Kerry-Boxer Climate Change Bill – Tax Issues & Implications

The Kerry-Boxer climate change bill^[1]   (the “Senate Bill”) that was introduced in the Senate on September 30th, contains a number of new programs directed at reducing pollution, decreasing America’s foreign energy dependence and increasing economic activity associated with clean energy production. In addition to the environmental and economic implications of the Senate Bill, the tax consequences of the proposed programs need to be considered as well.

While the IRS has previously addressed certain tax consequences associated with similar programs in the context of the sulfur dioxide (“SOX”) emission allowance program established under the Clean Air Act Amendments of 1990, there are significant differences between the SOX program and the proposed programs contained in the Senate Bill. ^[2]   Therefore, it is not clear whether the tax consequences for participants in the new programs would be the same as for participants in the SOX program. As a result, there is significant uncertainty with respect to the tax treatment of transactions that would occur under the Senate Bill. This Tax Bulletin sets out some of the tax issues raised by the Senate Bill and suggests some possible treatments for those issues.

Overview of Key Provisions and Associated Tax Issues of Senate Bill

Among other things, the Senate Bill provides for the issuance of grants, the issuance, banking and trading of emission allowances ("Allowances"), and the creation, issuance, banking and trading of compensatory allowances and offset credits ("Credits").

• Grants: Any cash Grant made under the Senate Bill will generally be taxable, as ordinary income, to the recipient in the year it is received.
  
  

• Allowances: Under the Senate Bill emission Allowances could be issued by domestic and foreign governments with respect to CO2 emissions, fluorocarbon emissions and other greenhouse gases (“GHGs”) identified as such in the Senate Bill. Entities that are covered under the Senate Bill will be issued Allowances. Each Allowance issued will have a “vintage year” after which it will expire. A recipient of an Allowance would be able to trade (including through a sale, exchange or transfer) the Allowance with other parties, bank it for use in future years or retire it through actual use or expiration.
  
  The following tax issues are raised under the allowance program:
  
  
  • Issuance – Would the receipt of an Allowance be taxable to the recipient as income? If the Allowances are treated like SOX allowances, then they would not be taxable upon receipt, however, it is not clear if that would be the case. Is this analysis affected by the provision of section 721(c)(1) which provides that the Allowances do not constitute a property right?
    
    

  • Are the Allowances Subject to Withholding Tax? Section 704 of the Senate Bill provides for the issuance of Allowances to achieve a reduction in GHG emissions from deforestation in developing countries. If the Allowances are issued to recipients who are not US resident taxpayers, are the Allowances subject to withholding under sections 1441 and 1442?
    
    

  • Sale/Trade/Transfer of an Allowance –
    
    
    • How would gain from the sale of an Allowance be taxed? Would the seller of an Allowance be able to identify the precise basis of the Allowance sold and use that basis rather than an average cost basis? The treatment should differ if the seller of the Allowance was a dealer in allowances. Dealers in Allowances may have to use an average cost, or otherwise allocate the tax basis in all of the Allowances it holds in some other manner to the specific Allowances being sold.

      
      
      

    • What would the basis of an Allowance be? The determination of an Allowance’s tax basis will depend on whether the holder acquired it directly from the government or by purchase or exchange. If the holder received the Allowance upon issuance by a government, and no gain was recognized on the receipt of the Allowance, the holder should have a zero tax basis in the Allowance. If the holder recognized income on the receipt of the Allowance, the holder’s tax basis would be equal to the amount that was included in the holder’s income which should be the fair market value of the Allowance at the time of issuance.

      
      
      

    • If the holder acquired the Allowance by purchase in a taxable transaction, it should have a tax basis equal to the purchase price paid for the Allowance. Alternatively, if the holder acquired the Allowance through an exchange that was not-taxable under section 1031, then the basis of the acquired Allowance would be the same as the basis of the exchanged Allowance.

      
      
      

    • Would gain be Capital or Ordinary? The character of the gain will also depend on whether the holder is a dealer or a non-dealer with respect to the Allowance.

      
      
      

    • For non-dealers, an Allowance should constitute a capital asset because it would not be held for sale in the ordinary course of business, would not be self created and would not fall within any of the other categories in section 1221 that would prevent its classification as a capital asset. This is consistent with the treatment of SOX allowances in Rev. Proc. 92-91, although such classification was merely assumed and not the subject of any particular analysis. Accordingly, any gain from the sale of the Allowance should be a capital gain

      
      
      

    • If the holder of the Allowance is a dealer in Allowances, then the gain on the sale of the Allowance would be ordinary income.

    
    
  • Exchanges – Could Allowances be exchanged tax-free, as like-kind property, under section 1031? Although it is likely that a domestic Allowance could be exchanged tax-free for another domestic Allowance with respect to the same GHG, what, if any, affect would the vintage of an Allowance have on the tax treatment? Exchanges involving different types of GHGs? Foreign versus domestic Allowances? State allowances for Allowances under section 777 of the Senate Bill?

    
    
    

  • Distributions – Would the distribution of an Allowance by a partnership to a partner be taxable as a disproportionate distribution of substantially appreciated “inventory items” under section 751? Although a distribution of an Allowance should generally not be taxable, a dealer in Allowances may be treated differently.

    
    
    

  • What would the tax consequences be with respect to Borrowed Allowances? In general, entities would apply Allowances that they have been issued that expire during a particular year against emissions they generate in that year. If an entity does not have enough Allowances that expire in that year to cover that year’s emissions, the covered entity would be able to “borrow” Allowances that it has been issued with later vintage years. However, borrowing Allowances from years after the next year could result in an “interest” charge imposed on the borrower during the year from which the Allowance was borrowed. The covered entity would have to hold Allowances equal to 1.08 multiplied by the number of years for which the Allowances are borrowed for each borrowed Allowance.

    
    
    

    • How should the additional 8% be treated for tax purposes? As interest subject to possible capitalization under the interest expense capitalization rules? Or as an ordinary and necessary business expense?

    
    

  • Are the Allowances Depreciable? Unlike the SOX emission allowances, which do not expire, the Allowances will have vintages, and can not be used after the vintage date of the respective Allowances.

    
    
    

    • In Rev. Proc. 92-91, the IRS concluded that the SOX emission allowances had no ascertainable useful life over which they could be depreciated. In contrast, because the Allowances would have a definite useful life, the basis an Allowance should presumably be depreciable over the term of the Allowance ending on the vintage date.

      
      
      

    • If depreciable, there is an issue as to what depreciation method should be used. Because the Allowances would be intangible property in the hands of a covered entity, the tax basis for each Allowance would presumably be depreciable on a straight line basis under Reg. 1.167(a)-3(b)(3).

    
    

  • Retirements; Expirations – The Bill provides for the voluntary retirement of Allowances, and for Allowances to expire once their vintage year is past.

    
    
    

    • The retirement or expiration of an Allowance should be treated as a loss deductible under Section 165, to the extent of the covered entity's tax basis in the Allowance, however, that result is not certain.

    
    

  • Are the Penalties Deductible? Section 723(b)(2) of the Senate Bill provides for a penalty to be paid by a covered entity to the extent that its GHG emissions are greater than the number of Allowances or Credits it holds for the year in question. The penalty is equal to the product of the number of tons of CO2 equivalent GHG emissions for which the covered entity does not have Allowances or Offsets multiplied by twice the FMV of the Allowances for the year in question. It is not clear whether this penalty would be a penalty under section 162(f), in which case it would not be deductible for income tax purposes.

  
  

• Offsets: Offsets differ from Allowances in that they are self-created assets, rather than intangible assets granted to a covered entity by the government. They are similar to Allowances in that they can only be used once, and once used will expire.

  
  
  

  • The following tax issues are raised by the Offset Program:
    
    
    • Issuance – Since the Offsets are self-created, the creation of the Offsets should not be a taxable event to the covered entity.

      
      
      

    • Capital Asset Classification – Even though the Offsets would be self-produced, they should nonetheless be classified as capital assets under section 1221 since they are not the type of intangible assets listed in section 1221(a)(3) – i.e., they are not copyrights, literary or musical compositions, etc.

      
      
      

    • Tax Basis/Capitalization – Unlike Allowances, Offsets will not expire until they are actually used. Accordingly, an Offset would have a useful life substantially beyond the tax year in which it is created. Therefore, the costs of creating the Offsets may have to be capitalized under section 263 and in such case would not be deductible in the year the costs are incurred. A covered entity would need to allocate a portion of the costs of the project which generated the Offsets to the basis of the Offsets. The rules for allocating costs to Offsets should be clearly addressed by the IRS in official guidance.

      
      
      

    • Exchanges – There is a great deal of uncertainty as to whether Allowances and Offsets would be considered to be like-kind, eligible to be exchanged tax-free under section 1031. Since the former are issued by the U.S. Government and the latter are self-created, it could be argued that they are not like-kind. This point should be clarified since both Allowances and Offsets are likely to be actively traded.

      
      
      

    • Sale/Trade/Transfer of an Offset – The tax consequences and issues of a sale or exchange of an Offset should be the same as the tax consequences for Allowances.

      
      
      

    • Are the Offsets Depreciable? – The Offsets are similar to the SOX emission allowances in that they do not expire until used to offset emissions during a particular year. Accordingly, consistent with Rev. Proc. 92-91, the Offsets may not be depreciable by the covered entity which generated the Offsets. Any unrecovered tax basis would in that case be taken into account in the tax year in which the Offsets are sold, or are used.

      
      
      

    • Retirements – The tax consequences of a retirement of an Offset should be the same as the tax consequences for Allowances – so that a deduction should be allowed by any remaining tax basis in the year the Offset is used.

      
      
      

    • Reversals of Credits – The Senate Bill provides for a reversal of benefits when a Credit has been used in a prior year and the project generating the Credit no longer qualifies. In such case, if the Credit has been used in a prior year, is the deduction claimed in the prior year subject to recapture? If so, in what year? The year used? Or the year the project no longer qualifies?

If you have any questions, please feel free to contact any member of our Tax & Wealth Planning or Green Businesses practice groups.

^[1] The Clean Energy Jobs and American Power Act, S.1733. The Waxman-Markey Bill, HR 2454, that was passed in the House differs from the Senate Bill, and any final bill would have to reconcile the provisions of both, or other legislation that is passed at a later date.

^[2] See, Rev. Proc. 92-91 (guidance with respect to the tax treatment of transactions under the SOX emission allowance program); and Rev. Rul. 92-16 (IRS held, with no analysis, that the receipt of SOX emission allowances did not result in the realization of income).