How Should We Tax Climate Change Permits?

By :: July 21st, 2009

Now that the House has decided to give away, rather than auction, most CO2 emission permits, I’ve been wondering how Treasury is going to tax this windfall. There is a huge amount of money at stake--by some estimates more than $100 billion-a-year in emissions permits.

Remember, how they would work: Congress would turn the right to emit CO2 into a valuable, saleable asset. Into, one might say, money. The companies that receive these permits—mostly big producers or generators of fossil fuels such as oil refiners or utilities—could either use them for the right to pollute or sell them.

This government give-away raises a lot of interesting tax questions. Here is one: Is the value of these permits taxable as soon as they are received or only when they produce income (by selling either the permits or the energy produced under the emission rights). Here is another: If the receipt of these permits is not taxable, is the profit from their sale ordinary income or a capital gain that would be taxed a lower rate?

The energy industry, not surprisingly, says the credits are not income at all. They argue that they’d owe no tax unless the permits are sold at a profit, and that those profits should be subject only to capital gains rates. That, at least was the argument of Duke Energy’s senior tax vp Keith Butler at a Senate Finance Committee hearing in June.

His claim is based on a rather perfunctory 17-year old IRS revenue ruling (Rev Ruling 92-16) that applied to sulfur dioxide emissions under the Clean Air Act. Different chemical. Different law. But, energy companies insist, same principle.

“A travesty,” said Gary Hufbauer of the Peterson Institute for International Economics. Are free carbon trading permits income?, “My answer is a decisive ‘yes,’” Hufbauer concluded.

As a matter of good tax policy, I’m inclined to agree with him, but the matter may not be entirely clear-cut.

I asked my former TPC colleague Dan Halperin, now back at Harvard Law School. Dan is not an energy expert, but he does know how to read a revenue ruling. Dan’s view is the IRS ruling, essentially one sentence long, clarifies little.

The argument over whether the windfall should be taxed as income or gains is, as Dan notes, mostly about timing. But with this kind of dough at stake, timing matters. 

The Obama Administration had hoped to auction, rather than give-away, these permits. That seems off the table. The question now is whether Treasury will lose still more revenue by allowing companies to both defer tax on this largess and when they do pay, to do so at capital gains rates.

If the Senate ever confronts climate change legislation—and that may take a while— Congress will have to decide what to do about this thorny issue. Ducking the matter by relying on a brief, nearly two decades-old IRS opinion won’t cut it.