Presentation made in Direct Taxes Regional Training Institute, Mumbai on direct tax issues related to carbon credit

1. Carbon Credit ~ The green money
Direct tax issues
Direct Taxes Regional Training Institute,
Mumbai.
22 July 2011
CA Romesh S A Sankhe

2. Contents
Introduction
Direct tax issues
Direct Taxes Code
Allied laws
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3. Introduction (1) | UNFCCC
• ‘Intergovernmental Panel on Climate Change’ (IPCC) is a body established
in 1988 by the United Nations, with an aim to evaluate the risk of climate
change caused by human activity
• IPCC’s first climate assessment report was completed in 1990 illustrating
the country wise analysis of gas emission levels in the world
• ‘United Nations Framework Convention on Climate Change (UNFCCC)’ is
an international environmental treaty which was introduced in Earth
summit conducted by United Nations at Brazil in June 1992
• UNFCC’s objective is to stabilize greenhouse gas concentrations in the
atmosphere at a level that would prevent dangerous anthropogenic
interference with the climate system
• As on July 2011, 194 parties are signatory to UNFCCC
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4. Introduction (2) | Kyoto Protocol
• However, UNFCCC has no mandatory limits on greenhouse gas emissions
for individual countries and no enforcement mechanisms
• In December 1997, ‘Kyoto Protocol’ to UNFCCC was first agreed in Japan
under which ‘Annex I countries’ of UNFCCC (industrialized nations) was to
provide a commitment towards reduction of gas emissions of following:
• Four greenhouse gases (GHG) i.e. carbon dioxide, methane, nitrous oxide and
sulphur hexafluoride,
• Two group of gases i.e. hydro fluorocarbons and per fluorocarbons,
• This protocol was effective from 16 February 2005; 190 parties have signed
this protocol till July 2011 which accounts for about 64% of the gas emissions
from Annex I countries in 1990
• The notable exclusion is of United States Of America which was responsible for
36% of the 1990 gas emission levels of Annex I countries
• The target agreed upon was an average reduction of 5.2% from 1990 levels
by the year 2012 by 39 Annex I countries, the defaulting country will have to
make up for deficit plus an additional 30% and it will be suspended from
making transfers under an emissions trading program
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5. Introduction (3) | CERs
• Kyoto protocol provides for following three mechanics which can be used by
Annex I countries to meet their emission reduction commitments:
• International Emission Trading
• Clean development mechanism
• Joint implementation
• Clean Development Mechanism allows Annex I countries to invest in emission
reductions wherever it is cheapest globally i.e. in developing nations
• Certified Emission Reductions (CERs) are positive difference between the
standard emissions and actual emissions of the approved CDM projects
under the prescribed rules of the Kyoto Protocol
• One CER is equivalent to one metric ton of carbon dioxide (CO2) emissions
Certified Emission Reductions (CERs) are popularly known as
‘carbon credits’
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6. Introduction (4) | Trade prices
• Apart from CERs, carbon credits approved by European Commission under
European Union scheme are also traded globally, this are known as
European Union Allowance (EUA)
• European Climate Exchange (ECX) facilitates more than 85% of the global
carbon credit sales and deals only in futures
• CER’s all time high price is Euro 24 (2008) and all time low price is Euro 7.35
(2009)
• Settlements prices of CERs and EUAs futures for September 2011 on ECX
are as under:
• CER = € 9.87
• EUA = € 12.08
Source : http://www.theice.com/
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7. Introduction (5) | Opportunity for Indian Businesses
• Annex I countries primary have two ways to control the gas emission, either to
develop the CDM projects or purchase the CERs from developing nations
such as China, India, etc
• Commitment period under the Kyoto protocol may end in 2012
• However, Annex I countries are expected to extend their commitments till 2020
• Globally the carbon credit market (i.e. EUA, CER, etc.) grew at a compound
annual growth rate (CAGR) of 89% during 2005 to 2009 which was
• 2005 (USD11 billion), 2006 (USD31 billion), 2007 (USD63 billion), 2008
(USD126 billion), 2009 (USD138 billion).
• In 2010, market grown by 5% to USD144 billion and it is expected to reach
USD1200 billion in 2020
• However, CER derived from CDM projects forms a small part of the this global
carbon credit market which was USD6.5 billion in 2008, USD2.7 billion in 2009
and USD1.5 billion in 2010
• Till 2012, India is not under any commitment towards emission reduction,
hence CERs does not have a significant market within India
• However, post 2012 India may accept the voluntary commitment towards
emission reduction which may result into increased demand of CERs within
India
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8. Introduction (6) | India’s CER position
• As on 18 July 2011, total CDM projects registered with UNFCCC are 3,292
1600 1482
1400
1200
1000
800 698 696
600
400
193
200 94 129
0
Brazil China India Malaysia Mexico Others
Source : http://cdm.unfccc.int
• Till 18 July 2011, total CER issuance to India is 98.44 Million i.e. 15% of the
total issuance by UNFCCC of 655.76 million
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9. Introduction (7) | Setup Procedure In India
• Preparation and submission of Project Concept Note (PCN)
1 and Project Design Document (PDD)
One time Activity
• Approval from National CDM Authority (NCDMA), part of
2 Ministry of Environmental and Forest
• Validation by Designated Operational Entity (DOE)
3
• Registration by UNFCCC
4
• Monitoring and review by DOE
Annual Activity
5
• Issuance of CER verification report by DOE
6
• Issuance of CER Certificates by UNFCCC
7
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10. Direct tax issues
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11. Characterization of income (1) | Business?
• “Income” under section 2(24)
• Even if a receipt does not fall within the ambit of any of the sub-clauses in
section 2(24), it may still be income if it partakes the nature of the income
- CIT v. G.R. Karthikeyan [1993] 201 ITR 866 (SC)
• “Business” under section 2(13)
• Based on the past judicial precedents following principles emerge:
• Any activity akin to business may be taken to be an adventure in the
nature of trade
• A single transaction may also constitute an adventure in the nature of
trade, there need not be regularity or repetitiveness in the activity
• The activity alleged/claimed to be an adventure in the nature of trade
need not be allied to the already existing activity of the assessee
• The activity or the transaction said to be an adventure in the nature of
trade must be with the object of earning profit
- Eclat Construction (P.) Ltd. v. CIT [1988] 172 ITR 84 (Pat.).
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12. Characterization of income (2) | Other possibilities?
• “Capital asset” under section 2(14)
• Property of any kind held ………….., but does not include any stock-in-
trade, consumable stores or raw materials held for the purposes of his
business or profession ;
• “Income from other sources” under section 56
• Income of every kind which is not to be excluded from the total income
under this Act shall be chargeable to income-tax under the head “Income
from other sources”, if it is not chargeable to income-tax under any of the
heads specified in section 14,
Characterization assumes importance !!
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13. Characterization of income (3)
Income from
sale of CERs
Business Income from
Capital gains ?
income ? other sources ?
- Taxed at normal - Concessional - Taxed at normal
rates rate of tax if rates
- Eligible for set held for more
off against the than 36 months
business losses - Eligible for set
off against the
capital losses
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14. Characterization of income (4) | Legal precedents
• Business income vs. Other heads of income
Even if an item of income is earned in the course of carrying on a business, it
will not necessarily fall within the head ‘Profits and gains of business’. Income
earned by an assessee carrying on business will in each case be broken up,
and taxable income under the head ‘Profits and gains of business’ will be that
amount alone which is earned in the business, and does not fall under any
other specific head
- CIT v. Chugandas & Co. [1965] 55 ITR 17 (SC)
• Carbon credit ~ business income ?
• Section 28 (iv) - the value of any benefit or perquisite, whether convertible
into money or not, arising from business or the exercise of a profession
• Section 28(va) - any sum, whether received or receivable, in cash or kind,
under an agreement for
(a) not carrying out any activity in relation to any business
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15. Characterization of income (5) | Legal precedents
• Carbon credit ~ business income ?
• Compensation received under Montreal Protocol is exempt under section
28(va)(ii),
• However in Eagal Flask India Pvt. Ltd. v. JCIT [2009] 2009-TIOL-623
(Pune ITAT) it was held as under:
• Compensation, in cash or in kind, for not carrying out business activity from
UNDP under Montreal protocol for phasing out Ozone Depleting substance will
not be covered section 28(va)(ii).This proviso has nothing to do with the non
taxability of the amounts received from the Multilateral fund to meet increased
operations costs which a more ozone friendly technology may require’
• Carbon credit ~ investment income ?
• CBDT also wishes to emphasise that it is possible for a taxpayer to have
two portfolios, i.e., an investment portfolio comprising of securities which
are to be treated as capital assets and a trading portfolio comprising of
stock-in-trade which are to be treated as trading assets. Where an
assessee has two portfolios, the assessee may have income under both
heads, i.e., capital gains as well as business income
- Circular No. 4/2007, dated 15 June 2007.
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16. Characterization of income (6) | Accounting Principles
• Currently no accounting standard or GAAP is existent in India or
globally in relation to treatment of CERs
• Earlier the international Accounting Standards Board had issued an
interpretation to ‘International Financial Reporting Interpretations
Committee (IFRIC) 3 – Emission rights’ in December 2004, however the
same was withdrawn in June 2005
• Guidance note on Accounting for Self-generated Certified Emission
Reductions (CERs) issued by ICAI in June 2009, states as under
• CERs should be recognised in the books when those are credited by
UNFCCC and are unconditionally available to the generating entity,
• CERs are inventories of the generating entity as they are generated and
held for the purpose of sale in the ordinary course of business,
• Even though CERs are intangible assets those should be accounted for as
per the AS 2 (Valuation of inventories) at a cost or market value whichever
is lower,
• “Cost of CER” may includes consultant’s fees, certification fees and cash
payments made to UNFCCC for obtaining the CER credits
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17. Characterization of income (7) | Summary
• Self-generated CER’s
• Business income, since the same could be used in own business
(currently own use is not feasible in India) as well as could be sold in the
outside market ,
• If the classified as investment by the taxpayer and held for substantial
period then may be treated as capital gains
• CERS purchased for resale
• Business income or investment income depending on the intention of the
taxpayer, holding period etc., reference may be made to CBDT circular no.
4/2007
• CERs should be recognised in the books when those are credited by
UNFCCC and are unconditionally available to the taxpayer,
• “Cost of CER” may includes consultant’s fees, certification fees and
cash payments made to UNFCCC for obtaining the CER credits
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18. Tax Deduction (1)
If treated as business income, whether CER gains will be eligible for
deduction under section 80IA, 80IAB and 80IB?
• View 1 - Not eligible
• Section 80IA, 80IAB, 80IB have a common scheme which refers to profit
“derived from an industrial undertaking”,
• As held by Supreme Court in Liberty India v. CIT [2009] 317 ITR 218 the word
“derived from” is narrow in scope and hence the tax holiday provisions would
not apply to income such as duty drawback, DEPB, export entitlement etc.
• View 2 - Eligible
• CERs generation is directly related to the operations of industrial undertaking
and hence may deem to be the income from source of first degree, as held in
Liberty India v. CIT [2009] 317 ITR 218 (SC) “The words "derived from" is
narrower in connotation as compared to the words "attributable to". In other
words, by using the expression "derived from", Parliament intended to cover
sources not beyond the first degree”,
• Further CERs are classified as inventory of an generating entity as per the
accounting principles in India, hence deem to be “derived from an industrial
undertaking” and eligible for tax benefits,
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19. Tax Deduction (2)
If treated as business income, whether CER gains will be eligible for
deduction under section 80IC, 80ID, 80IE, 80JAA and10AA?
• Section 80IC, 80ID and 80IE of the Act extends the benefit to ‘gains derived
by an undertaking’ from the specified business
• “derived by an undertaking” appears to be wider that “derived from an
undertaking”, hence the tax deduction benefit may be available
• Section 80JJA of the Act extends the benefit to ‘gains derived “from the
specified business”
• “derived from the specified business” appears to be narrower that “derived from
an undertaking”, hence the tax deduction benefit may be subject to facts of the
case and process in which the CERs are generated
• Section 10AA of the Act extents the benefit to unit who begins manufacture
or produce articles or things in the Special Economic Zone
• Since CERs may be classified as inventory of the generating entity, the gains
derived from the overseas sales of CERs may be eligible for the tax benefit
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20. Direct Taxes Code
• Income from business
• Section 33(2)(xi) includes any consideration accrued or received on transfer
of carbon credits
• Section 314(46) - “carbon credit” for trading purposes in respect of its one
unit shall mean reduction of one ton of carbon dioxide emissions or
emissions of its equivalent gases which can be traded in market at its
prevailing market price, which is validated by the United Nations Framework
on Climate Change.
• It appears that even CERs purchased for resale may also be treated as
business asset irrespective of period of holding
• Definition does not include European Union Allowance certified by
European Commission or Voluntary Emissions Reductions certified by
other authorities, however the same may also be covered under the
income from business
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21. Allied Laws
• In January 2010, Delhi Government vide its notification has stated that
CERs are akin to intangible goods and hence Value Added Tax would
be levied at transfer of CERs at the concessional rate of 4%,
• No clarification from any other state Governments or Union Government
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22. Open house ..
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Romesh S A A Sankhe

23. CA Romesh S A Sankhe
(M) 9892 892504
(E) romesh_sankhe@rediffmail.com
The views expressed in this presentation are solely that of the speaker and do not constitute any kind of professional advice. These
views or opinion expressed in this presentation should not be applied or used without a prior professional advice, as the review of the
facts and prevailing judicial position is of utmost importance in the analysis of tax implications.
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