The Senate Finance Committee held hearings to learn more about the tax implications of climate change legislation, including whether companies should be taxed for carbon emission allowances.

Most major climate change proposals set an emissions target that would cap greenhouse gas emissions, noted committee chairman Max Baucus, D-Mont. The cap is then divided into emission allowances that would give companies the right to emit one ton of carbon dioxide or its equivalent. Companies and investors would be able to buy or sell the allowances, or hold onto them for the future. Some proposals would distribute allowances free of charge, while others would sell the allowances through an auction, or combine distributing with auctioning.

“If allocations are distributed for free, should the tax law treat them as income to the recipient?” Baucus asked in his opening statement. “Should the Tax Code treat an emission allowance as a capital asset, subject to depreciation over time? Or should the law allow buyers to deduct the cost of buying an allowance as a cost of doing business? How should the law treat gains and losses associated with allowances? Should the law treat them as capital gains or ordinary income from a sale? And should the system allow emission allowances to be banked, and carried forward to future years?”

Ranking member Charles Grassley, R-Iowa, wondered whether there was any point in questioning the tax implications when the cap-and-trade system is not a sure thing yet. “The first point I should make is that, if cap and trade isn’t enacted, then we’re worrying about all these tax questions for nothing,” he said. “However, if it is enacted, then a bunch of tax issues need to be dealt with. For example, if allowances to emit carbon dioxide are given away for free, should the corporations that receive these valuable allowances be taxed upon receipt of them?”

Gary Hufbauer, a senior fellow at the Peterson Institute for International Economics, testified that free allowances of carbon permits should be considered income. “When the U.S. government issues free permits, it is already conferring a big favor on recipient firms,” he said. “It would be a travesty to double up the favor by exempting these permits from the definition of income for the purposes of the Internal Revenue Code.” He also believes that the purchase of carbon permits should be considered a business deduction, especially when the purchaser uses the permit to satisfy its own greenhouse gas obligations.

“This is an ‘ordinary and necessary’ business expense,” he added. “Two refinements should be noted. If the permit is purchased in year one, but not used until year two, the deduction should be claimed in year two. If the permit is purchased and later resold (not used by the purchasing firm), that transaction would give rise to trading gains or losses.” He recommended the FIFO method of inventory valuation on the expectation that the value of carbon permits would rise over time.

Mark Price, a principal in the Washington National Tax office of KPMG, discussed some of the tax laws as they might apply to such a system. One implication he noted in his written testimony related to like-kind exchanges. “Some entities may be subject to multiple cap-and-trade systems, either because some regional or state programs are not preempted or because the entities operate in foreign countries that have their own national or regional cap-and-trade systems,” he said. “Under current law, CO2 allowances appear to be eligible for like-kind exchange treatment for federal income tax purposes.”

Keith Butler, senior vice president of tax at Duke Energy, talked about how a power company might deal with taxes on emission allowances. “Receiving an allocation of an emission allowance that involves no direct cost to the recipient should not create gross income, nor should the recipient receive a deduction of value when that allowance is utilized,” he said. “The ability to freely transfer, sell or exchange allowances results in taxable transactions that are supportable by tax legislation and tied to the tax basis of the asset. The tax regulations allow alternative treatment in sale transactions, and whether sales result in capital or ordinary gains or losses is dependent upon the nature of how the emission allowance is held or used by the taxpayer in its trade or business. Under the current view, a like-kind exchange, although not tied to the time period associated with the allocation of the allowance, is restrictive relative to the type of allowance, whether it be for SO2 or NOX. The fact that the allowances have an indefinite life, if not used in the year designated to a specific allocation, seems to support the inability to determine a time period over which to depreciate or amortize the allowance, in spite of it being viewed as a capital asset.”

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