Voluntary carbon offsets (VCOs) provide businesses with the opportunity to achieve a net reduction in greenhouse gas emissions by financially supporting the efforts of another entity involved in carbon reduction initiatives. Their significance is growing as companies evaluate and disclose their environmental, social, and governance (ESG) goals and practices.

Frameworks for consistent and reliable ESG disclosure are being developed by U.S. and international financial reporting boards and agencies, including the SEC. The tax treatment of VCOs is not clearly defined and varies based on individual circumstances. VCO costs may be currently tax deductible under Sec. 162 if proven to be an ordinary and necessary expense, but if providing long-term benefits, they may be subject to capitalization under Sec. 263.

Some companies acquire VCOs by funding carbon offset projects managed by not-for-profit entities, with payments to such entities often treated as charitable contributions. However, arguments can be made that the nature of VCOs makes these payments ordinary and necessary expenses deductible under Sec. 162.

Over the past two decades, the concept and implementation of carbon offsets have experienced significant growth and acceptance. The offset approach facilitates the transfer of resources to achieve emissions reductions, allowing one party to purchase carbon offsets and fund projects reducing emissions for another party. This mutually beneficial transfer addresses challenges faced by businesses with difficult-to-reduce emissions and others with more achievable reductions but limited resources.

Carbon offsets are utilized in both compliance and voluntary markets. While compliance markets involve meeting legal requirements, voluntary markets allow participants to address ESG objectives without formal obligations to reduce emissions. Companies are increasingly focusing on ESG goals, and the purchase of VCOs is emerging as a strategic approach to support these objectives.

The discussion emphasizes the tax deductibility of VCO purchases as trade or business expenses. As VCOs and ESG actions become more expected and stakeholders increasingly prioritize environmental considerations, the question arises: Can these voluntary expenses be treated as "ordinary and necessary"?

The TCFD and SEC discussions underscore the shift towards de facto mandatory reporting on ESG actions, making these expenditures crucial for reputational goodwill. The deductibility of VCO payments under Sec. 162 relies on them being considered ordinary and necessary expenses tied to the taxpayer's business purpose.

The analysis delves into the income tax principles of Secs. 162 and 263 to determine the deductibility of VCO payments. Sec. 162 requires expenses to be ordinary and necessary for carrying on a trade or business, while Sec. 263 addresses the capitalization of costs providing long-term benefits. The Welch v. Helvering case highlights the importance of expenses being ordinary and necessary, and the Jenkins case provides insights into deductions made to protect business reputation.

Considering the evolving nature of VCOs and broader ESG initiatives, companies are moving towards internalizing externalities and measuring the full cost of operations, including environmental impacts. Although not currently mandatory, these actions are becoming expected, impacting strategic decision-making, customer preferences, and supply chain considerations.

The deductibility of VCO payments hinges on their nature and the timeframe of benefits. While VCOs may resemble payments in the example in Regs. Sec. 1.263(a)-4, being treated as deductible expenses enhancing the business's operating viability, the unique property right nature of VCOs raises considerations of capitalization on purchase. However, the retirement of VCOs after being counted against a company's emissions suggests that they cannot be double-counted, aligning with the goal of achieving net-zero emissions.

The discussion also considers the potential shift away from charitable contributions as VCO markets evolve towards exchange-based approaches. Companies are increasingly purchasing VCOs on the market, introducing the question of whether payments to not-for-profit entities should be treated as charitable contributions or ordinary and necessary expenses.

In conclusion, the motivation for incurring ESG expenditures, including VCOs, is evolving into an expected ordinary and necessary cost of doing business. Stakeholders' changing expectations and the movement towards mandatory reporting continue to incentivize companies to adopt VCOs and other climate-related strategies. The tax deductibility of these expenditures will likely remain a subject of ongoing evaluation and adaptation as regulatory frameworks and stakeholder expectations continue to evolve.

Source: The Tax Adviser