As we continue to see an increased focus on environmental, social, and corporate governance (ESG) issues, one area seeing continued expansion is carbon offset projects involving the timber industry. In a prior article, we discussed the federal tax considerations for such projects and pointed out that the nature of the contract or project had a significant impact on how the income from such a project is treated. The same applies when we consider the state tax impact of such projects.
Compliance Markets
For federal tax purposes, the IRS considers the granting of offset units or credits in compensation of carbon sequestration agreements as a transaction separate from that of selling such credits or units in a compliance market. For federal and state tax purposes, this gives us two transactions to consider.
Transaction 1: Credit Issuance
Following the limited federal guidance available, we can easily determine that the initial transaction of exchanging carbon offsets units or credits for sequestration can be viewed as a sale of an easement. As such, most states should view that transaction as being sourced to the situs of the timber interests that is the source of the sequestration. If the contract is a long-term contract that could be viewed as a sale of a capital interest in real estate (not real estate held for sale in the ordinary course of business), the respective state guidance on such a transaction is fairly well established. What, then, do we have for a transaction in the compliance market when the contract is short-term? Returning to the federal guidance, if the contract is more of the nature of a lease agreement and cannot be viewed as a sale of an interest in real estate or a permanent easement, the state allocation or apportionment of rental income also is fairly well established for this portion of the transaction for most states.
Transaction 2: Sale of Credits
The second step in a transaction involving offset units or tax credits involves the subsequent sale of those credits. To what state is the sale sourced for state income tax purposes? For this step, we would first need to consider whether the income from the units or credits is apportionable income. Do we traditionally buy and sell such credits for gain, or is this activity a nonbusiness/investment activity in nature? Assuming that the credits were received as compensation in an offset project, we will assume for discussion purposes that the credits are not held in the ordinary course of business. As such, we consider them to be intangible assets. The sale of an investment asset or an intangible asset that is not held in the ordinary course of business is commonly sourced to the state of domicile for the seller.
If we look at California, which at this time is the only U.S. jurisdiction that issues such offsets or credits, we can see that such is the treatment. Because the buyer of these credits would be a company with a California presence and carbon liability, we would need to specifically consider whether the income from the sale of the offsets is sourced to the state of domicile or sourced to the market of the buyer. Even if our company were to lack nexus in California other than this transaction, economic nexus rules must be considered. If we take the position that the credits are intangibles not held in the course of business, California guidance indicates that the income generated from the sale is not apportionable or allocable to California. However, if our position is that these credits are inventory to our company, then the economic nexus rules may apply, causing a shift of the income to California.
This is a good point to refer you back to the previous article that discusses the tax basis impact of both pieces of such a transaction in any compliance market. It is reasonable to expect that the largest taxable gain would be realized in the initial transaction or at the granting of the offset units. The second transaction, or the subsequent sale of the units, would reflect a gain only in the valuation difference between the time of issuance and sale, plus or minus any transaction-related expenditures or fees.
Voluntary Market
A transaction for carbon sequestration offsets in a voluntary market, where the transaction is the result of a company’s desire to mitigate its own carbon footprint, could lead to a substantially different agreement and state tax impact.
Whether such agreement is a short-term agreement, which is more likely than not viewed as a lease, or that of a sale of an interest in real estate, the state tax treatment of those transactions again leads to a fairly clear answer. The income would be sourced to the situs of the property and apportionment or allocation would be determined based on the respective states’ rules regarding such (allocation and apportionment). In this type of transaction, the consideration as to whether the timber owned is in a trade or business, or that of an investor, could be important to the determination.
The majority of states seek to allocate this type of income if it is that of an investor, while most states follow apportionment rules for business income.
Summary
The nature of the agreement and the type of market in which any timber investor is participating have a significant impact on the state tax treatment of income from carbon offset projects. The answer and tax impact are not a one-size-fits-all kind of answer. As states move to adapt to a changing e-commerce market, we would expect them to also seek to adapt to new markets created by ESG initiatives. Each transaction should be carefully analyzed to determine all of the unique aspects that impact the ultimate tax burden of the investor. For state tax purposes, we not only have to consider the nature of the transaction (capital versus ordinary), but we also have to consider state nexus issues and allocation/apportionment issues.
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