South Africa: Friendlier tax treatment on Carbon Credits
In a bid to encourage the use of Clean Development Mechanism projects in South Africa and encourage energy efficiency, there are two amendments to tax legislation that were contained in the Taxation Laws Amendment Act, 2009.
The following is an extract from the Explanatory Memorandum on the Taxation Laws Amendment Act 2009, South Africa (Submitted to the standing Committee on Finance: 10 September 2009). The Act was signed into law by the President on 30 September 2009.
3.1. EXEMPTION FOR CERTIFIED EMISSION REDUCTIONS
[Clause 26; Application section: 12K]
Background
The Kyoto Protocol, the main environmental instrument of the United Nations Framework Convention on Climate Change (UNFCCC), has been ratified by 189 countries including South Africa. The Kyoto Protocol provides mechanisms to ensure that developed countries (as listed in Annexure 1 of the UNFCCC)) can meet their emission reduction targets. At the same time, the Clean Development Mechanism (CDM) ensures participation of developing countries in a global carbon reduction market. The Kyoto Protocol financing and technology transfer is accomplished through CDM projects which are available only within developing countries. These CDM projects focus on development in renewable energy, energy efficiency and other related fields designed to achieve emission reductions.
A key feature of CDM projects is the demonstration of additionality, which means that the project participants must demonstrate that the envisaged project would not have been viable without Kyoto Protocol support:
Emissions (environmental) additionality: This element ensures any emissions reduction is additional to what would occur without the proposed project;
Financial additionality: This element ensures that any public funding from Annexure 1 countries for the CDM project is additional and not a diversion of preexisting official development assistance;
Investment additionality: This element ensures that the investment project would not take place without a CDM project;
Legal additionality: This element ensures that the project is additional to what is already mandated by laws or regulations; and
Technical additionality: This element ensures that superior technology is used that would not have been possible to transfer to the developing country without the CDM project.
If these elements are satisfied, the Kyoto Protocol allows for these CDM projects to yield GHG reduction credits (commonly known as carbon emission reduction credits) in the form of certified emission reductions (CERs). These CERs are technically saleable to and usable only by developed countries for the purpose of meeting legally binding Kyoto Protocol emissions reductions obligations. CERs effectively operate as a concomitant revenue source for CDM projects, thereby seeking to make otherwise marginal projects viable.
Reasons for change
There has been only limited uptake of CDM projects within South Africa. This lack of uptake mainly stems from high financial (and bankable) hurdle rates given the risks associated with CDM project activities.
The South African government fully recognises that climate change is a global environmental market failure that requires a considered international and domestic policy response. The global nature of climate change arises from the fact that a ton of carbon emitted anywhere in the world (by developing or developed countries) has the same effect on temperatures globally. South Africa's greenhouse gas emissions rank within the top 20 in the world, contribute 1.8 per cent to global emissions and are responsible for 42 per cent of Africa's emissions (primarily due to South Africa's heavy reliance on coal for electricity and its sizeable use of motor vehicles versus other forms of transport).
In terms of tax, the disposal of CERs is largely untested, thereby creating further uncertainty for CDM projects. The default interpretation is to treat the disposals of CERs as ordinary revenue from trading stock. While this tax result could theoretically be applied, taxation of CERs at full ordinary rates will add a prohibitive cost for otherwise marginal CDM projects given their high financial hurdle rates. Hence, as part of South Africa's domestic policy response to climate change, tax relief is required to overcome the market failure associated with environmental protection.
Proposal
A. Overview
An income tax incentive is proposed for any person holding CDM project registration whilst that person implements the project. The incentive applies to the disposal of CERs issued in respect of that project. In essence, amounts received or accrued upon disposal (or anticipated disposal) of these CERs are exempt for
purposes of normal tax and capital gains tax. This exemption includes "in specie" distributions.
B. Qualifying Criteria
By way of background within the South African context, treatment of an activity as a CDM project requires both South African approval and UNFCCC registration. More specifically, South African approval is obtained from the Department of Energy (referred to in UN parlance as the "Designated National Authority"). UN registration is provided by the UNFCCC Executive Board of the Clean Development Mechanism after validation by the UNFCCC approved Designated Operational Entity ("DOE").
CERs represent emission reductions that are verified and certified by the DOE. After verification and certification, CERs ultimately only exist once issued by the UNFCCC Executive Board of the Clean Development Mechanism.
Example 1
Facts: Foreign Company owns all shares of South African Company. By virtue of South African Company's involvement in a CDM project, the UNFCCC Executive Board issues CERs worth R5 million to the South African Company on 10 June 2010. South African Company disposes of these CERs to Foreign Company and receives R10 million on 10 July 2012.
Result: The mere receipt of CERs (worth R5 million at the time) by South African Company from the UNFCCC Executive Board is a non-event under common law principles. The disposal by South African Company of the CERs will be exempt by virtue of section 12K. Because no taxable income results from the disposal of CERs, the expenditure incurred by South African Company will not qualify for a deduction under section 11(a). Similarly, because there is no receipt of taxable income, the value of the CERs held by South African Company will not be taken into account under section 22 as closing or opening stock.
Example 2
Facts: The facts are the same as Example 1, except South African Company sells the future rights to the Foreign Company on 1 September 2009 for R3 million (in lieu of the 10 July 2012 sale).
Result: Because the payment of R3 million is in respect of a disposal for delivery at a future date, the section 12K exemption implicitly includes the R3 million anticipated disposal.
C. Value-added Tax ("VAT") treatment of supplying CERS
Questions have been raised as to how the disposal of CERs should be treated for VAT purposes owing to the newness of the CERs concept. Upon review, it is believed that the supply of the CERs is a supply of "services" (as opposed to the supply of "goods"). The CER itself should fall into the ambit of a "right" or "a facility" or "advantage" envisaged in the definition of services. Internationally, countries like the UK and Sweden treat the supply of the CERs as the supply of services. The OECD also regards CERs as equivalent to services.
Because all CERs will be exported (being useful only for Annex 1 (industrialised) countries, the supply of CERs by persons operating CDM projects will by default (in terms of the normal VAT rules) be zero rated. Because CERs would be viewed as services, the documentary requirements are fairly liberal (i.e. being less stringent than that of exported goods).
Effective date
The proposed amendment will be effective for the disposal of CERs occurring on or after 11 February 2009 in respect of CDM projects registered on or before 31 December 2012. The exemption contains the 2012 sunset clause to coincide with the expiry of the Kyoto Protocol.
3.2. SPECIAL ALLOWANCE FOR ENERGY EFFICIENCY SAVINGS
[Clause 27; Applicable provision: 12L]
Background
The primary energy sources in South Africa are fossil-fuel based. Energy derivedfrom fossil fuel has a negative effect on the environment and current electricity prices do not reflect these environmental costs. Given the need to address the challenges relating to climate change and to improve energy use, it has become necessary to find ways to improve energy efficiency. Energy efficiency savings can indeed be viewed as one of the low-hanging fruits to help address the concerns relating to climate change and energy security.
Reasons for change
In the context of energy efficiency savings, the conversion by taxpayers of old technologies to new ones often involves a substantial amount of capital expenditure. The perceived long pay-back period tends to discourage business from making upfront investments relating to energy efficiency savings. Given the contribution that energy efficiency savings can make towards a reduction in the demand of energy especially electricity) and resulting reduction in CO2 emissions (given the fossil fuel intensive nature of energy production in South Africa), it is deemed appropriate to encourage greater levels of energy efficiency savings.
Proposal
It is proposed that taxpayers be entitled to claim a notional allowance for all forms of energy efficiency savings resulting from activities in the production of income. This notional allowance will enable the taxpayer to capture the full profit from energy efficient savings during each year in which incremental energy efficiency savings is initially realised.
The allowance for each year of incremental savings is determined as follows:
(Energy efficiency savings x applied rate) ÷ 2
For purposes of the formula, it is expected that energy efficiency savings will be determined by an accredited measurement & verification professional using standardised baseline methodology. All forms of energy efficiency savings will be taken into account. All these forms of energy efficiency savings will be expressed in kilowatt hours equivalent (kWh) to achieve uniformity. This energy efficiency savings is determined by measuring energy use against an initial baseline, as set by a measurement and verification professional.
Also for purposes of the formula, the applied rate is the lowest feed-in-tariff rate at the beginning of the year of assessment expressed in rands per kWh determined in terms of Regulatory Guidelines set by the National Energy Regulator. Given that the lowest feed-in tariff rate is higher than the current rate per kWh for electricity generated from fossil fuel, the overall formula is divided by 2. The Minister may change this denominator. It would have been theoretically been possible to use the average actual electricity rate (rand per kWh) for each taxpayer, but this approach would have resulted in unnecessary administrative and differential benefits.
The energy efficiency savings certificate is the key pre-requisite for the allowance. The certificate must contain the pre-determined energy-use baseline, the annual energy efficiency savings expressed in kilowatt hours equivalent (kWh), and the revised baseline. All this information must be authenticated and issued by an institution, board or body as determined by the regulations.
All the criteria and methodology used to determine the baseline and energy efficiency savings must be in terms of regulations issued by the Minister of Energy after consultation with the Minister of Finance and the Minister of Trade and Industry. The regulations will be based on the International Performance Measurement and Verification Protocol of the Efficiency Valuation Organisation.
Effective date
The amendment comes into operation on a date determined by the Minister of Finance by notice in the Gazette.