Carbon sequestration: deduction for cost of planting trees

Is the taxpayer entitled to a deduction, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), for the costs incurred in planting trees to be grown for the purposes of carbon sequestration, where the trees are not intended to be felled?

No. The taxpayer is not entitled to a deduction, under section 8-1 of the ITAA 1997, for the costs incurred in planting trees to be grown for the purposes of carbon sequestration, where the trees are not intended to be felled. Such expenditure is capital in nature.

The taxpayer is carrying on carbon sequestration activities. The taxpayer has leased land from land owners for the purpose of planting forests for carbon sequestration purposes.

The taxpayer intends to plant trees on the leased land and leave them undisturbed for at least 100 years. The taxpayer does not intend to harvest the trees for timber.

The taxpayer has entered into a formal agreement with the land owners. Under the agreement the taxpayer holds all right, title and interest in the forest, and all right and title and interest in any carbon sequestration right. All carbon sequestration rights vest in the taxpayer.

The taxpayer has incurred costs in purchasing seedlings and in planting the trees.

The taxpayer intends to derive assessable income from trading in the carbon sequestered by the trees.

A deduction is allowed under section 8-1 of the ITAA 1997 for losses or outgoings to the extent that the loss or outgoing is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowed under the section where the loss or outgoing is of a capital, private or domestic nature, or is incurred in producing exempt income, or where another provision prevents a deduction.

In order for a deduction to be allowable under section 8-1 of the ITAA 1997 there must be a sufficient nexus or connection between the expenditure and the earning of assessable income. As the taxpayer is purchasing and planting the trees for the purpose of deriving assessable income from the use of the carbon sequestered by those trees there is a sufficient connection between the expense of purchasing and planting the seedlings and the income earned from the carbon sequestration activities. The only relevant question then in determining the deductibility of those expenses under section 8-1 of the ITAA 1997 is whether the expenses are capital in nature.

The decision of the High Court in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; [1938] HCA 73 ( Sun Newspapers Case ) is a leading authority on the distinction between revenue and capital expenditure.

In the Sun Newspapers Case Dixon J stated that there are three matters to consider when deciding whether an expense is revenue or capital in nature. These are: • the character of the advantage sought by the outgoing • the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer, and • the means adopted to obtain the advantage, such as by recurring payments.

In a more recent decision the High Court in G P International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1 added emphasis to the first point above. The court stated: ...for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.

In relation to the character of the advantage sought by the outgoing it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205, by Viscount Cave at 213-214: But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

The costs incurred by the taxpayer in purchasing and planting the seedlings are capital in nature because they secure for the taxpayer an enduring benefit being the establishment of the trees from which the taxpayer will obtain its income through the carbon sequestered by those trees. As the trees are not intended to be felled they will become capital assets of the business when planted. This expenditure is correctly characterised as establishing the profit yielding structure of the business rather than being a working expense. As the costs of purchasing and planting the trees is capital in nature no deduction is allowed for these costs under section 8-1 of the ITAA 1997. Note: ATO ID 2004/718 addresses the deductibility of expenses in situations where carbon sequestration activities are conducted in conjunction with normal forestry operations, where the trees are harvested for timber.