16 January 2025

IRS concludes operator of carbon offset project must include state carbon offset credits in gross income upon grant

  • The IRS has issued non-precedential guidance addressing when an operator of a carbon offset project recognizes gross income as a result of the grant of certain state carbon offset credits.
  • Nevertheless, whether the receipt of property, such as non-tax credits, represents an accession to wealth and, thus, gross income at the time of receipt or when the property is utilized remains unclear.
  • Therefore, taxpayers should consult with their tax advisors regarding any position taken with respect to the recognition of income from those credits.
 

In AM2024-004, the IRS has concluded that state carbon offset credits (referred to as ARB offset credits below) received by an operator of a carbon offset project are an accession to wealth and must be included in the operator's gross income upon receipt of the credit.

Facts

To address global warming, California enacted the California Global Warming Solutions Act of 2006 (the Act), which authorized the California Air Resources Board (CARB) to establish, through rules and regulations, programs to limit and reduce greenhouse gas (GHG) emissions within the state to their 1990 levels by 2020.

The CARB created the Cap-and-Trade Program under the Act. The program sets a cap on statewide GHG emissions from large industrial facilities, utilities, distributors of natural gas and other fuels, and electricity generators, and uses "'market mechanisms to cost-effectively achieve the emission-reduction goals.'" The program requires a business entity subject to the cap to surrender a compliance instrument (e.g., an "ARB offset credit") for every ton of GHGs it emits each year.

The CARB also issues ARB offset credits, which are tradable compliance instruments that represent a GHG reduction or removal enhancement of one metric ton of carbon dioxide equivalent, to approved offset projects. Offset projects include "equipment, materials, items, or actions that are directly related to have an impact upon GHG reductions, project emissions or GHG removal enhancements within the offset project boundary."

The CARB establishes offset protocols that the operator of a carbon offset project must follow for the project to gain CARB approval and receive ARB offset credits. An independent verification service then examines the offset project for compliance with the CARB-approved offset protocol. If the offset project is in compliance, the CARB issues one or more ARB offset credits to the project's operator. The operator may sell, trade or transfer the ARB offset credits, provided the credits have not "been retired, surrendered for compliance or otherwise used, … been invalidated by the CARB, or … placed in a buffer account as required by a CARB regulation."

Analysis

The IRS considered Baboquivari Cattle Co. v. Commissioner, 135 F.2d 114 (9th Cir. 1943) and Ginsburg v. US, 922 F.3d 1320 (Fed. Cir. 2019) and concluded those court opinions were consistent with the IRS's position in Revenue Ruling 60-32, 1960-1 C.B. 23. In Revenue Ruling 60-32, the IRS concluded payments made to farmers under the Soil Bank Act were includable in gross income. That ruling represents the IRS's position that money or property received by a taxpayer from the government as compensation for an agreed performance is an accession to wealth.

In AM2024-004, the IRS concluded that an offset project operator has an undeniable accession to wealth when the operator is granted ARB offset credits by the CARB for agreeing to an approved offset protocol. The IRS also determined that the operator has complete control over the credits because the operator can sell, trade or transfer the credits without any restrictions. Accordingly, the IRS concluded that an operator must include the value of ARB offset credits in its gross income upon grant, arguing effectively that the facts of the scenario at issue were similar to those in the above-cited authorities.

In the advice memorandum, the IRS acknowledges that it has previously treated government grants of valuable permits and/or privileges as non-taxable (i.e., not income). For example, in Revenue Ruling 92-16, 1992-1 C.B. 15, the IRS concluded that that a utility's receipt of transferable sulfur dioxide emissions allowances from the Environmental Protection Agency did not cause the utility to realize gross income. Therefore, the utility's basis in the allowances was not measured by reference to their fair market value. However, the IRS attempts to differentiate the rulings in Revenue Ruling 92-16 (and other cited authorities) from the conclusion in this scenario as follows:

The offset project operator is not required to retain ARB offset credits to operate a regulated trade or business. Nor is the CARB allocating a limited public resource to offset projects: the number of ARB offset credits increases every time the CARB grants one to an offset project operator complying with the terms of one or more approved offset protocols. In contrast, the rights granted the taxpayers in [Revenue Ruling] 67-135, [Revenue Ruling] 92-16, and GCM 39606 are necessary for them to conduct their regulated trades or businesses (that is, mining on federal lands, operating an electric utility and operating, or leasing FAA slots to, an airline). The rights granted the taxpayers in [Revenue Ruling] 67-135, [Revenue Ruling] 92-16, and GCM 39606 represent scarce resources that a government is responsible for allocating and are thus limited in quantity.

Further, citing Revenue Rulings 79-315, 1979-2 C.B. 27, and 70-86, 1970-1 C.B. 23, the IRS confirms that it does not treat a taxpayer's state tax credit as an item of income to the extent the taxpayer uses the credit to reduce its tax liability. The IRS, however, does treat any part of a state tax credit that is refunded to a taxpayer or sold for consideration as includible in the taxpayer's gross income. The IRS noted the Tax Court adopted the IRS's position in Tempel v. Commissioner, 136 T.C. 341 (2011), aff'd sub nom. Esgar Corp. v. Commissioner, 744 F.3d 648 (10th Cir. 201), in which the taxpayers sold state income tax credits they received for making conservation easement donations. The Tax Court held that the taxpayers "experienced an undeniable accession to wealth because they sold the credits for cash."

Implications

Whether the receipt of property in the form of non-tax credits and certain other scenarios represents an accession to wealth and, thus, gross income at the time of receipt, as opposed to when the property is utilized (e.g., monetized through sale, etc.) remains unclear. The IRS position set forth in this non-precedential guidance is consistent with certain authorities, such as Revenue Ruling 60-32 and private letter rulings in which the IRS has ruled that unless IRC Section 451(b)(1)(A) requires earlier inclusion, a real estate investment trust's income from certain carbon offset credits will accrue upon the earliest of when the credits are earned, received or due (see PLRs 202401011 and 202402002 (Tax Alert 2024-0201); PLRs 201949004, 201949005 and 201949007 (Tax Alert 2020-0076); PLRs 201720008; PLR 201751011 (modifying PLR 201123003)). This position, however, arguably is at odds with previous positions taken by the IRS in Revenue Ruling 92-16 and is counter to the treatment afforded tax credits by the IRS in rulings, such as Revenue Ruling 79-315. As such, taxpayers receiving credits, such as the ARB offset credits discussed herein, should consult with their internal and external tax advisors to document any position taken with respect to the credits.

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Contact Information

For additional information concerning this Alert, please contact:

National Tax — Accounting Periods, Methods & Credits

National Tax — Passthrough Transactions Group

Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Mannetta, legal editor

Document ID: 2025-0256