EU VAT: EU VAT implications of emissions allowance trading and the threat of fraud

Faced with the threat of carousel fraud in the context of EU emissions allowances, together with the different responses to this issue by certain EU Member States, the European Commission has published a draft directive giving Member States the option to apply the reverse charge mechanism to the supply of EU emissions allowances, as well as to a list of goods typically susceptible to VAT fraud.

This article looks at the emissions market, the potential for carousel fraud, the reaction of certain Member States to this threat and the implications of the proposed Directive.


Emissions market

The concept of emissions trading was conceived of as one of the tools in the global effort to reduce pollution. The idea for a market for emission allowances emerged with the Kyoto Protocol (adopted in 1997 and entering into force in 2005), an international agreement linked to the United Nations Framework Convention on Climate Change, under which signatory countries must meet their targets primarily through national measures, although the protocol offers additional means of meeting targets by way of three market-based mechanisms. These include a mechanism of emissions trading (or carbon market), a clean development mechanism (allowing countries with emission reduction obligations to implement projects in developing countries to reduce emissions, and thereby earn credits) and a joint implementation mechanism (allowing a country with an emission reduction obligation to earn credits through projects in another country with emission reduction obligations).

The EU adopted a Quota Directive (Directive 2003/87/EC) in 2003 (updated in 2009) that provides for the creation of a greenhouse gas emission trading scheme within the Community. The EU Emission Trading Scheme, based on the directive and which became effective on 1 January 2005, is the world's largest "multi-country, multi-sector emission trading system." It allows "polluters" to emit a certain amount of greenhouse gases during a specified period. The scheme covers activities with high emission levels (e.g. oil refineries, the production of gas and electricity, the iron and steel industry, the manufacture of construction materials and the glass industry).

The EU uses "National Allocation Plans" to achieve the reduction in greenhouse gases. In developing National Allocation Plans, EU Member States are allocated quotas of greenhouse gas emission allowances depending on the installations (i.e. technical units carrying out specified activities) in their territory. According to the Quota Directive, the term "allowance" refers to the right to emit one ton of carbon dioxide equivalent during a specified period.

Following allocations to Member States, the installations in the respective territories receive a specific quantity of emissions allowances per year. These allowances can be exchanged between the different installations according to their level of polluting activities. In this way, the installations can sell their extra allowances or purchase additional allowances on the exchange. Interestingly, the market is not reserved exclusively to carbon dioxide emissions or to a particular Member State.

The transfer and acquisition of quotas takes place through a real marketplace that is open to all types of business and different types of greenhouse gases.

The transfer of emission allowances qualifies as a supply of services for VAT purposes (the transfer of rights), taking place between taxable persons and falling within the scope of VAT. Thus, for example, when a transaction takes place in Luxembourg for VAT purposes, it is subject to Luxembourg VAT and does not benefit from any exemption. In the case of a cross-border supply of emissions allowances, the supply is taxable in the country where the (taxable) recipient is established, with the recipient liable for VAT under the reverse charge mechanism (i.e. instead of the usual situation in which the supplier applies VAT to the transaction before collecting and paying it to the tax authorities, the recipient of the service becomes liable for the VAT via a "self-assessment" procedure on his VAT return and then recovers the VAT on the same VAT return according to his normal VAT recovery position). In the majority of Member States, there is currently no exemption for these transactions.


Threat of carousel fraud and reactions of Member States

Carousel fraud has been an intractable issue in the EU, with Member States losing billions of euros in revenue from the practice. Carousel fraud is a form of VAT fraud, typically involving transactions comprising small but high value goods (e.g. cell phones, computer chips, etc.) and chains of supplies between entities in different Member States. Typically one of the traders in the chain collects the VAT from his customer on a local transaction, but disappears before paying this over to the tax authorities. The customer nonetheless has a valid VAT invoice on which it has the right to recover the VAT from the VAT authorities. This results in a situation in which the Member State's treasury does not receive the VAT on the supply, but must nonetheless give the next trader in the line the relevant credit. It now appears that carousel fraud could arise in the context of other commodities, such as emissions trading. In its simplest form, a carousel fraud scheme could work as follows: Company A, a taxable person based in Luxembourg, purchases emission allowances from Company B, in another Member State. Company B does not charge VAT on the purchase because it is an intra-Community supply. Company A resells the emissions allowances to Company C, also in Luxembourg, and charges VAT on the transaction. B then disappears without paying the VAT due to the Luxembourg tax authorities.

Given that the values in question can be high, certain Member States have reacted to carousel fraud concerns by amending
their rules:
- On 10 June 2009, France decided to exempt relevant transactions for VAT purposes, treating them as transactions involving financial products. By exempting these transactions, suppliers will not charge VAT on the supplies. However, when the transactions are with EU counterparties, the supplier will be unable to recover any VAT incurred on related costs.
- On 14 July 2009, the Netherlands decided to extend the reverse charge mechanism to apply to all transactions relating to emissions allowance trading, including local transactions. As a result, the purchaser, rather than the seller, is responsible for the VAT upon purchase; and
- On 31 July 2009, the U.K. decided to zero-rate these transactions, meaning that the transactions fall within the scope of VAT but VAT is charged at 0%. Unlike under the exemption mechanism, zero rating (also referred to as "exempt with VAT credit") allows the supplier to recover VAT incurred on related costs.


Draft VAT Directive

In response to the existing level of fraud for certain goods, together with the threat of such fraud in the context of emissions trading and the different responses by Member States, the European Commission published a press release on a draft directive on 29 September 2009 proposing an optional and temporary application of the reverse charge mechanism in relation to certain supplies of goods and services, including the trading of EU greenhouse gas emissions allowances.

Furthermore, in such cases the reverse charge also would apply to local purchases of these goods and services. Application of the reverse charge in this context would eliminate the potential threat of fraud because the customer would become liable for the VAT and, to the extent that it has a full right to deduct the VAT on its purchases, the overall impact is neutral because the customer would declare and recover the VAT on the same return.

It is important to note that:
- Unlike previous proposals relating to the reverse charge to combat fraud, the draft directive is not intended to have general application to all goods and services; Member States would be permitted to apply this reverse charge only to specific categories of transactions and further limited to a maximum of three categories, of which no more than two can be goods.
- Application of the reverse charge would be optional for the Member States, which may suggest that the Member States remain free to choose other methods (if appropriate and in line with EU law).
- In the absence of actual statistics of the extent to which the reverse charge is actually an effective instrument to tackle fraud, it will be necessary to evaluate the regime as implemented by the Member States. More particularly, Member States choosing to apply the reverse charge regime to greenhouse gas emissions will have to establish criteria for evaluation and produce a report at the end of the period to conclude on the effectiveness of the measures.
- Member States choosing to introduce the reverse charge mechanism will be required to implement a number of measures, including the identification of the taxable persons involved (if not already the case), appropriate and effective reporting obligations and appropriate and effective control measures.

While the draft directive has not yet been approved by ECOFIN, this is likely to take place in the near future because the fight against fraud remains high on the priority lists of the Member States.