The global focus on climate neutrality is pressuring businesses to consider sustainable measures to reduce their carbon footprint. Organizations are being lauded for implementing green initiatives but for some, reaching a meaningful reduction in carbon emissions may prove too costly or disruptive. As an alternative, companies are considering a program that supports investments in environmental projects as a means of balancing their own carbon output.
How?
By purchasing carbon offsets.
What Are Carbon Offsets?
In lieu of taking steps to reduce your business’s carbon output, you can pay for another business to reduce theirs. When you purchase a carbon offset, you incentivize another business to invest in sustainable sources of energy, thereby improving overall carbon emissions.
But how do carbon offsets actually work?
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Step 1: |
Company A measures their carbon output and decides they want to reduce their carbon emissions. |
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Step 2: |
Company A invests in a carbon emissions reduction project organized by Company B. |
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Step 3: |
Company B uses that money to fund their emissions reduction project (e.g., building a solar park, erecting wind turbines, planting trees, assisting sustainable farming initiatives, etc.). |
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Step 4: |
Company B acknowledges that Company A’s investment helped them reduce carbon emissions by granting them with a carbon offset certificate. |
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Step 5: |
Company A presents this carbon offset certificate to show stakeholders or compliance agencies they’ve taken steps to reduce carbon emissions. |
You can purchase carbon offsets to meet environmental compliance standards, like those set by the Environmental Protection Agency (EPA), or you can purchase them voluntarily. Businesses that voluntarily invest in carbon offsets do so for a variety of reasons — out of concern for the environment, to boost their public image, as a stopgap measure until they can implement sustainable changes to their own operations — but no matter their intent, they need to know how to report those costs to the IRS.
Are Voluntary Carbon Offsets Deductible?
Voluntary carbon offsets (VCOs) are — by definition — optional, which begs the question: Are they deductible for tax purposes?
Section 162 of the Internal Revenue Code states that an expense must be “ordinary and necessary” to be deductible. If a business purchases a VCO, they are not reducing their own carbon footprint; rather, they are enabling another business to reduce theirs. Can they truly argue that the expense is ordinary and necessary?
The IRS has not yet released firm guidance on how to treat VCOs, but typically, an expense is not ordinary and necessary if it is undertaken for reasons unrelated to the business. Determining whether your VCO purchase helped support your business’s purpose will depend on all the facts and circumstances. You can make this determination by asking yourself some of the following questions: Why are you purchasing a VCO? What are you gaining from your purchase? How will this VCO purchase and future VCO purchases help you long-term?
We also cannot ignore that stakeholders’ expectations have changed. Stakeholders today expect most businesses to be taking steps toward reducing their environmental footprints. Even if businesses aren’t technically obligated to make more sustainable choices, one could argue that VCOs are both ordinary and necessary for businesses to remain competitive.
Should VCOs Be Capitalized?
If you and your tax advisor believe you can successfully argue for the deduction, you must then figure out if you can take that deduction currently under Section 162 of the Internal Revenue Code, or if you should capitalize those costs under Section 263. If a VCO will benefit your business years into the future, you may need to capitalize those costs. By capitalizing your VCO purchases, you will be deducting those costs slowly over time, more closely tying the tax deduction with the benefits you reap from your investment.
The IRS does not have a bright line test to determine if an expense like a VCO should be capitalized or deducted when incurred. In support of Section 263, the IRS will look to see whether you created a separate and distinct intangible asset when you purchased the VCO. An intangible asset is separate and distinct when its value is ascertainable and when it is capable of being sold, transferred, or pledged. VCOs may very well meet this definition. Many VCOs are purchased on a carbon offset exchange, and businesses can trade or sell rights to those VCOs to other businesses.
Comb through all the facts and circumstances with your tax advisor to determine the best route for you to take.
