VATSC06584 - Consideration: Payments that are not consideration: Payments in specific sectors: Carbon offsetting: VAT treatment of trading activities

Introduction

There is a distinction, for VAT purposes, between compliance market credits (see VATSC06582) and non-compliance market credits (see VATSC06583). The sale of compliance market credits is a supply of services which is subject to VAT (currently at the standard rate), whilst VERs are outside the scope of VAT. This changes from 1 September 2024 (see below).

Compliance Market Credits

Compliance market credits are recognised under the statutory Kyoto, UK Emissions Trading System (UKETS) and EU Emissions Trading System (EUETS) ‘cap and trade’ regimes (see VATSC06582). These regimes provide for exacting verification and regulatory processes, which allow parties to a compliance market transaction to attribute a subjective value to the credit units. The credits are widely traded on national and international markets.

Polluting businesses which are subject to the UKETS and EUETS must hold, or obtain on the open market, and then ‘retire’ sufficient emissions credits to cover their emissions. If they do not, then they will suffer financial penalties. The businesses ‘consume’, in a VAT sense, the compliance credits so that they can engage in economic activity without penalty and meet their regulatory commitments.

From a VAT perspective, the motive of an individual paying for a credit does not matter, nor does it matter what is done with it. Thus if a private individual buys a compliance market credit, the supply of the credit to that person is still taxable (even though they are not subject to any regime) because the credit is capable of consumption.

The sale of compliance market credits was standard rated up until 30 July 2009, when a temporary zero rate was introduced to tackle Missing Trader Intra Community (MTIC) Fraud. 

From 1 November 2010 the UK introduced a new reverse charge mechanism for some compliance market credit transfers, the previous zero rate provision was withdrawn, and the VAT liability of sales of compliance market credits therefore reverted to the standard rate. VAT Notice 735 – 'Domestic reverse charge procedure' provides detailed guidance on the operation of the reverse charge mechanism.

Only those compliance market credits which can be used to meet obligations under the EUETS are subject to the new reverse charge mechanism. Previously these comprised of EU Allowances, some Certified Emission Reductions (CER) and some Emission Reduction Units (ERU), as defined in Directive 2003/87/EC (as amended). As from 1 May 2021, these CERs and ERUs are no longer within the reverse charge.

The UKETS broadly follows the EUETS and an amendment was made to the scope of the reverse charge so that it applies to UK allowances from 1 May 2021.

Suppliers must account for output tax on supplies of any non-EUETS compliance market credits, for example Assigned Amount Units (AAUs) and Removal Units (RMUs), in the usual way.

Non-compliance market credits (Voluntary Carbon Credits)

Policy until 31 August 2024

A Verified Emission Reduction (VER) (see VATSC06583) is essentially a promise that carbon has been or may be reduced somewhere in the world. There may be a general benefit to the reputation of a business (good PR, marketing and corporate responsibility) in paying for a VER, but no particular service is rendered which can be identified as a cost component of the business. There is therefore no consumption. No service is being provided to an identifiable consumer and no benefit is being provided which is capable of forming a cost component of the activity of another person in the commercial chain.

Payment for a VER might produce a general social benefit, it might produce a specified result, or it might give rise to a legal relationship with reciprocal obligations. However, a taxable person’s income is relevant for VAT purposes only if it constitutes the consideration for a supply of goods or services to a consumer. The mere fact that something is or may be done in exchange for a payment is insufficient to bring such a transaction within the VAT system. The public at large cannot constitute a specific recipient of the kind which must exist in order to give rise to a transaction chargeable to VAT. Further, and in marked contrast to the situation with compliance market credits, there was initially no evidence of the existence of a genuine secondary trading market in VERs.

Policy from 1 September 2024

From 1 September 2024, certain voluntary carbon credits will be in the scope of VAT. HMRC recognises that there have been significant changes in the voluntary carbon market that now means they can be incorporated into a business’s onward supply. A not insignificant secondary market has developed and in recognition of this HMRC has updated this manual.

What is a carbon credit?

Carbon credits are seen as part of the ecosystem service market.

Ecosystem services are the benefits delivered by nature, for example carbon sequestration, biodiversity, water quality improvement and flood mitigation. Ecosystem services are measured in units or credits which are a quantified amount of an ecosystem service, for example a tonne of carbon or a defined amount of biodiversity, that can be sold in the market.

A carbon credit is a tradable instrument issued by an independently verified carbon-crediting program that represents a reduction or removal of one metric tonne of carbon dioxide or an equivalent amount of greenhouse gases from the atmosphere measured by reference to a baseline scenario.

There are other ecosystem services that may have shared characteristics with carbon credits and as such may have the same treatment provided certain principles are met.

Principles for determining VAT treatment of ecosystem services

The key principles that should be used when considering the VAT treatment of ecosystem services are listed below. This list is not exhaustive.

  • Is there a tradeable instrument issued? If the credit or unit can be traded it is more likely a supply for the purposes of VAT.
  • Does the instrument represent a quantifiable reduction, removal or gain of an ecosystem service unit or credit? If it does, then there is more likely an identifiable benefit accruing for a specific recipient.
  • Is there some additionality? A key feature of carbon credits and other ecosystem service units is that there needs to be additionality. That is the reductions/removals achieved are truly “additional” to what would have happened without the project. Credits or units cannot be said to be generated by doing nothing. This again confirms that an identifiable benefit accrues for a specific recipient.
  • Are there buffers? Projects or initiatives often place safeguards to ensure the credit represents the equivalent of the anticipated removal, or reduction. Where there are such buffers, this can be an indicator that the sale of a credit is taxable.
  • Is there registration or verification of the credits/unit by an independent third party or government body? Independent verification, registration and management ensures that the credits or units are not double-counted, additionality exists and often indicates that once the instrument is created it can be traded.

Issuing carbon credits

Carbon credits (and other units) are issued in one of two ways.

  • Credits can be issued after the removal/reduction has occurred (sometimes called ‘ex-post’ credits).
  • Credits can also be issued before the removal/reduction (sometimes referred to as ‘ex-ante’ credits).

Which carbon credits are in the scope of VAT?

Most transactions involving voluntary carbon credits will be within the scope of VAT. A voluntary carbon credit is any carbon credit that is not a compliance market credit. Guidance on compliance market credits already confirms that they are in scope of UK VAT and this is explained in VATSC06584.

The following activities are still be treated as outside the scope of VAT:

  • the first issue of credit by a public authority under a legal obligation
  • the holding of credits as an investment, where there is no economic activity
  • donations made to carbon credit projects
  • sales of credits from self-assessed or low integrity projects with no independent or third-party validation or verification 

Some examples have been provided in VATSC06586.