Federal Tax Considerations for Carbon Offset Projects
The focus on environmental, social, and corporate governance (ESG) issues may be relatively new, but the timber industry has long been considered stewards of the forests and the environment. It is no surprise that as ESG continues to emerge, groups are turning to this industry to leverage their long-term stewardship. The voluntary carbon offset market is emerging from the shadow of the compliance markets and becoming an interesting investment for those who desire to offset their carbon footprint. We also are seeing programs established to provide an avenue for smaller landowners to participate in these markets as well.
With the emergence of new industries or revenue sources, the proper tax treatment of revenue and expenditures is a common consideration. This holds true for the carbon offset market. There are no existing federal tax laws or Treasury Regulations that specifically address the taxation of income generated from a carbon offset program, so we must look to existing laws, rulings, and regulations in other areas to determine the proper treatment. The IRS has issued a few private letter rulings (PLR) related to the real estate investment trust (REIT) industry and its treatment of carbon offsets. To emphasize the evolution of this industry, we have seen the IRS change its view on the treatment of this income.
In 2011, the IRS issued PLR 201123003, which stated that for REIT purposes, the sale of tradable carbon units in the compliance market equated to a single transaction for the sale of an interest in real property. This ruling did not address the issuance of the offset units, only the sale. While the ruling did not specifically address the income tax treatment, the position that the transaction was equivalent to the sale of an interest in real estate was insightful and supported a position that the income was that of a capital transaction. However, in 2017, the IRS rescinded and replaced the 2011 ruling. PLR 201720008 and PLR 201751011 stated the granting of units in exchange for the restrictions imposed by the program is a taxable transaction in and of itself, and any subsequent sale of the tradable units is a sale of an intangible asset. The IRS noted that the units were transferable and not inseparable from the underlying real property and are more properly considered to be intangible assets. The ruling also stated that the granting of the units in exchange for the land restrictions was akin to receiving payment for the granting of an easement for a term of years with respect to the taxpayer’s real property.
In many ways, the 2017 ruling falls in line with existing regulations regarding the timing and recognition of income. In summary, the income from the issuance of offset units is recognized upon the earliest of the following events to take place: units are earned, units are received, or units are due. A second income recognition event occurs with the subsequent sale of the tradable units. While these rulings provide clarity as to the timing of the multiple steps in the transaction, they do leave room for additional considerations for both federal and state tax purposes.
When you consider that the initial granting of units is akin to the granting of an easement, this causes the terms of the agreement to have a strong influence on how the transaction is reported for income tax purposes. Is the transaction a short-term easement that is equivalent to rent, or is the easement a long-term agreement that is akin to the sale of an interest in real estate? When you then consider the emergence of the voluntary market and acknowledge those agreements may vary widely as to the term, one cannot make a unilateral assumption about the taxation of carbon offset agreements in general. Some agreements will generate ordinary income, which is the equivalent to rental income, and some agreements will result in capital transactions from the sale of an interest in real estate. In addition, a determination must then be made as to the character of the income derived from the sale of the units. Are these assets held for sale in the ordinary course of business, or are they capital assets?
As this market continues to expand, additional guidance from the IRS should be expected. In the interim, each transaction should be carefully analyzed to determine whether the transaction is a capital transaction or a transaction equivalent to a lease. These determinations then lead to the consideration of state tax nexus and income recognition issues. A future article will address the state tax considerations of both the issuance and sale of offset units.
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