Tax changes likely for New Zealands Emissions Trading Scheme ETS and the treatment of NZUs

The Emissions Trading Scheme (ETS) is a cornerstone of New Zealand's efforts to combat climate change and the new, National led collation, Government have confirmed it will continue to be the main mechanism in New Zealand's efforts to combat climate change. However, the implementation of New Zealand's ETS regime has resulted in somewhat complex tax outcomes for participants.

New Zealand's climate change efforts have, until recently, been primarily focussed on the promotion of exotic forestry. The previous New Zealand Government consult on changes to capture more sources of sequestration, incentivise permanent indigenous forestry and, potentially, remove carbon credits from forestry from the regime entirely. Prior to the General Election, both the National and Labour Parties indicated that they would extend the ETS regime to capture a wider range of carbon emitting and capturing activities. In our view, this could include extending the ETS to the development of wetlands, on-farm sequestration and ocean carbon.

In this article we will explore New Zealand's ETS regime as it applies to forestry, the intersection with the tax regime and recent announcements which may result in an extension of the ETS regime. Any changes to the ETS regime will require careful consideration to determine how they will fit within the existing tax framework.

 

Understanding the New Zealand ETS

New Zealand's ETS began operation in 2008 under the Climate Change Response (Emissions Trading) Amendment Act 2008, which amended the Climate Change Response Act 2002 to establish the ETS.

Broadly, the ETS requires heavy emitters captured by the regime to surrender tradable emission units (NZUs) to the New Zealand Government for each tonne of emissions they produce. The New Zealand Government controls the supply of units in the trading market, which determines the emission price based on the traditional concept of supply and demand.

NZUs can be acquired by participants through various means, including purchasing from other participants, Government auctions, earning through removal activities (carbon storage), a free allocation for “trade-exposed” high emitters, or purchasing from external offset mechanisms (typically domestic). The cost to acquire NZUs is intended to be a material consideration for businesses with higher emissions, as well as acting as a revenue opportunity for those involved in carbon capturing activities (such as forestry).

Uniquely, New Zealand's ETS currently operates as a domestic-only system. Whilst the New Zealand ETS was initially designed to be operated as an internationally-linked ETS regime consistent with the Kyoto Protocol, linking NZUs to Kyoto units was not considered practicable due to volatility in the global carbon market. NZUs were subsequently de-linked in 2015.

 

New Zealand's forestry sector

New Zealand has around 10 million hectares of forests, covering 38% of the land. Around 8 million hectares is native forest, with approximately 2 million hectares of forest being “plantation forest”. Notably, the plantation forest in Australia totals approximately 1.7 million hectares, illustrating the relative size of New Zealand's forestry sector in a geographically smaller country.

In New Zealand, forest is classified as either pre-1990 forest 67% or post-1989 forest 33%.

Traditionally, New Zealand ETS obligations applied as follows:

• Pre-1990 forestry participants are responsible for emissions from deforestation, unless they meet exemption criteria. However, they are not accountable for emissions associated with harvesting if replanting takes place within a certain amount of time. Emissions returns must be filed when deforestation occurs.

• Post-1989 forestry participants who opted into the New Zealand ETS before 2019 accumulate NZUs as their forests grow. There are obligations to redeem NZUs where there is harvesting or deforestation. Emissions returns for registered post-1989 forest must be submitted within six months after the conclusion of every five-year Mandatory Emissions Return Period (MERP) or in the event of deforestation.

From 1 January 2023, post-1989 registered forests are classified as “either standard” or “permanent”:

• Standard post-1989 forests will apply “averaging” accounting whereby participants earn units as the forest grows up to the long-term average level of carbon stocks over multiple forest rotations.

• Permanent post-1989 forests face a 50-year prohibition on deforestation and clear-fell harvesting, while accruing units as the forest grows which can exceed the average level of carbon stock mentioned above.

 

Income tax treatment of NZUs

The New Zealand income tax treatment for NZUs can be complex. There are three main reasons for this:

1. The income tax legislation has been amended in line with some of the changes outlined above. This means the tax treatment of NZUs in relation to pre-1990 forest is different from the tax treatment of NZUs in relation to post-1989 forest.
2. The income tax treatment of NZUs requires the consideration of valuation and timing rules. These determine, and generally defer, the timing of income and expenditure for tax purposes.
3. NZUs are generally sold as part of a wider transaction. The tax treatment of forestry transactions is already complicated because of specific valuation and timing rules which apply to sales of timber (which includes standing timber, i.e. trees).

In broad terms, the regime was intended to operate such that post-1989 NZUs are generally not subject to income tax until they are sold or surrendered. Where NZUs are surrendered to the Crown (i.e. at the time the forest decreases, either by harvest or another event), no consideration will be received, and no income tax will be payable. If the post-1989 NZUs are sold to a third-party purchaser, then income received from the sale will be subject to income tax. A tax deduction for any amount paid for those NZUs can be deferred until the time the NZUs are sold or surrendered (i.e., the tax deduction for the amount paid for the NZUs is deferred to match the timing of the corresponding income). The treatment for pre-1990 NZUs is different and, sales of pre-1990 NZUs are not taxable when sold, provided the land to which the NZU relates would not be taxable to the person at the time they sold the NZUs.

Despite the summary above, the relevant New Zealand income tax legislation is not straightforward. From a technical perspective, NZUs are an “excepted financial arrangement” which has a specific tax regime. For income tax purposes, an owner of NZUs can be required to add back, as income, the value of any NZUs at year-end. Then there are specific rules which can enable those NZUs to be valued at zero at the end of the income year.

In a straightforward situation for a forest owner (which owns both the land and forestry rights), the ETS assigns value to carbon capturing activities, with the forest owner accumulating NZUs over the life of the forest. Provided no NZUs have been sold, these should be available to be returned to the Crown when the forest is harvested and on the assumption that it is not replanted. In this circumstance, no tax may be payable. In practice, complexity often arises for forest owners as NZUs are often bought and sold during the life of the forest, at different times and at different values.

In most cases, NZUs are sold as part of a wider transaction, along with other forest assets, such as timber, buildings, “depreciable land and forestry improvements” (i.e. improvements in schedule 20 of Income Tax Act 2007) and land. Purchase price allocation (PPA) rules can require parties to a transaction to allocate value to all assets being sold. However, “market value” rules can also apply to sales of NZUs and timber. If NZUs are sold for less than market value they can be deemed, for tax purposes, to be sold at market value. This can result in unexpected outcomes for tax, such as where the value of the NZUs exceed the value of the land. This can also give rise to arguments as to what is the true market value of NZUs.

 

GST treatment of NZUs

The GST treatment of NZUs is more straightforward. Generally, NZUs are zero-rated supplies under New Zealand's Goods and Services Tax 1985 (GST Act). In essence, this means NZUs are generally treated as being subject to GST for the purposes of measuring taxable supplies made by businesses. Nonetheless, the actual amount charged (and therefore amount accounted for) is in most cases zero.

 

Changes proposed

Earlier this year, the New Zealand Government consulted on four options for change to the ETS:

1. Decreasing the amount of NZUs so that the carbon price increases.
2. Increasing the demand for NZUs by allowing the Government and/or overseas buyers to purchase them.
3. Restrictions or conditions are placed on removal activities (requiring emitters to purchase more NZUs for redemption).
4. Emitters will not be able to purchase NZUs from foresters to meet their redemption obligations.

Further changes to the ETS scheme are now likely under the new Government. It is not yet clear how the tax regime will need to change to address further amendments to the ETS but it will result in additional tax complexity.

For anyone interested in the New Zealand ETS regime and possible tax changes please contact someone in our New Zealand tax team.