Direct Taxation and Carbon Credits: Global and Indian Insights

Mohanish Verma, Former PCCIT- IRS

Direct Tax Provisions and Carbon Credits for a greener Economy – A global comparison and the Indian Context.

COP 29 held at Baku has once again highlighted the urgent need to address the needs for regulating carbon emissions and other pollutants both in domestic and global environments as the impact on human life is becoming extremely lethal. The “polluter pays” principle since 1972 has become too mild. Stronger and fundamental reforms which are sustainable are now necessary. The focus must shift to generate resources for developing and transitioning to technologies and machineries which have zero carbon emissions. The targets to move to net zero carbon emission regime appears to be ambitious for most countries in the near future. However the mechanisms must be established to move in the right direction.

The conflict between developed and developing nations for financing and providing financial resources to move to a zero carbon era is far from being resolved. Emerging nations like India, China and Brazil are at cross roads to balance their development plans to align with the global requirements for carbon emissions. In recent times there have been rapid developments in creating a mechanism to regulate carbon emissions through carbon credits which can also being regulated and traded. In India also a new legislation has been passed (Energy Conservation Bill, 2022) for Carbon Credit monitoring and trading in line with many developed countries like USA and UK.

The most polluting industries in India as per government and independent sources of research are Power, Cement, Iron & Steel, Chlor-alkali, Pharmaceuticals, Fertilizers, Refineries, Pesticides, Distilleries, Sugar, Pulp & Paper, Textile, Tanneries. On the other hand, at the global level the sectors contributing towards highest pollution levels are Fossil fuels, Agriculture, Fashion, food retail, Transport and Construction are the sectors recognized globally as contributing to high pollution levels.

There are multiple financial and other policy tools through which the policies to control carbon emissions can be monitored and different countries have already initiated regulations in varying forms. Incentives through lower taxation or tax holidays for green technologies, accelerated depreciation on new machinery cheaper loans for financing from financial Institutions, subsidies for specific sectors are some specific tools adapted. It is important to identify the Sectors which contribute most to carbon emissions. Textiles, Automobile and Manufacturing of Chemicals and specific areas relating to agriculture in India need to be taken up on priority. Multiple sources of data need to be analyzed and deliberated upon for urgent action in the most urgent sectors and regions.

Initially the principle followed was based upon the logic of “polluter pays”. However this logic has become irrelevant since it may generate revenues but is not effective in checking pollution in the long run. Various taxation tools have been used by many countries by levying higher VAT and other indirect taxes. This provides a disincentive or a penal provision for use of certain machinery or technology. However recent trends and analysis call for longer term more fundamental changes for reforming and transitioning to new technology and such machinery and equipment which will result in greener environment in the long run. Such changes call for larger investments for which huge funds are needed.

The United States, China, Japanese, South Korea, France, and Russia, among others, have set up environmental funds to finance corporate spending on activities to reduce pollution (Bian et al., 2021; US Environmental Protection Agency, 2015). For example, the Japanese government subsidizes power development company’s flue gas desulfurization activities (Inui, 2002). In addition, the Australian government has established an emission reduction fund based on the pollution reduction activities of companies (Bian et al., 2020). Moreover, the Chinese government provides special funding subsidies for developing advanced environmental technologies and equipment, environmental protection products, energy-efficient technologies and equipment, energy-efficient products, resource recycling, and other projects¹.

We intend to flag the importance of taxation as a tool for acting as a change agent in promoting green Industry and also regulating the taxation and markets of Carbon Credits in India.

Global Emphasis on New Economic Measures of taxation

In the US, through the Inflation Reduction Act, large tax credits and subsidies are being offered to companies investing in electric vehicles and renewable energy technologies like batteries, solar panels and wind turbines.. Investment tax credit of 30% and production tax credit of US $ 0.0275/kwh, 2023 value will be deductible from their federal taxes².

European Commission has proposed the “Green Deal Industrial Plan for Net-Zero Age”. Tax credits and accelerated depreciation along with other incentives are under active consideration. Subsidies for solar panels, batteries and heat pumps are also being considered³.

Punishing bad behavior and incentivizing good behavior is the main principle for handling the area of green industries. While revenue generation should never be the prime motive for considering the legislative and administrative measures, the more significant area of concern should be providing medium and long term incentives for transitioning to a greener industrial and manufacturing environment where green steel or green machinery or green cotton starts dominating the domestic and global economies.

Recent Trends in promoting Greener Economy through Direct Tax tools

Coming to the specific areas where Direct taxes reforms are already being considered by different countries of the world some specific areas can be identified as follows as per OECD⁴ observations in many of its partner countries:

a. Accelerated depreciation for faster writing off of its machinery which are environmentally certified for a greener environment.

b. Reduction or exemption of corporate taxes for a specified period with specified details of the machinery and equipment to be installed replacing the earlier inefficient one.

c. Investment tax credit or Investment allowance. This relates to providing tax credits on the basis of specified investments made.

d. Introducing specified deductible expenditure related to specialized labor or having lower slabs of taxation for specified investments and activities of any business related to green environment.

e. Total exemptions for setting up or transitioning to environment compatible technology and equipment and machinery in particular sectors or territorial regions for a specified period. This will encourage quicker and smoother transitioning to a greener economy in a phased manner.

f. Targeted subsidies for providing incentives to specific sectors and industries and activities can be designed.

Several countries use a combination of these tools to move towards a greener manufacturing and industrial economic environment. Apart from the strictly fiscal measures elaborated above there is need to support the same through supporting policies of physical regulation, other complementary laws and also investment policy, trade policy and financial market policies to synergize with the overall prioritize with domestic and global environmental goals.

Carbon Credit Regulation and Taxation in India and globally

Carbon credits are generated through projects that facilitate emissions avoidance. These projects must follow established methodologies and undergo verification by accredited third-party organizations. Verification ensures that the emission statistics are real and verifiable.

Carbon credits are verified by independent third-party organizations that specialize in greenhouse gas accounting and verification. Examples of leading verification standards include the Verified Carbon Standard (VCS), Gold Standard, and American Carbon Registry (ACR)⁵.

The emergence and development of the new financial Instrument like the Carbon Credits is also resulting in its widespread use and acceptance all over the world and in many economies, it has also become operational. In India, the necessary legislation was finalized through necessary amendments in the Energy Conservation Bill, 2022. The detailed operational support mechanism was subsequently released by the Niti Aayog through the Carbon Capture, Utilization and Storage (CCUS)-Policy Framework and its deployment in India. This report was prepared after considering various inputs on sector wise emissions, capture and utilization of technologies, potential for CO2 storage etc. Inputs from various countries like USA, Canada, EU and Australia were also considered and incorporated in the context of what would be most appropriate in the Indian context⁶.

Further the latest Energy Conservation Bill, 2022 envisages that the carbon credits will not initially be available for export. (Energy Conservation (Amendment) Bill 2022, 2022; Rajesh Kumar Singh & Bloomberg, 2022). The bill’s provisions will permit the generation of carbon credits by public and private sector entities in India with the aim of reducing emissions. The carbon credit certificates will be domestically tradeable between companies and individuals, subsequently setting up a compliance market (Energy Conservation (Amendment) Bill 2022, 2022; Rituraj Baruah & Livemint, 2022).

Initially, the compliance mechanism will cover entities from nine industrial sectors already regulated under the PAT scheme: aluminium, chloralkali processes, cement, fertiliser, iron and steel, pulp and paper, petrochemicals, petroleum refining, and textiles. The government plans to expand the scope at a later stage, notably to coal-fired power generation.

The Bureau of Energy Efficiency, India (BEE) expects to release detailed regulations for the voluntary offset mechanism by the end of 2024, with CCC trading of voluntary offsets beginning in 2025. India aims to have the compliance carbon market fully operational by 2026, signalling its commitment to addressing climate change through market-based solutions. The CCTS will initially cover carbon dioxide (CO2) and perfluoro-carbons (PFCs), with provisions to expand to other greenhouse gases in the future. The scheme will cover both direct (scope 1) and indirect (scope 2) emissions⁷.

The actual designing of the carbon credits along with the regulation and monitoring of authorised agencies is also crucial and must be evolved quickly and transparently. There must be regular audits of issuing Institutions and at the same time, there should be designing of carbon credits for different intensities of polluting items which are eliminated along with higher credits for regional movement from a higher polluted location also. For example replacement of machinery generating a very poisonous gas should be given higher credit than less damaging ones or moving away from a very populous area to a desert location for some polluting industry can also be given credit. Designing of carbon credits can be used as an effective tool for signalling the priorities on reduction of pollution in any economy.

Provisions for Environment related Incentives in Indian Income tax laws

The Indian Income Tax Act at present also has some specified provisions in existence which encourage environment friendly investment and economic activities. Some important ones in existence can be summarized as follows⁸:

1 Depreciation of 40% and an Additional Depreciation of 20% under Section 32 of the Income Tax Act 1961 is available on Solar Plant Machinery that has been operational for more than 180 days in the financial year. Therefore there is up to 60% depreciation available for Solar Plant Machinery in the first year of purchase.

2. Under section 80IA, a 100% exemption from income tax is available on profits derived from setting up and managing the eligible business of power generation from renewable sources. The exemption of 100% is available for 10 consecutive years out of the 15 years from the date of commencement of activities. This encourages long-term investments in renewable energy infrastructure like solar farms and wind parks

3. Section 80JJA allows businesses to claim deductions for profits and gains derived from the collection and processing of biodegradable waste for generating power or producing bio-fertilizers or other biological agents etc. The whole of the profits or gains from such business shall be allowed as a deduction for five consecutive years starting from the assessment year in which such a business has commenced.

4. Section 80CCF Investment in Green Bonds allows the taxpayer to deduct a portion of the investment of certain long-term green bonds from the taxable income. A deduction of ₹ 20,000 is available on investment in long-term green bonds that help the environment. These bonds help fund sustainable projects like clean water, renewable energy etc.

5. Exemption under Section 10 for all Institutions engaged in functions relating to General Public Utility (GPU) as defined in Section 2(15) of the Income tax Act, subject to the regulations prescribed in the Act.

Using taxation and carbon credit tools for promoting sustainable green technologies in a global context

One of the most high-profile examples of tax incentives to encourage investment in decarburization is the US Inflation Reduction Act (IRA) tax credits⁹, which were enacted in August 2022. The IRA tax credits expanded and extended the existing tax credits for a variety of renewable energy assets, such as solar, wind and fuel cells, and introduced new tax credits for emerging asset classes, such as standalone storage, hydrogen, and sustainable aviation fuel (SAF).

In United Kingdom the current tax policy is to reward all investment in national infrastructure, regardless of its environmental impact. This means that there are no specific tax incentives for green investments as such at the moment in the UK, although there are a few areas where the UK imposes additional taxes to discourage unsustainable behaviors, such as the plastic packaging tax and the climate change levy. However in coming times reforms are anticipated since the Labor party has committed to invest up to GBP 30 billion in the energy transition.

Japan has raise USD 150 billion under its Green Transformation Act to push nuclear renewable energy infrastructure alongside other renewable energy sources. And we have seen similar measures in Brazil, and South Africa as well¹⁰.

In some countries there is a shift towards encouraging the supply side, such as in Korea which is ramping up the tax credits for manufacturing batteries, whilst phasing out some of the purchase incentives.

EU has also been strongly moving towards using fiscal tools for discouraging polluting industries and activities. One of the key frameworks for achieving this, initially announced in July 2021, is the “Fit for 55” initiative, which contains measures to encourage the use of renewable fuels and building materials, to boost innovation and investment in “green” technologies, to boost international cooperation with regard to the energy purchase, to encourage reduction in emissions share for traditionally high energy consuming sectors such as aviation, and to encourage the use of lower carbon transport methods more generally. To this end, legislation has been adopted with a view to adapting the EU’s climate, energy, tax, and transport policies in order to reduce net greenhouse gas emissions, and thereby potentially slow the rate of climate change.

The French Finance Bill 2024 includes a new tax credit system available to companies in the battery, solar wind and heat pump sectors. This is estimated to generate EUR 23billion in private investment by 2030 in France, and could create up to 40,000 jobs. In Belgium, there is already an increased tax investment deduction tax credit system, and in October, the government announced an increase in those tax benefits for sustainable and socially responsible investments. So Member States are each looking at how they can encourage investment in this area, and this is at least partly in response to the US IRA¹¹

One of the major announcements made during Singapore’s Budget 2024 is the introduction of the Refundable Investment Credit (RIC) for sizeable investments¹², including projects with decarburization objectives. The RIC benefit is in the form of a tax credit which can be offset against corporate income tax payable. It is awarded on qualifying expenditures such as capital expenditures, manpower costs, intangible asset costs, and freight and logistics costs. An interesting feature of this benefit is that any unutilized tax credits will be refunded to the company as cash within four years.

Netherlands: The Environmental Investment Deduction (MIA) offers a 45% deduction for investment costs related to environmentally friendly investments, while the Vamil offers a deduction equal to 75% of investment costs. In many instances, depending on the asset purchased, you can get both MIA and Vamil benefits for most assets, providing a deduction of up to 120%.

USA: offers a Cost Recovery for Qualified Facilities scheme which allows businesses with a qualifying property to deduct from their taxable income the depreciating value of their business assets, such as equipment, faster than the value declines. In practical terms, qualifying facilities or property will be able to take bigger deductions as they will be treated as a 5-year property (i.e. rate of 20% per year) – leaving them with lower taxable income – in the earlier years of a clean energy investment¹³.

South Korea: tax credits (of up to 25% depending on company size) have been made available for investment in facilities that commercialize national strategic technologies such as rechargeable or secondary batteries, hydrogen, carbon neutral technologies and future means of transport.

China: In 2022, the State Taxation Administration of China released the “Guidelines for Tax and Fee Incentive Policies to Support Green Development,” which outlined 56 tax and fee incentive policies supporting green development in four aspects: environmental protection, energy conservation and environmental protection, encouraging comprehensive utilization of resources, and promoting low-carbon industry development¹⁴. These include tax incentive policies for environmental protection, such as periodic reduction or exemption of corporate income tax for qualified environmental protection projects, tax credit for investments in specialized environmental protection equipment, and a preferential tax rate of 15% for third-party enterprises engaged in pollution control. The emphasis in the Chinese taxation regime for encouraging pollution control are more focused on VAT and there is now a move towards a more comprehensive system to coordinate consumption taxes, VAT and corporate taxes to develop incentives and also penalize through higher rates.

Canada: tax credits applied across several technologies needed to support Canada’s transition to a “clean economy while also supporting the creation of good jobs for Canadians”:

• Tax credit for clean technology manufacturing: a 30% refundable tax credit is available for investments in eligible property associated with eligible activities for clean technology manufacturing and processing, as well as critical mineral extraction and processing. The 30% rate is available until 2032.
• Tax credit for geothermal energy: a 30% refundable tax credit is available for companies investing in eligible property that is acquired to generate heat and electric energy solely from geothermal energy. The 30% rate is available until 2034.

• Clean electricity tax credit: a 15% refundable tax credit for new and refurbishment projects to support clean electricity technologies and expand the capacity of Canada’s clean electricity grid and accelerate progress towards a net-zero grid. The tax credit is available until 2034.
• Clean hydrogen tax credit: between 15% and 40% (rate dependent on carbon intensity of project) for eligible projects’ costs to produce clean hydrogen. A 15% tax credit is also available on equipment that converts clean hydrogen to ammonia to facilitate transportation. The tax credit rates are available until 2034.
• CCUS tax credit: between 37.5% and 60% (depending on the type of equipment) for the cost of purchasing and installing eligible equipment for eligible CCUS projects. The tax credit is available until 2041.¹⁵

Capital allowances, investment tax credits and reductions in the corporation tax rate emerge as the preferred options given that their implementation is likely to create less complexity for businesses than production tax credits, which would require a big step-change in tax policy and potentially clash with other policy¹⁶

Evolving provisions relating to Direct taxes, Carbon Credits in India for boosting the green economy towards zero carbon era

The importance of using fiscal instruments including direct and consumption taxes as well as subsidies has been recognized globally. The mechanism of issuing and managing the Carbon Credits has also begun operations in some countries. However in most economies the Carbon credit authorities, regulation and provisions of taxation have not stabilized at present. Most legislation and formal frameworks have been put in place since 2022. In India also the present provisions in Direct taxes need to seriously rethink about specific provisions relating to incentives in sectors, regions and technologies for boosting a time bound plan to transition to a greener economy. Most important economies are also working towards similar goals. The Indian Income Tax Act and the regulatory mechanism as a whole will do well to consider some of the issues being flagged

on the basis of ground level environmental challenges and various global developments already in the offing.

1. Emphasis on more sector wise provisions for encouraging and expediting replacement of polluting units, since presently only energy and power sector has been provided tax incentives for investment and modernization.

2. Expanding the scope of taxation for setting up more Financial Institutions with specific Objectives of financing green technologies and replacement of polluting plant and machinery at different levels.

3. More focused provisions on Investment allowance and accelerated depreciation. Eg. Environmental Investment Deduction in Netherlands.

4. Increase the scope and tax treatment of capital subsidies for transitioning to a more eco friendly machinery and equipment regime, sustainable in the long run.

5. Setting up and regulation of a robust Carbon Credit authority with more clarity on the mechanism and also ensuring taxation provisions which appreciate the transactions of Carbon Credits trading and accounting norms, including exemptions from taxation wherever needed. Follow USA, Canada, Singapore and improvise the model as per Indian requirements and priorities. Tax credits can accordingly be incorporated in legal provisions.

6. Specifically addressing the 17 most polluted sectors as identified by the Government of India for tax holidays and benefits for a specified period of 3 to 5 years, ensuring a quick transition to replace polluting industries. Each sector might require specific provisions and conditions to design the nature of tax benefit or exemption.

7. Addressing the carbon and methane emissions in agriculture sector by specific tax provisions to invest in checking these emissions. Agriculture remains one of the top polluters globally. Encouraging machinery or technologies aimed at reducing pollution and damage in agricultural sector should be given tax holiday or tax benefits like higher depreciation or Investment allowance.

8. Considering lower tax rates for specified Industries like Chemicals, automobile, textiles in certain regions of the country which are contributing to pollution, subject to their transition to greener technologies.

9. Analyzing and designing of variations of Carbon Credits (with more importance to reduction in higher polluting sectors) for better targeting, can be differentiated for graded tax incentives. Reducing pollutants of higher severity and reducing environmental hazard in some regions and sectors should be given more weightage by design.

10. Focus more on bringing in specific provisions in Tax Exemptions Chapter for 100 percent exemptions to donors making contribution to funds established to finance replacement of polluting machinery and technologies. Institutions with objectives relating to environment and pollution control are already exempt under section 10 of the IT Act.

Conclusion

The Indian economy is one of the fastest growing economies of the world. It has a large multiplicity of growing sectors including many which need to be regulated closely for ensuring environmental parameters. Multiple policy measures including Industrial and agricultural policies will certainly be playing a role. However the fiscal tools and particularly incentives and penalties through Income tax provisions in the coming times can also help in making available additional resources to operating businesses and sectors to use the same for transitioning to a greener regime with more sustainable technologies, machinery and equipment. The new Direct Tax Code under consideration needs to be apprised of some crucial issues and the low hanging fruits must be achieved sooner than later.

Notes:

¹ Taxes or subsidies to promote investment in green technologies for a supply chain considering consumer preferences for green products Author links open overlay panelYongxi Yi, Yangyang Wang, Chunyan Fu, Yuqiong Li from https://www.sciencedirect.com/science/article/abs/pii/S0360835222004193 (Visited on 23/11/24)

² https://www.aoshearman.com/en/insights/tax-incentives-for-sustainable-investments-what-businesses-should-be-thinking-about Visited on 19/11/2024

³ ibid

⁴ Fiscal Incentives for Green Private Investment: Alex Bowen, Grantham Research Institute on Climate Change and the Environment London School of Economics and Political Science.

⁵ https://climatetrade.com/everything-you-need-to-know-about-carbon-credits/ (Visited 23/11/24).

⁶ INDIA’S CARBON CREDIT TRADING SCHEME & THE INDIAN GOVERNMENT’S CCUS REPORT, ERROL PINTO Senior Consultant Policy and Commercial.

⁷ (https://icapcarbonaction.com/en/news/india-adopts-regulations-planned-compliance-carbon-market#:~:text=The%20amended%20Energy%20Conservation%20Act,or%20removal%20from%20the%20atmosphere.)

⁸ https://www.caclubindia.com/articles/green-tax-51979.asp#google vignette.

⁹ https://www.aoshearman.com/en/insights/tax-incentives-for-sustainable-investments-what-businesses-should-be-thinking-about Visited on 19/11/2024

¹⁰ https://www.aoshearman.com/en/insights/tax-incentives-for-sustainable-investments-what-businesses-should-be-thinking-about

¹¹ https://www.aoshearman.com/en/insights/tax-incentives-for-sustainable-investments-what-businesses-should-be-thinking-about

¹² https://www.sciencedirect.com/science/article/abs/pii/S0360835222004193 Visited on 19/11/2024

¹³ https://www.cbi.org.uk/media/zg5helql/tax-and-green-investment-report.pdf (Visited 23/11/24)

¹⁴ Front. Environ. Sci., 03 June 2024,Sec. Environmental Policy and Governance Volume 12 – 2024 | https://doi.org/10.3389/fenvs.2024.1392244 Constructing and implementing a green taxation system in China under the dual-carbon target

Hehe Liu*

¹⁵ ibid

¹⁶ Ibid.

(The Author is a former Principal Chief Commissioner of Income Tax, IRS in India, with multiple publications on contemporary tax and Public Policy Issues and the views are personal)