Concept of voluntary carbon credit
Voluntary carbon credits are intangible instruments recorded in an electronic registry that each represent one metric ton of carbon dioxide equivalent reduced, avoided or removed from the atmosphere. The credits allow the environmental benefits of project activities to be transferred from the projects ultimately to businesses or individuals wishing to offset their emissions. They are issued, can be bought and sold and ultimately they can be retired to offset emissions. They are not regulated, there is no limit to the number of voluntary carbon credits that can be generated, and prices are determined based on supply and demand. Although the demand for voluntary carbon credits used to be limited a decade ago, it has now become an enormous market anticipated to reach USD 40 billion by 2030.1
Given the significant developments of the trading activity relating to voluntary carbon credits, including the emergence of a secondary market trading, HMRC have decided to re-visit the VAT treatment applicable to transactions involving voluntary carbon credits.
A voluntary carbon credit is defined by HMRC as "tradable instrument issued by an independently verified carbon-crediting programme. It represents a reduction or removal of one metric tonne of carbon dioxide, or an equivalent amount of greenhouse gases (GHGs) from the atmosphere measured by reference to a baseline scenario."
The default rule: taxability
From 1 September 2024, the trade of voluntary carbon credits will generally be subject to VAT. Consequently, market participants in the UK will be expected to pay VAT on the purchase of voluntary carbon credits and apply VAT on subsequent sales where their counterparty is in the UK.
Generally, this should have a positive impact on market participants who will be entitled to deduct VAT on costs associated with the trading of voluntary carbon credits.
Nonetheless, this will add to compliance costs, as the failure to properly account for VAT on the purchase and sale of voluntary carbon credits could lead to financial penalties and late interest payments. Market participants are therefore encouraged to review their arrangements as soon as possible in order to assess the scope of their VAT and compliance obligations, and should consider how VAT is dealt with under their contracts.
HMRC have confirmed that voluntary carbon credits can potentially qualify for the zero-rated relief set out in the Terminal Market Order (TMO)2. The TMO regime has traditionally been limited to the trades in "real" commodities (e.g., gold, silver, platinum, coffee). However, since Brexit, HMRC have been able to extend the zero-rate relief under the TMO and can include "intangibles" such as carbon credits. The application of the TMO regime to voluntary carbon credits should constitute a welcome development since it removes unnecessary VAT frictions on the trades of this new "commodity" whilst granting input tax deduction.
Given the complex set of rules governing the TMO regime, and the ongoing review of how it is applied, market participants should carefully consider the rules before relying on it.
Some transactions will remain outside the scope of VAT
HMRC have recognized the need to accommodate the rules for specific types of transactions that do not give rise to a VAT supply (which are comparable to the regime attached to specific areas of VAT law such as shares issues in the primary market or passive holding companies). HMRC acknowledge the following are out of scope of VAT:
- The first issue of a voluntary carbon credit by a public authority.
- The holding of voluntary carbon credits as an investment, where there is no economic activity.
- Donations made to voluntary carbon credit projects.
- Sales of voluntary carbon credits from self-assessed projects with no independent or third-party verification.
This should avoid VAT being applied on businesses that are not trading in carbon credits as part of their business activity. However, it means market participants will need to diligently characterize their activity and should document those transactions out of scope in case of a VAT audit.
1 https://www.bcg.com/publications/2023/why-the-voluntary-carbon-market-is-thriving
2 Value Added Tax (Terminal Markets) Order 1973 (as amended).
