As an alternative, they can try to strike deals, either directly or indirectly, with the manager of an offset project to guarantee a supply of VCOs in the future. These “emission reduction purchase agreements” entail a commitment to transfer offsets resulting from the project in the future on predetermined terms. For instance, businesses may sign long-term contracts to buy or “offtake” a portion of the credits produced by a specific project over time at predetermined costs. To develop the project, this may be used in conjunction with investment funds in the form of equity or debt.
How do companies tax voluntary carbon offsets?
When employing voluntary carbon offsets, UK companies may run into a lot of tax complications and difficulties. These are partially derived from ambiguities regarding the legal status, accounting treatment, and transactions involving these offsets.
VAT
Varying carbon offset forms and nations receive different VAT treatment. Transactions involving carbon offsets will only be liable to UK VAT if an identified supply is made by a business in exchange for payment of consideration. The purchase of a VCO does not constitute an identifiable consumable supply and is, thus, outside the purview of VAT, but the purchase of compliance market credits is a sale of services liable to VAT, according to HMRC. HMRC argues that the discrepancy can be explained by the fact that compliance market credits are regulated, verifiable, have a subjective value connected to the credit unit, and are sold on both domestic and foreign markets.
Although it is advantageous that HMRC has created a clear distinction between how carbon offsets should be treated in terms of VAT, there are two potential problems. First off, it is obvious that most other European countries lack clear guidelines on this matter, and that the tax authorities in some nations, like France, have stated their belief that voluntary carbon offsets should be subject to VAT in the same ways as compliant market credits. Consequently, there is international inconsistency even if Europe has a shared foundation. Second, according to HMRC’s commentary, VCOs may eventually be viewed by the buyer as a consumable supply and so be subject to VAT as VCO regulation is tightened and the global voluntary carbon market grows. A change in how VAT is treated can cause legal ambiguity and, in some cases, result in a purchaser paying VAT that is not refundable.
Corporation tax
The accounting treatment of VCOs serves as the foundation for evaluating their corporation tax classification. Due to the lack of clear direction from accounting standards bodies, the accounting is not precise. Without direction, management of businesses must rely on their own discretion, which may result in varying approaches to the same credit. In general, the accounting treatment is dependent on the intended use; if the VCO is promptly retired, the acquisition expenses may be recorded as an expense; if the VCO is maintained for use in the future, as an intangible fixed asset; or, if the VCO is held for trade, as inventory.
Any expense may not be deducted, in part because HMRC has not released any explicit guidance on VCOs. Trading companies in particular must take into account whether these costs are “wholly and exclusively for the objectives of the trade”. According to the facts and circumstances, the expenditure on the VCOs should pass this test (even if there are incidental benefits that accrue to others). However, if the trading company bears the expense solely or partially in the interests of its affiliates or other stakeholders, it may be challenging to argue that the expenditure is deductible. Therefore, it will be crucial for the business incurring the VCO expenditure to have a clear and justifiable reason for doing so. There are more intricate investment structures with longer time frames and varied terms, as was already mentioned. These may also have ambiguous accounting and tax repercussions.
Transfer price and global considerations
On their way to net zero, multinational corporations are acquiring and utilizing VCOs in a more strategic way. Given that VCOs are fungible in their use across a multinational group and have a global context for their creation and trading, such an approach is likely to involve some centralization of procurement activity. Transactions between group companies during such centralization might need to be conducted on arm’s length terms in order to adhere to transfer pricing regulations. A similar number of transactions could take place between group companies engaged in strategic carbon activities on the one hand, and those that may need to use VCOs to balance their own emissions on the other, given the variety of potential transactions that the group as a whole might engage in.
Determining acceptable and tenable arm’s length terms for transactions in VCOs within group companies may be challenging given the nature of the markets for VCOs and uncertainties surrounding their values. Who profits from the group’s expenditures is another topic of discussion. For instance, should the associated costs be split between key operational companies in the product’s internal supply chain on the basis of emissions offsets or on the basis of sales made if marketing a certain product as carbon-neutral benefits the group as a whole?
Voluntary carbon offsets taxation and multinational companies
It is also possible to develop carbon pricing agreements amongst group companies, as well as to use the pricing of externally bought VCOs as a foundation for other financial and investment decisions. Business units should be strongly motivated to decrease the carbon intensity of their operations and be assisted in prioritizing business model modifications to reduce or eliminate emissions by making polluting enterprises in the group pay a price for their emissions in the form of actual or notional offset. However, in order to abide by transfer pricing regulations, any actual fees imposed on group companies that produce emissions must be on terms that can be justified as being at arm’s length.
For multinational groups, the offshore tax treatment of VCO transactions may have tax ramifications. In places where projects are being done, the tax status of VCOs may be ambiguous, which could have tax ramifications for the company receiving the offsets or add to the entire arrangement’s tax costs. For instance, depending on the jurisdiction, the issuance of credits may be subject to indirect taxes or withholding taxes. Depending on the specifics of the contractual agreements and the local tax laws, there may also be a danger that the investor in a carbon project establishes a taxable presence in the project jurisdiction. The evaluation of options should take into account any associated tax expenses or hazards.
