Beware Forestry Emissions Trading Scheme Tax Traps
13 October 2022
With New Zealand Emissions Units (NZUs) commanding high prices, landowners looking to boost cashflow by planting new forests and taking advantage of Emissions Trading Scheme incentives should be aware of tax implications, which can come as quite a shock. Not only are most NZUs taxable when sold, but care needs to be taken when purchasing NZUs.
NZUs which are not ‘replacement units’ for others already sold must be brought in at cost at the end of the income year which effectively cancels out a tax deduction for the purchase until they are later sold or surrendered. This compares to NZUs purchased to replace units issued by the Crown, which are valued at zero at year end, and thus qualify for a tax deduction in the year of purchase.
Therefore, it is important to understand how NZUs are taxed before taking any action to avoid unanticipated obligations to Inland Revenue while still gaining the desired cash injection.
Firstly, NZUs are currently trading at around the attractive price of $83 on the secondary market and that has piqued the interest of many registered forest owners. However, while this is a sound way of spiriting up positive cashflow, bear in mind the taxman also wants a share of the spoils.
Data from the Ministry for Primary Industries confirms that landowners are responding to the incentive, with material growth in forestry land registered under the Emissions Trading Scheme in response to their eligibility to earn carbon credits or NZUs.
As is often the case, the legislation determining the tax treatment is complex, but as a broad rule:
Pre-1990, NZUs were issued to compensate for the loss in capital value of the forest land and are generally on capital (non-taxable) account in the hands of the landowner to whom they were issued.
Post-1989, NZUs carry tax consequences as they are deemed to be revenue account property (i.e. on taxable account) for income tax purposes. The effect of this position, and other relevant tax rules, is that the sale or disposal of NZUs generally gives rise to taxable income. If NZUs are transferred at other than market value, they are deemed ‘disposal at market value’ for income tax purposes.
The emissions units also fall into the rules for excepted financial arrangements, and, as such, their value must be accounted for at year end – much like trading stock – this is the bit that can cause issues as we explain below.
The allocation of post 1989 NZUs to a forest owner does not give rise to taxable income. Further, while these are excepted financial arrangements, the NZUs allocated by the Crown are valued at zero at the end of the year. That’s because the landowner has merely received the allocation of the units, rather than any consideration in monetary terms, and the clear policy intention is to not tax NZUs when allocated.
This changes upon the sale of NZUs as it brings in money – which is considered taxable income. The whole of the sale price is the taxable amount because there was no cost when the NZUs were issued by the Crown.
When NZUs are purchased by the same entity to replace those issued by the Crown, there is a deduction for their cost in the year of purchase. If the replacement units remain on hand at year end, their value is zero.
But this is not the outcome if NZUs are not ‘replacement NZUs’, which must be carried at cost.
As an example, Hypothetical Farmer Brown is allocated 10,000 NZUs. If Farmer Brown sells them all, then buys 15,000 NZUs, 10,000 NZUs are replacement units for the initial NZUs issued by the Crown: these are valued at 0 at year end. 5,000 NZUs are not replacement units and must be valued at cost at year end.
This is the bit that could well be a sting in the tail. Their valuation at cost at year end means the tax deduction for purchase is delayed until they are sold.
In one such (real world) case, a Findex client owned 4,000 NZUs and wanted to move the forest and NZUs into their company.
When the NZUs transfer to the company, they are no longer units issued by the Crown or replacement units, and thus the client would have had taxable income of $332,000, while the company would not get an offsetting deduction. The result is an overall tax cost of over $100,000 for shifting the units from A to B.
This shows how tax can bite when NZUs acquired are not ‘replacement units’. If they were replacement units, a deduction of $332,000 would have arisen to the purchaser company as valued at 0 at year end.
If you are participating in the ETS, it is highly advisable to know the tax implications. Find out more by contacting one of our trusted advisers.