Gains from the Sale of EU Carbon Emission Allowances Not Treated
as Subpart F Income
By David R. Tillinghast,
Esq.
Baker & McKenzie, New York, NY
The subject matter of PLR 200825009 does not concern everybody, but
it is of some importance to those CFCs that it does affect. The PLR
concluded that, at least in the circumstances presented and under the
existing regulations, gain recognized on the sale of EU carbon
emission allowances by a CFC (and a partnership in which a CFC was a
partner) to unrelated parties does not constitute currently taxable
foreign personal holding company income under §954(c).
The PLR involved a CFC in which a U.S. corporation indirectly owned
stock and a partnership in which another CFC owned by the U.S.
corporation and one of the parent's domestic subsidiaries owned all of
the partnership interests. Both the first CFC and the partnership were
engaged in a business within the European Community which resulted in
the creation of emissions of carbon dioxide (CO2). They were,
therefore, subject to the terms of the EU Emissions Trading Scheme,
which regulates the emission of CO2. Briefly, each EU country is
assigned a quota which limits the amount of greenhouse gasses
(including CO2) which industries within its borders may emit. Each
country then grants to its affected industries allowances for the
amount of emissions each may produce. If an enterprise produces
emissions in excess of its quota, it must pay a fine. If it emits less
than its quota, it may sell the excess. The allowances are traded over
the counter and on several European exchanges.
For the two years at issue, both the CFC and the partnership had
excess allowances, which they sold to unrelated
persons.1 The question presented
was whether gain on such sales was foreign personal holding company
income under §954(c) of the Code. Two possible characterizations
were considered by the IRS -- that the gains should be treated as
realized: (1) on the sale of commodities, and thus subject to the
provisions of §954(c)(1)(C); or (2) on the sale of property that
does not give rise to income, subject to §954(c)(1)(B)(iii).
The regulations under the latter subsection provide that it does
not apply to “intangible property (as defined in section
936(h)(3)…to the extent used or held for use in the controlled
foreign corporation's trade or business. . .
.”2 The IRS took the view
that the quoted exception applied. That section defines intangible
property to include a franchise, license, contract, or similar item
that has substantial value independent of the services of any
individual.3 The IRS considered
that emission allowances fell within this designation. In addition, it
noted that, since it would be unlawful for the CFC and the partnership
to operate without the allowances, the allowances were
“used” in the conduct of their businesses.
This latter conclusion is not quite right. Obviously, the
allowances that were sold were not in fact “used.” More
appropriately, they could be said to have been “held for
use” in the business. Interestingly, in this regard the IRS did
not require any representations by the taxpayer concerning the need
for the amount of allowances it held. Presumably, emission allowances
are scarce items, and at least some enterprises would like to have
more than they can get. Thus, it may have been thought that the
country issuing the allowances would monitor the need for them.
But also no inquiry was made into whenthe allowances had
been sold. There were two years at issue in the ruling. Suppose that
the facts would show that the allowances sold were year 1 allowances,
that management decided early in year 1 that they were not needed but
held off selling them until near the end of year 2, thinking that the
price would rise. Under the CFC rules, results differ if an item of
property once held for use in a business ceases to be so
held.4 Despite these caveats,
however, it appears that the IRS probably came to the right conclusion
on this issue.
More puzzling is the way in which the IRS treated the issue of
whether the allowances could be considered commodities subject to the
provisions of §954(c)(1)(C). To begin with, the PLR notes that
the taxpayer argued that the allowances should be treated as
commodities subject to that subsection. It is not apparent why the
taxpayer considered this advantageous. The IRS’ response to this
contention is even more mysterious. It stated that the IRS is
“currently studying this question but, solely for the purpose of
this letter ruling, believes it is appropriate at this point to
analyze the CO2 allowances as property that does not give rise to
income within the meaning of Code section 954(c)(1)(B)(iii).”
The ruling it issued, however, was that gain from the sale of the
emission allowances was not foreign personal holding company income
“within the meaning of Code section 954(c).” This
encompasses a ruling that §954(c)(1)(C) does not apply.
This is probably correct under the existing regulations. Regs.
§1.954-2(a)(2) defines a commodity as “tangible personal
property” of a kind that is actively traded or with respect
to which contractual interests are regularly
traded.”5 While emission
allowances are traded, they are not tangible property and are not
contractual interests in tangible property.
What is one to make, then, of the IRS's statement that it is
currently studying the status of allowances as commodities subject to
§954(c)(1)(C)? Does this mean that it is considering making a
change in the regulation quoted above? If so, it must think that
treating the emission allowances as commodities might make gain on
their disposition foreign personal holding company income. This may or
may not be true.
First, a determination would have to be made whether emission
allowances are principally or regularly traded (an issue on
which this author is not informed) and what standard is applied for
this purpose.6 It would also be
necessary to decide whether emission allowances are excluded from the
commodities rules under §954(c)(1)(C)(ii) as “active
business gains” from property described in §1221(a)(8),
which applies to “supplies of a type regularly used or
consumed by the taxpayer in the ordinary course of a trade or business
of the taxpayer.”7 This
author was unable to find in the §954 regulations a definition of
“active business gains.” There is a definition of
“qualified active sales” of commodities applicable only to
an active producer, processor, merchant, or handler of commodities,
which would not be applicable
here.8 This author also could not
find any authority on whether EU emissions allowances could be
“supplies,” although a PLR has treated emission allowances
issued under the U.S. Clean Air Act as not constituting supplies under
§1221(a)(8).9 It seems
likely, therefore, that §1221(a)(8) would be found inapplicable
here.
A child, asked to give his opinion of a book on penguins, is said
to have replied, “This book tells me considerably more about
penguins than I care to know.” The patient reader of this piece
undoubtedly feels that same way about emission allowances.
This commentary also will appear in the September 2008 issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Yoder, 927 T.M.,
CFCs--Foreign Personal Holding Company Income, and in Tax Practice
Series, see ¶7130, U.S. Persons--Foreign Activities.
1
A sale to a related party would involve the possible application of the foreign base company sales income rules of §954(d). See Regs. §1.954-3(a)(1) (rules not limited to sales of inventory property).
2
Regs. §1.954-2(a)(3)(iv).
3
§936(h)(3)(B).
4
Regs. §1.954-2(a)(3) provides that “the use for which property is held is that use or purpose for which it was held for more than one-half of the period during which the controlled foreign corporation held the property prior to disposition.”
5
Emphasis added.
6
The phrases “primarily traded” and “regularly traded” appear at various points in the Code and Treasury regulations. Many of these references are inapposite here because they refer specifically to trading in shares. Two possibly relevant references are Regs. §1.1092(d)-1(a), defining actively traded personal property as any property for which there is an established financial market (as defined in paragraph (b)), and Regs. §1.367(a)-1T(c)(3)(ii)(D), defining “regularly traded” limited partnership interests as those “regularly quoted by brokers and dealers making a market in such interests.”
7
Emphasis added.
8
Regs. §1.954-2(f)(3).
9
PLR 200728032. The ruling was taxpayer-friendly in that it preserved gain on sale of the allowances as capital gain.
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