Emissions Trading Scheme amendments - income tax

2010 amendments to the income tax treatment of the allocation of emissions units to qualifying businesses in the Emissions Trading Scheme.

Section ED 1B of the Income Tax Act 2007

Amendments have been made to the income tax treatment of the allocation of emissions units to businesses in those sectors which qualify for allocation under the New Zealand Emissions Trading Scheme (NZETS) (see the description of Industrial Allocation at https://www.mfe.govt.nz/climate-change/new-zealand-emissions-trading-scheme/participating-nz-ets/industry-nz-ets-1). The new provisions align the recognition of income to the business's entitlement to receive emissions units under amendments made to climate change legislation in 2009.

Background

The Government introduced the NZETS by way of amendment to the Climate Change Response Act 2002. Under that Act:

  • businesses in certain sectors are required to surrender emissions units to the Government based on greenhouse gas emissions they either produce themselves or which products they sell will ultimately produce; and
  • the Government allocates emissions units to businesses carrying out specific activities under the Industrial Allocation rules to reduce the economic impact the emissions trading scheme would otherwise have. These activities have met the eligibility criteria of being emissions intensive and trade exposed.

A further important component of the NZETS is trading in emissions units taking place between business vendors and purchasers, such as businesses which have been allocated emissions units selling them in private transactions to businesses which have an obligation to surrender units. For more information on the emissions trading scheme see https://www.mfe.govt.nz/climate-change.

The majority of transactions in emissions units are on revenue account, and so give rise to taxable income or deductible expenditure as appropriate. Ordinary principles are supplemented by express statutory rules to achieve this outcome.

The basis of allocation of emissions units for Industrial Allocation was changed in 2009. Under those changes, businesses carrying out an eligible activity will receive allocations calculated by reference to:

  • the level of assistance which applies to businesses carrying out each specific kind of activity in the relevant emissions year; and
  • the business's production output for the emissions year.

Emissions years are always calendar years. Allocation to businesses under the Industrial Allocation rules (other than those in the agricultural sector) will be made on the following basis:

  • The business will receive a provisional allocation of emissions units in the first half of the relevant emissions year. That interim allocation will be based on the business's production in the previous emissions year.
  • In the first half of the following year, a "square-up" will take place, by reference to the business's actual production in the previous emissions year. If the business has received too many emissions units (production was lower than the previous year) it will be required to either transfer the excess units back to the Government, or offset them against a future allocation. If the business received too few emissions units (production increased compared to the previous year) then it will receive additional emissions units.

These allocations begin from 1 July 2010 (note that the explanation above applies for full years beginning 1 January 2011 and following; different timing applies to the initial six-month period). The allocation mechanism for the agricultural sector is simpler - a single allocation will be made, after the end of the emissions year, based on final production figures. The agricultural sector enters the emissions trading scheme from 1 January 2015.

Key features

Section ED 1B provides the rule which values units allocated by the Government and which are held at the end of the year (zero-value units). Under the new rules, income arises from valuing an appropriate number of zero-value units at market value. The appropriate number of zero-value units to value at market value is determined by applying the formula set out in the Climate Change Response Act 2002 to the business's production for the income year.

Application date

The income tax amendments apply from 1 July 2010.

Detailed analysis

The new rules conceptually need to do two things:

  • determine an amount of income to be recognised in the year arising from the entitlement of the business to be allocated emissions units; and
  • ascribe values to those units which are actually received by the business during the course of the income year to enable rules dealing with transactions like sales and surrenders to work on a sensible basis.

The new legislation deals with these two issues simultaneously.

Ordinary concepts of accrual accounting are used to determine the business's income (defined as "unit entitlement" in section ED 1B(7)). Sections 83 and 85 of the Climate Change Response Act 2002 provide a statutory formula by which the business's ultimate entitlement to units for the income year can be determined. The formula multiplies some known factors (the prescribed level of assistance, and the "allocative baseline" for the specific eligible activity) by the business's production output for the year to determine the business's ultimate entitlement to an allocation of units. If the business's income year does not end on the same 31 December date as an emissions year, two calculations are likely to be required, because the prescribed level of assistance changes from one emissions year to the next. These income calculations are likely to be the same as those used for financial reporting purposes. The output of these calculations is a number of emissions units which, when multiplied by the market value of emissions units, is an amount of income.

It is likely that the business will have received some emissions units from the Crown during the course of the income year, and may still hold some or all of them. Because of the two-step method of allocation, it is unlikely that the business will hold precisely the same number of emissions units as its allocation as described in the previous paragraph.

In the simplest scenario, if the business has not carried forward from a previous year a unit shortfall, subsections (6) and (8) will assign year-end market value to the number of zero-value units held as equal to the unit entitlement determined under subsection (7). If the business holds more zero-value units than the unit entitlement, the excess units are assigned a value of zero (subsection (8)(b)) to be carried forward into the next income year. (See Example 1.)

If the business holds fewer zero-value units than the unit entitlement (unit shortfall), subsections (9) and (11) effectively create an additional amount of unit value (unit shortfall value), which the business is required to recognise as income by virtue of its addition to the value of emissions units held under subsection (11). (See Example 2.)

The consequences of a unit shortfall in a previous year are dealt with by subsections (3), (4) and (10). Zero-value units received in a year subsequent to a unit shortfall year are first applied to the unit shortfall, by being valued at the market value which applied at the end of the unit shortfall year. (See Example 2)

These income recognition rules also apply to emissions units transferred to Negotiated Greenhouse Agreement participants to compensate them for the increased cost of their inputs.

Example 1: Falling production - excess emissions units allocated

A Ltd has a 31 December year-end. In March the Government transfers 150 emissions units to A Ltd. However, because of falling production, its final allocation for the year is only 100 units. It values 100 units at market value at year-end, and continues to hold the remaining 50 at nil value. These units will either be transferred back to the Government or offset against a future allocation.

Example 2: Rising production - insufficient emissions units allocated

B Ltd has a 31 December year-end. In March the Government transfers 100 emissions units to B Ltd. However, because of increasing production, its final allocation for the year is 150 units. It values all 100 units at market value, and records an additional amount of income equal to 50 units x market value.

In March of the next year, B Ltd receives an additional 50 units, representing the shortfall for the previous year. These 50 units will be assigned a market value equal to the market value of a unit at the end of the previous income year. (The legislation operates to ensure that no double-counting of income occurs because the unit shortfall value is reduced by subsection (10) and so no longer forms part of the subsection (11) adjustment.)