As the global business community adopts more sustainable practices, there is a growing need for companies to find new ways to reduce carbon emissions. One way is by investing in voluntary carbon offsets (VCOs), which allow a company to neutralize its emissions from sources it cannot eliminate through operations. VCOs can be purchased from carbon credit exchanges and are used in compliance or voluntary markets. As the market for VCOs evolves, it is important to understand how these investments will be taxed.
The IRS has issued private letter rulings (PLRs) that address the income tax treatment of carbon credits. While most of these PLRs are based on specific circumstances, the guiding principles in the rulings can help businesses navigate the tax implications of carbon credit exchange.
In general, the term “carbon credit” refers to a reduction in greenhouse-gas emissions that can be purchased and sold. This reduction may be achieved through a number of methods, including avoided nature loss (including deforestation), nature-based sequestration through reforestation or forest management, or technology-based carbon capture and sequestration. In addition, some projects that are considered to generate carbon credits are the reforestation of land previously used for agriculture or for mining activities and the capture and storage of methane from landfills.
There are two main types of carbon pricing initiatives: emissions trading systems (ETSs) and carbon taxes. ETSs are systems that operate like a cap-and-trade system, while carbon taxes are systems that operate more like a baseline-and-offsets model. While different jurisdictions use different terminology, the distinction between these two types of initiatives is largely technical in nature.
The Bipartisan Budget Act of 2018 introduced significant changes to Section 45Q, which is a federal tax credit for carbon capture and sequestration. In the final version of the legislation, the program was expanded to include carbon dioxide and carbon oxide. It also removed limits on how many credits could be claimed in a year, allowing investors to claim credits for carbon captured through a project placed in service in a calendar year after February 9, 2018.
A key question in determining the taxability of Section 45Q credits is whether or not they are capitalizable under Sec. 263. The answer depends on whether a taxpayer owns the equipment that physically or contractually ensures that the carbon dioxide and carbon oxide are captured, stored, or injected in secure geological storage spaces or utilized as a tertiary injectant in connection with oil or natural gas extraction processes.
VCOs are often sourced in compliance markets, where participants are required to reduce their net emissions by a particular deadline. However, a number of businesses are taking on the voluntary challenges of carbon reduction and using VCOs as part of their environmental, social, and governance (ESG) strategies. As the carbon markets continue to develop, it will be essential that businesses are prepared to identify and explain why the purchase of VCOs is a current ordinary and necessary expense. Otherwise, the IRS could potentially disallow the deductions and credits that are increasingly being offered for sustainability-related expenditures.