Government released a paper on 24 September 2007, to address New Zealand Emissions Trading Scheme (NZETS) tax issues (Footnote 1). Appropriate tax treatment of NZ Units is important to ensure that the policy rationale underlying the design of the NZETS, in particular the policy reasons underlying the free allocation of NZ Units, are not subverted.

The issues paper applies current tax law to determine the tax treatment of the NZETS (rather than proposing a new statutory tax regime for the NZETS).   Feedback on the issues paper will be taken into account in determining whether legislation is required to clarify uncertain areas, or where treatment under the current law could undermine the policy objectives of the scheme.   Because of the particular nature of the forestry sector, different tax rules are proposed for that sector.

The discussion below provides a starting point for submissions on the tax specific issues (due 31 October) and wider NZETS consultation.

Background

In our September 2007 'FYI' on Emissions Trading, we highlighted aspects of Government's long awaited proposals for an emissions trading scheme for New Zealand.  For a more detailed treatment of the 'why's' and 'hows' behind the Government's proposals for the  adoption of an emissions trading scheme as its core measure for mitigating climate change, go to http://www.simpsongrierson.com/publications/fyis/fyi-energy-works-.html 

To recap, the NZETS will follow a "cap and trade" model that operates within the cap on emissions set by the Kyoto Protocol for the first commitment period (2008 to 2012).  A core obligation is imposed on certain parties to hold and surrender to Government, a tradable emission instrument called a New Zealand Unit (NZ Unit) for each tonne of carbon dioxide equivalent emissions, for which it is responsible.  Government has identified six major sectors of the economy that will be progressively brought into the NZETS.  The forestry sector is the first sector with a start date of 1 January 2008.

The NZETS is designed to create an incentive for parties with emissions obligations to reduce actual greenhouse gas emissions.  This reduction will reduce their costs of complying with the NZETS (or alternatively, will provide increased benefits from participating in the NZETS).

The NZETS raises a number of tax issues.  Some of the key tax issues include:
deductibility of NZETS compliance costs;
whether the allocation of free NZ Units by Government is taxable income of the recipient;
timing of recognition of NZ Units for income tax purposes; and
GST issues.

Expenditure (other than forestry)

Under current tax law, persons carrying on a business can claim a deduction against their taxable income for expenditure incurred in carrying on that business.  Deductions are not available for expenditure that is of a capital nature.

The issues paper states that indirect NZETS costs will typically be deductible under standard income tax rules.  Deductions will be for items of a revenue account nature, such as increased input costs (eg the cost of electricity or oil), incurred in the course of carrying on a business.  Direct NZETS costs for oil companies in the liquid fossil fuels sector, for example, will be an incident or consequence of doing business.  It is an annual cost associated with the production process, from which income arises in a particular year.  The costs of meeting emissions obligations should be an expense and deductible under current tax law.

In terms of timing, the issues paper takes the view that these costs should be deductible on an accruals or emerging basis over time.  That is, a taxpayer will be able to claim a deduction at balance date, if the balance date occurs before the person is required to settle their NZETS obligations.

It is proposed that market values be used to determine the value of the accrued expenditure at balance dates.  The likely volatility of the price of NZ Units, along with other timing considerations regarding the actual point in time that NZ Units are acquired, raises interesting issues for NZETS participants regarding potential mismatches between the tax position and actual expenditure.

Income (other than forestry)

As part of the NZETS design Government is proposing free allocation of NZ Units to some industrial producers.  Somewhat intriguingly, it makes no mention of the fact that there is also to be a free allocation of NZ Units to the agriculture sector.  It is difficult to see why there should be different tax treatment, but why the omission?

The discussion around free allocation or “gift” of NZ Units suggests that, from a tax perspective, these units are in effect, compensation for revenue account expenses that are associated with emissions obligations or other costs arising from the scheme that will result in a reduction in business profitability. The paper proposes that NZ Units allocated to these participants under the free allocation mechanisms be either taxable income or represent a reduction in deductible expenditure.

In terms of timing, the issues paper takes the view that income from the allocation of free NZ Units should be recognised as taxable income on an emerging basis over time.  This means the income is recognised on a systematic basis in the same periods as the expenditures for which the NZ Units are intended to compensate the recipient.

Officials believe that market values should be used to determine the value of the accrued income at balance dates.

As touched on above, the recognition of income and expenditure on an accruals approach may have significant cash flow implications on participants.  Due to pricing volatilities, the actual liability of the participant on settlement of its NZETS obligations may be significantly different to that recognised on balance date for tax purposes.  Although there will be a "wash up" calculation to reconcile the figures, there will be timing and cash flow implications to manage.

Simpson Grierson sees issues relating to the recognition of income and expenditure on an accruals basis as a technically complex area which requires careful review by affected parties. 

Forestry sector – forests planted before 1990

Pre-1990 forest owners will incur NZETS obligations if they convert their land to non-forest land.  Free NZ Units will be allocated to recognise that the scheme will have an impact on land values, since there will be a potential liability if land use changes for example, from forestry to dairy.  The issues paper suggests that free allocation of NZ Units in this case should generally be treated as capital and remain outside the tax base (as a change in land use is generally a capital matter for income tax purposes).

Therefore, pre-1990 forest owners can sell their NZ Units for a tax free capital receipt.  If they decide to convert their land into non-forest in the future they will face a NZETS liability at that point.  However, if they need to buy NZ Units to cover that liability, it is proposed that the cost not be deductible for income tax purposes, as it will be capital in nature (as a change in land use is generally a capital matter for income tax purposes).

Forestry sector – forests planted after 1989

Post-1989 forest owners will be able to elect into the NZETS and receive NZ Units for net increases in carbon stored in their forests, but conversely, will have to surrender NZ Units if there is a net decline in carbon stocks stored in a forest, primarily as a result of harvest. 

The issues paper states that  the receipt of NZ Units should be taxable income of the forest owners, however, the cost of meeting emissions obligations are an expense that should be tax-deductible.  The rationale for this treatment is that the NZ Units relate to the operation of a revenue activity.

The issues paper notes that there are problems, however, in relation to the timing of recognition of accruing obligations for harvesting post-1989 forests (or loss of forest due to fire or disease etc).  The main difficulty with adopting an accrual method of recognition is the potential uncertainty regarding the timing of harvesting, as before harvest, the obligation to surrender NZ Units may be contingent.   This also affects the recognition of NZ Units received as income.  Several options are suggested to mitigate the impact of this.  They include:

recognising income from NZ Units as it is received and allowing a deduction for expenditure on an emerging basis provided there is an intention to harvest; or
deferring recognition of income from and deductions for expenditure on, NZ Units, until a NZ Unit is used to settle an obligation arising from the scheme, or is sold.

Post-1989 forest owners who intend to elect into the NZETS should consider making submissions in respect of the timing of the recognition of NZ Units, as this could have significant cash flow implications.  The approach of recognising NZ Units for income tax purposes when a NZ Unit is used to settle an obligation arising from the scheme, or is sold appears to be a practical solution and would be consistent with the income tax treatment of timber generally (ie the cost of timber is only deductible when the timber is sold – it is not deductible on an accruals basis).

Naturally, if a post-1989 forest owner elects to stay out of the NZETS, there will be no NZ Unit tax implications.

Goods and Services Tax

In relation to GST, the issues paper states that NZ Units will be treated as a supply of services and that the normal GST rules for non-exempt services will be applied.

However, as it is anticipated that NZ Units may become actively traded.  The issues paper has asked for submissions in respect of the GST position of traders who normally deal in financial services, such as shares or certain futures contracts which are generally exempt from GST.

It is not clear from the issues paper whether the allocation of free NZ Units by Government to a recipient will be subject to GST.  For example, under section 5(6D) of the Goods and Services Tax Act 1985, a GST liability will arise in respect of a registered person who receives a payment in the nature of a grant or subsidy from the Crown or any public authority.  Whether free allocation of a NZ Unit is, or should be considered a "payment" in the nature of a grant or subsidy is open to debate.  GST in this context has the potential to be a significant value issue for participants and one which should be specifically addressed as part of any discussion of tax issues.

Submissions

Submissions in respect of the forestry tax issues are required to be made by 28 October 2007.  Submissions on the general tax issues are required to be made by 30 November 2007.   Please contact a member of our Emissions Trading team if you would like to discuss this further or if we can assist in any way.

¹ The full text of the paper can be viewed online at
http://www.taxpolicy.ird.govt.nz

This newsletter is produced by Simpson Grierson. It is intended to provide general information in summary form. The contents do not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters.