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Hearing of the Senate Finance Committee - Climate Change Legislation: Tax Considerations


Location: Washington, DC

Chaired By: Sen. Max Baucus

Witnesses: Gary Hufbauer, Reginald Jones Senior Fellow, Peterson Institute for International Economics; Mark Price, Principal-In-Charge, Financial Institutions and Products, Washington National Tax, KPMG LLP.; Keith Butler, Senior Vice President of Tax, Duke Energy

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SEN. MAX BAUCUS (D-MT): We'll come to order.

First, I apologize for starting so late. I think this is a record. Since I've chaired this committee, I've never commenced a hearing as late as this, and I apologize to all of you that something came up we had to attend to.

The author Theodore Roszak wrote, "Nature composes some of her loveliest poems for the microscope and the telescope."

Today, we consider one of the broadest subjects in nature, that of climate change, and we are going to look at it through a particular microscope, that of tax policy. Today, we'll look at the tax implications of legislation on global warming. We'll consider the narrow question: How should the tax law treat allowances? The answer will have broad implications.

Most major climate change proposals set an emissions target on greenhouse gas emissions. For example, the Obama administration proposes capping greenhouse gases in 2020 at 14 percent below the level emitted in 2005. The cap is then divided into emission allowances. An allowance is the right to emit one ton of carbon dioxide or its equivalent. People can then buy or sell those allowances. Or folks can hold onto them for the future. Some proposals would distribute allowances free of charge. Other proposals would sell the allowances through an auction. Still others would combine distributing and auctioning.

Today, we'll put questions like these under the microscope: If allocations are distributed for free, should the tax law treat them as income to the recipient? Should the tax code treat an emission allowance as a capital asset, subject to depreciation over time? Or should the law allow buyers to deduct the cost of buying an allowance as a cost of doing business? How should the law treat gains and losses associated with allowances? Should the law treat them as capital gains or ordinary income from a sale? And should the system allow emission allowances to be banked and carried forward to future years?

The Treasury Department has provided some approaches to some of these questions through guidance on legislation to limit acid rain. The Clean Air Act amendments of 1990 successfully cut sulfur dioxide emissions in the least costly way, and Treasury's guidance was important in determining how the exchange of allowances should be considered from a tax perspective.

Should Congress abide by this same guidance in considering legislation to reduce carbon emissions? It may be appropriate to adopt some past practices on tax treatment of allowances, but the scope of the Clean Air Act amendments is much smaller than legislation to cut carbon emissions. For example, the acid rain program applied to fewer than 120 facilities nationwide. Cap and trade will apply to over 7,000. Moreover, the law has changed since 1992. Congress has enacted major tax legislation, including legislation affecting the amortization of intangible assets, since Treasury issued its 1992 guidance.

I support legislation to reduce carbon emissions. The Finance Committee will play a key role in that law's development. In a recent hearing, we explored the implications of a carbon auction. In another hearing next month, we'll look at what climate change legislation means to our trade-exposed industries.

We have also been working hard to smooth the transition to a low- carbon economy through other means, especially energy tax incentives. In the last year, we passed more than $38 billion in energy tax incentives for areas ranging from fuels to efficiency to clean electricity. We have a great deal more to do and will continue our efforts in the coming weeks and months.

I appreciate our distinguished witnesses being here today, and I also appreciate the Joint Committee on Taxation for providing yet another solid background pamphlet for today's hearing.

Now the tax law is certainly not among the world's loveliest poems, but every now and then, it's important to take a look at it under a microscope, and, by doing so today, we'll try to advance one of the broadest goals in nature, that of slowing climate change.

Senator Grassley?

SEN. CHARLES GRASSLEY (R-IA): Thank you, Mr. Chairman.

There are, of course, many technical tax questions that will be addressed.

The first point that I should make is that if cap and trade isn't enacted, then we're worrying about these questions for nothing. However, if it is enacted, then a bunch of tax issues need to be dealt with.

For example, if allowances to emit carbon dioxide are given away free, should the corporations that receive these valuable allowances be taxed upon receipt of them? There are various opinions about whether allowances should be given away or auctioned off. Waxman- Markey initially gives away 85 percent of its allowances for free. These 85 percent of allowances are estimated by CBO to be worth about $693 billion over 10 years.

However, Peter Orszag, the administration's OMB director, yet when he was CBO director in 2007, testified before Congress that, quote, "If you didn't auction the permits, it would represent the largest corporate welfare program that has ever been enacted in the history of the United States," end of quote.

Similarly, in responses to my question for record from a March 4, 2009, hearing on the administration's budget, Secretary Geithner wrote, quote, "The program will be implemented through an economy-wide cap and trade program in which all emission allowances will be auctioned to ensure that the biggest polluters do not enjoy windfall profits," end of quote.

So, if the administration has its way, we won't even need to consider the tax treatment of allowances given away for free.

One thing that concerns me with cap and trade is that the current version appears to be pain and no gain. In other words, the American consumer will pay higher energy prices as well as higher prices for all goods and services. That's the pain part. But, unless there's an agreement with China, which is the largest emitter of greenhouse gases, as well as, you might include, for instance, Russia and India and other large emitters, then there is no gain.

We could reduce our greenhouse gas emissions while the rest of the world continues to increase its emissions, resulting in increasing emissions worldwide. Meanwhile, our consumers and economy then would suffer from our own cap and trade program.

We have a June 13 Washington Post article stating, quote, "Instead, the special U.S. envoy for climate change said yesterday he would press for China to reduce the rate at which its emissions grow. Even Todd D. Stern said at a news conference that he wants China's emissions to increase less than projected, quote, 'So that's not an absolute reduction below where they are right now,' Stern said, 'because they're not quite at that point to be able to do that'," end of quote.

Of course, that sounds a lot like President George Bush's proposal to limit greenhouse gas intensity relative to GDP, which was roundly panned by environmental groups.

I'm also concerned about the fact that the speculators from Wall Street, Chicago, and San Francisco have been all too eager to embrace cap and trade. Cap and trade would represent a huge new market that hedge funds and private equity firms are salivating over. In fact, Enron and AIG were two of the early proponents of cap and trade.

Four years ago, this committee held a hearing on the activities of The Nature Conservancy. These activities included the organization's receipt of contributions in exchange for emissions credit. The staff report on these arrangements raised a number of tax issues for both the exempt organization as well as polluters that also need to be addressed. We will hear today how all of these exotic derivatives on allowances should be taxed.

We know if cap and trade is enacted, of course, Wall Street people will be happy to help in designing derivatives based on allowances. Some of these derivatives will be futures, forwards, options, collars, swaps, call spreads, swaptions, and hybrids of the above derivatives. I worry about Wall Street speculators making fortunes off the back of the American taxpayer.

Thank you, Mr. Chairman.

SEN. BAUCUS: Thank you, Senator.

I'll now turn to our witnesses.

The first is Dr. Gary Hufbauer, the Reginald Jones senior fellow at the Peterson Institute for International Economics.

Welcome back, Gary. Good to see you.

Next, Mark Price, principal-in-charge of financial institutions and products at Washington National Tax Group at KPMG.

And finally, Keith Butler, senior vice president of tax at Duke Energy.

I'll ask each of you to summarize your statements. They'll all be automatically included in the record.

So why don't you begin, Mr. Hufbauer?

MR. HUFBAUER: Thank you very much, Mr. Chairman and members of the committee.

Recently, I was a co-author of the book "Global Warming and the World Trading System." I'm going to leave some copies, and that does not deal with these tax issues, but it does deal with a lot of the important trading issues which you will be addressing later.

As you've said, Mr. Chairman, this is a very serious problem. In my personal view, a carbon tax system would be vastly superior to a cap and trade system on transparency, uniformity, revenue raising, administration, and more readily adjusted at the border, and I think the Waxman-Markey bill illustrates the enormous complexity, opacity, and rent-seeking inherent in a permit type of system.

But, that said, the political forces are favoring a cap and trade system, so my purpose today is to comment on the tax and trading aspects of this system. And when I use the word "carbon permits," I'm referring to all greenhouse gas permits on a carbon dioxide equivalent basis.

So let me quickly run through just some questions and answers in my testimony.

Are free allowances of carbon permits income? This is the threshold question, and my answer is a very decisive yes. I think it would be an enormous travesty after these bills which propose to give all these free allowances -- and we don't even get to 50 percent auction in Waxman-Markey until 2029 -- to then make them in some sense tax exempt.

I think, Mr. Chairman, you've summarized the differences between the SO2 allowances and the carbon. In terms of size, in terms of dimension, it's completely different. And further, we learn a lot over time, and I think we've learned about markets for things like these kind of permits. So to draw heavily on the SO2 analogy, I think, would be quite inappropriate.

And in line with that, I would say that another task for this committee, working with other committees, is to ensure that these are tradable and easy to value, so we don't get into the opacity, which -- (inaudible) -- tradable permits would then slide into the non- taxation.

Should they be a business deduction? Well, by all means, they should be, and I would say in the year purchased as an ordinary and necessary business expense. I would hope that this does not get into the capitalization, all the complexities there.

On the trading in carbon permits, I would not make a distinction between the type of holder, and as for the type of income, I would hope that it would be all treated as ordinary income, again to get away from any kind of capital gains complexities.

Now let me turn to the oversight and regulation of trading in carbon permits. I'm a real believer in financial markets, but I am a very strong disbeliever, objector, to unregulated over-the-counter markets which got us into so much trouble as part of this financial crisis. So, if we create a system in this country of tradable permits, there should be a simultaneous authorization of exchanges to handle the permits, and all transactions should take place on those exchanges. They should be posting prices, volumes, and also the parties doing the trading should be notified.

One final point I'll make, and that's on collars. I think that collars would be a very good idea in a permit system -- that's floors and ceilings -- because that will smooth out and allow a longer appreciation by firms of the prices they're going to face and, therefore, the adjustments they have to make, and also will enable spikes to be avoided. In my view, the EPA should be the administrator which proposes the callers, but I think this will be such an important price for the American economy, Congress should review and possibly disapprove anything done by way of collars.

Just one final comment: I did have a chance over the weekend to read the joint committee's excellent pamphlet, and what I would say is this: This points out all sorts of room for complexity in the taxation of offsets and taxation of allowances and deductions and so forth and so on, and I do hope that the committees goes for simplicity, not complexity.

Thank you very much.

SEN. GRASSLEY: Now we'll call on Mr. Price.

MR. PRICE: Mr. Chairman, Ranking Member Grassley, members of the committee, good morning. My name is Mark Price.

I'm a principal at KPMG LLP, a major U.S. accounting form. I am pleased to have the opportunity to testify as an invited witness before the committee this morning on the topic of the tax considerations associated with climate change legislation.

During my testimony, I will take the next several minutes to summarize the points in the written testimony submitted to the committee. During this summary, I'd like to highlight the following points.

First, current law does offer an approach to taxing allowances and offsets, but current law may lack certainty on several issues of significance to the various participants in the cap and trade system and to the Internal Revenue Service.

Second, current law is based on authorities that have not been updated for changes in tax legislation.

And finally, the allowances and offsets in the cap and trade proposals raise issues that may be more appropriately addressed through legislation.

The two significant issues raised by cap and trade for covered entities are likely to be the character and timing of gain or loss, character because the current rule that corporations can only apply capital losses against capital gains and not ordinary business income may create cash flow issues from any set of rules that could produce ordinary income and capital loss and timing because the recognition of income in advance of expense could also affect an entity's cash flow.

The tax treatment of the transaction is fact dependent. As the chairman has noted, the tax treatment of cap and trade under current law would be based primarily on authorities issued by the Internal Revenue Service on the treatment of sulfur dioxide emissions under the Clean Air Act amendments of 1990. This guidance must be considered in conjunction with current law on other topics.

Now I'd like to summarize briefly what I believe is the current tax treatment under current law.

First, what happens on acquisition? Covered entities that are granted allowances from the federal government likely under current law do not have income on the date of grant. That is consistent with the 1992 ruling by the IRS on sulfur dioxide emissions allowances.

Second, what happens when a covered entity uses the allowance in its trade or business? Although the answer is not entirely clear, the strongest answer under current law is that the amount paid for the expense, if any, is allowed as an expense in the year the allowance would be used.

Third, if an entity sells an allowance, what is the character of the gain or loss? Now, interestingly, the answer to this will depend on whether or not the allowance is considered depreciable. Allowances not intended to be used in the business are generally going to produce capital gain or loss, but allowances that are intended to be used to satisfy emissions requirements may produce capital gain, may produce ordinary gain or loss, depending on, first, whether those allowances are depreciable and, second, the period of time for which the allowances are held.

This uncertainty is highlighted by -- is created in part by the fact that the IRS's guidance on the topic relating to sulfur dioxide emissions, as Mr. Hufbauer noted and as the chairman noted, predates the enactment of legislation regarding the amortization of intangibles.

Another category of character uncertainty relates to what happens to entities that are considered, quote, "dealers in allowances." I'd first note that under current law what is a dealer is an uncertain concept. Secondly, I'd say those dealers would have ordinary income or loss, assuming that they qualify as a dealer.

The final thing under current law I'd like to point out is: What happens to those entities that have to purchase emissions allowances? Entities that purchase emissions allowances will be required most likely to manage their price risk for the purchase of these allowances. They will likely have to do this through entering the derivatives market, and in entering the derivatives market, there exists an age-old question as to the character of gain or loss from the derivatives.

Obviously, it would be unreasonable for the law to produce capital loss or capital gain on the derivative while producing ordinary gain or loss on the commissions allowance. Unfortunately, under current law, it would appear the likely answer is that those emissions allowances would be capital, creating a character mismatch between the risk management policies that the users will need to undertake and the assets that they'll need to purchase to satisfy this new regulatory requirement.

I'd also take -- like to take a few minutes just briefly to comment on some considerations for tax legislation.

First, I think it's appropriate for the committee to consider whether or not the current law rules are appropriate. I've stated what I believe they are. It's still a second question as to whether the right tax policy answer is the answers that I've suggested.

Second, what should the committee do about the borrowing of allowances? This is a new concept not seen in the sulfur dioxide allowance rules. It's also a new concept that, you know, hasn't been developed in great detail. And the tax treatment of it's going to depend on the form, and the form should be -- as the form evolves, it would be appropriate to consider the taxation.

Third, the fees for non-compliance -- are these fees going to be deductible or not?

And finally -- here's an oddball comment -- whether or not these allowances are characterized as commodities creates a whole web of issues for taxpayers. It affects whether financiers can mark-to- market. It affects whether or not they're amortizable. It affects the international tax implications.

It would be reasonable for any tax-writing committee to consider whether, A, it's appropriate to link all of these to the concept of a commodity and, B, whether the right answers produced by the conclusion that it is or is not a commodity are desirable.

Thank you for the opportunity to testify.

SEN. GRASSLEY: Thank you, Mr. Price.

Mr. Butler?

MR. BUTLER: Good morning Chairman Baucus, Ranking Member Grassley, and other distinguished members of the committee. Thank you for the opportunity to appear before you today to discuss the tax considerations related to climate change.

My name is Keith Butler, and I'm senior vice president of tax for Duke Energy Corporation. We're the largest electric utility companies in the United States, supplying and delivering electricity to approximately four million U.S. customers in our regulated jurisdictions of North and South Carolina, Indiana, Kentucky, and Ohio.

Duke Energy is also an active developer and owner of an expanding portfolio of renewable energy assets. In considering the direction for the tax treatment of CO2 allowances, the most logical place to start is with the current treatment for SO2 and NOX allowances.

These allowances were established under Title 4 of the Clean Air Act amendments of 1990. These new and unique allowances at the time opened the door to tax directors and the Internal Revenue Service to establish guidelines, regulations, and interpretations of how these allowances should be treated for tax purposes. The tax treatment for these allowances became dependent on the nature and character of how the taxpayer handled these allowances within their company.

The initial issue that had to be addressed by taxpayers was the tax basis of the allowance. This was the least challenging issue in the sense that if the allowances were received through an allocation from the EPA, these were considered to be at no cost to the taxpayer, and thus the tax basis was zero. As with most acquired assets, if the allowance was obtained through a purchase by the taxpayer, the tax basis is the cost paid plus any incidental costs, such as fees to brokers, legal costs, et cetera. With respect to the proposed CO2 allowances, there are no material issues that would call for a change in this treatment.

A more challenging issue is centered on the recovery of the cost or tax basis of the allowance itself. The least controversial recovery consideration centers on the allowances allocated by the EPA to the taxpayer. Since the taxpayer has a zero basis in these allowances, the taxpayer would not have or need the benefit of a tax deduction at the time the allowance is utilized.

The more complex issues center on the treatment when the recovery of the basis is through the sale of the allowance and the determination of the nature of the gain or loss as to whether it is capital or ordinary. The treatment is determined by the characterization of the allowance by the taxpayer and the nature of the activity by the taxpayer with respect to these allowances. This is where there seems to be some ambiguity in the tax guidance.

A typical holder of allowances that is using the allowances for their own offset purposes and may have the occasional opportunity to sell an allowance would generally treat the sale as capital, thus resulting in a capital gain or loss. This is supported by the IRS's guidance in Revenue Procedure 92-91.

The taxpayer can have a mismatch in cash flow due to the inability to offset capital losses if the taxpayer does not have sufficient capital gains within the specific tax period. If, however, the taxpayer in their ordinary course of business is regularly dealing in allowances by buying and selling allowances as part of their business, the IRS guidance would imply ordinary treatment in the resulting gains and losses, although there is some lack of clarity in the tax guidance.

And lastly, if a taxpayer is treating the allowance as a commodity and trading in these securities, capital treatment would tend to rule, although this, again, is less clear.

Clearly, this is one of the areas in which more clarity from the IRS could be useful to taxpayers, especially if the CO2 allowances introduced broader recovery initiatives, including the introduction of international markets, restrictions to transactions only through commodity exchanges, or the consideration with offsets.

Another area to be addressed further is the one method for a taxpayer to recover its basis through a like-kind exchange. The guidance under Section 1031 of the code is clear on the treatment. The issue is: Is an emission an emission, is or there a unique differences between an SO2, a NOX, or a CO2?

As you can see from these comments, although the current program of SO2 and NOX allowances is working well, there are issues of ambiguity in the tax treatment introduced by the broadness in how these allowances are used, exchanged, and recovered. Flexibility is important, as different taxpayers have varying needs and uses for the allowances and as the markets evolve over time. A balance of clarity and flexibility is important to well-functioning markets.

The IRS Department of Treasury, your committee, and other key governmental agencies working hand in hand with affected taxpayers will need to factor in past, current, and future activities centering on emission allowances and related programs when formulating the tax treatment.

Thank you, Chairman Baucus, Ranking Member Grassley, and other members of the committee, for the opportunity to share these remarks. Duke Energy stands ready to work with you and your colleagues with these initiatives.

SEN. GRASSLEY: I'll start by asking questions of Mr. Price and Mr. Butler, at least the first question.

I refer to the non-partisan Joint Committee on Taxation writing in their pamphlet referred to so far: Giving away free allowances and not taxing these allowances upon receipt is in effect compensating those that receive free allowances and doing it twice. With the exception of entities where they regulate a rate of return, such as utilities, Joint Tax says, quote, "The argument that there is no accession to wealth from the receipt of free allowances is more difficult to sustain."

So, Mr. Price, Mr. Butler, do you believe that there is an accession to wealth from the receipt of tax-free allowances? Or I should say free allowances, not tax-free allowances. That's the question.

MR. PRICE: Senator Grassley, I agree with the statement in the joint committee report that as an economic matter, there is an accession to wealth as a result of the allocation of allowances. I would note under current law that's similar accession to wealth has existed for sulfur dioxide allowances and in other cases involving the allocation of favorable leases to oil and gas companies to mine for oil and gas or other mineral rights, and so it seems at least under current law that the policy has been -- notwithstanding the fact that as an economic matter there is accession to wealth, the better answer from perhaps an administrability perspective is not to tax it. And, you know, as far as whether it ought to be taxed as a tax matter, I mean, that's a policy question that I leave for the committee to consider.

SEN. GRASSLEY: Mr. Butler?

MR. BUTLER: Thank you, Senator Grassley.

I agree with Mr. Price's response. The issue is if you tax the allocation as a recognition of wealth, it simply comes back as a deduction, and it potentially could add ultimately cost to the end customer.

SEN. GRASSLEY: My second question is that we have Wall Streeters lobbying for Congress to enact a cap and trade tax regime. Now this is for all of you. Do you think the speculators from hedge funds and private equity firms should be allowed to participate in the cap and trade tax regime?

I'll start with you, Mr. Hufbauer.

MR. HUFBAUER: Thank you.

Yes, I do, but only under the conditions outlined in my testimony, which is it's an organized exchange, (funding ?) derivatives at the margin and variation margin set by the exchange, all participants are revealed, no street names, quantities are revealed, and there can be no transactions outside the exchange. If there's going to be a market, let's make it a real market that can then be also the basis for taxation, but also to prevent all this kind of hanky-panky which you're so familiar with.


Mr. Price?

MR. PRICE: Again, I'm not in a position necessarily to comment on the regulatory conclusions. I would say as a tax matter, you know, as a general matter, I would observe that to some degree these third- party participants will be necessary to ensure some liquidity to the market, if one's going to adopt a system and cap and, quote, "trade," that one needs to make sure that the trading works efficiently.

As a tax matter, I think it's a question that the joint committee raised, as to how one taxes it, whether one wants to tax that group punitively. Under current law, I think there are a lot of uncertainties that may make those participants uncertain as to how to enter the market in a tax-efficient way.


Mr. Butler, do you have anything to add?

MR. BUTLER: No, sir.


My third question to the panel, as well probably my last question because of the time, President Obama has proposed a large number of tax increases in the budget. For example, his carried interest revenue raiser is broader than previous carried interest proposals. Also, he has proposed to repeal the favorable treatment for dealers and traders for futures and options on commodities. If enacted, how would these proposals affect the tax treatment of allowances and derivatives based on allowances?

Mr. Price? Mr. Butler? Any of you can respond, please.

MR. PRICE: Well, it's not entirely clear based on the description the administration put forth on the commodities dealer provision exactly the scope of it. As best I can tell, it would ensure that entities that trade and deal in commodities would end up with ordinary income on all of their commodities dealing in trading activities, which goes back to the question or comment I raised in my testimony. Under current law, these allowances would not be considered commodities, and, therefore, all of that proposed legislation would be inapplicable, and whether that's right is a question that I think is worth considering.


MR. HUFBAUER: Mr. Chairman, my view on that very interesting question is that the committee should start with a white slate on this carbon thing. I mean, this is so big and the numbers are so large that I don't think you should be affected by all this SO2 and what I would regard all these lousy decisions by the IRS in the past, not to be too polite about it, and you should start with a blank slate and just write the tax law for carbon, including the derivatives, and don't go on all these old analogies which are inappropriate.

Thank you.

SEN. GRASSLEY: Did you have anything to add, Mr. Butler?

Okay. I'll call on Mr. Conrad.

SEN. CONRAD (D-ND): Thank you.

SEN. GRASSLEY: Senator Conrad. Senator Conrad. (Laughter.)

SEN. CONRAD: Thank you, Senator Grassley.

And, by the way, Mr. Hufbauer, you are the first person in all the time I've been on this committee who have suggested that Senator Grassley is familiar with hanky-panky. (Laughter.) If there was ever a guy that's not familiar with hanky-panky --

SEN. GRASSLEY: I assume --

SEN. CONRAD: -- it's Senator Grassley.

SEN. GRASSLEY: I assume that's a compliment. (Laughter.)

SEN. CONRAD: That's the highest compliment in North Dakota.

I would like to ask each of the witnesses have you heard something from the other witnesses that you strongly agree with or strongly disagree with.

I'd start with you, Mr. Hufbauer.

MR. HUFBAUER: Well, as you heard from my remarks, I strongly disagree with Mr. Butler that we ought to, you know, resort to these old rulings on SO2 which is much more marketable -- I won't go through it again -- or some of these old revenue rulings on capital treatment and so on and so forth.

I mean, just to use that distant stuff from the past for this new market which is so vast is -- you know, I mean, why don't we bring over the laws from Amsterdam and apply them in New York today?


Mr. Butler?

MR. BUTLER: I'm not advocating that we look to the old rules and just carry those forward. I'm advocating that we look to those rules and, as I pointed out in my discussion, is -- there is some ambiguity. There's some lack of clarity, this distinguishment of how are these -- are these capital or are they ordinary, and I think that needs to be dealt with.

I do believe, though, that these allowances should be granted with zero tax basis and they should not be taxed upon granting it because that just creates an ultimate cost that I don't think we need to create.

SEN. CONRAD: Mr. Price?

MR. PRICE: I guess I agree to some extent with Mr. Butler and disagree with Mr. Hufbauer on the issue of character. I don't think under current law, whether you're looking at the emissions allowance legislation guidance in particular or more broadly, that the question of what the character of these assets are is at all crystal clear.

I think there are businesses for whom it is appropriate probably as a tax policy matter as well as just as a matter of tax law to get capital gain under this position. I also think that there is other situations where ordinary is the appropriate answer. So I guess the item that I maybe take the most issue with is sort of the black-and- white portrayal of the character.


Mr. Hufbauer, what would you see as the consequences to the federal Treasury of following the SO2 treatment, carrying that over to the CO2?

MR. HUFBAUER: Thank you, Senator.

The result will be that not only do we have this what I call -- what I would agree is an inappropriate excessive free allowance in the Waxman-Markey bill going up to 2029, but then we wouldn't get any tax revenue from it in this time when the fiscal problems of our nation are so clear. I mean, it's just -- it's mindboggling that we would go down that path.

I mean, you look at President Obama's initial budget at a sort of $600 billion raise. When you go through the Waxman-Markey proposal, most of that is consumed by offsets as far as kind of the eye can see, and then not to have any taxes of that -- well, what you're going to do is throw out a couple hundred billion dollars, $200 billion, $300 billion, $400 billion. Who knows? And it's over a period of time when we have extreme fiscal stress.

So it just is amazing to even be contemplated.

SEN. CONRAD: Mr. Price, following up on Mr. Hufbauer's comment, what do you see as the implications for the federal Treasury of treating CO2 in the same way SO2 has been treated?

MR. PRICE: A lot of it's going to depend on which entities are allocated the allowances. I think if users are allocated the allowances, at least the historic practice of users of SO2 has been to use those allowances in the same year of grant. So to say they're income today means they include income in 2012 or 2014. And then when they use the allowance to satisfy their obligation, they would end up with a deduction in an equal amount in the same tax year. So I'm not sure that the revenue impact would be that great, assuming that the allowances are allocated to users of those allowances.

SEN. CONRAD: And to the extent that's not the case?

MR. PRICE: To the extent that's not the case, it depends on who those entities are. If those entities were to sell them, which presumably is the intention of giving them to non-users, they would want to sell them immediately to generate revenue for some purpose, then they would again have a tax consequence in the year in which they're granted. I'm not sure that there's much incentive for them to bank their allowances and to, you know, defer the time at which they would actually recognize the income and pay the tax.

SEN. CONRAD: Mr. Butler, how would you respond to that?

MR. BUTLER: I think that's the issue. The issue is: Is this a timing matter to the Treasury of generating the revenue through having them taxed versus the timing of when the deduction is taken? And also the other issue is the nature of the capital versus ordinary. Do you generate capital losses in which you don't have capital gains and you ultimately have to write off those losses and not be able to utilize them? Well, that could be a revenue generator, but I don't think that's the right answer of what we're looking for in these allowances.


I thank the chair.

SEN. GRASSLEY: Senator Nelson, it's now your turn.

SEN. NELSON (D-FL): Thank you, Mr. Co-Chairman.

What do you think we ought to do to the tax treatment of allowances to keep out the speculators?

MR. HUFBAUER: Well, Senator, my view on that is that, I guess maybe to start with, I don't think speculation is necessarily a bad thing. It can be market smoothing, but I think it's just critical to set the conditions in which markets operate, and I put those in my suggestions as outlines in my testimony.

And I do think that if it turns out to be an over-the-counter type of market -- Section 1031-type exchanges were mentioned -- that, again, is an amazing proposition to me -- well, then you're going to get all the kind of nonsense we had in the financial markets recently.

So, if it's open, transparent, for example, as the oil market is under the Chicago exchange, then I think it can serve a useful purpose. But if it's kind of an underground CDO type of market or one of these credit default swaps types of markets, then all kinds of mischief is going to occur.

MR. PRICE: I'm not sure there's a straightforward way to accomplish that through tax policy because you'll find that many entities that have the need for allowances will also be either optimizing the price for allowances or will have their own separate operations that one might perceive as speculation, one might perceive as trading. It's a matter of perhaps semantics. So it's hard to figure out a way to craft a rule that just says speculators are punished in terms of things one might mechanically do in a tax code.

The only real things you can play with without sort of some form of penalty tax would be character and timing, and both of those questions necessarily will be hard to draw the line between those entities that are speculators and those entities that are users, and I'm not really sure which answer is better: to say they're capital means speculators could have capital losses which are undesirable; to say they're ordinary means the individuals or the speculators -- they might bear higher taxes, but they can apply it against losses they have, you know, on other investments.

So it's a very difficult question to see how you'd resolve through tax policy.

SEN. NELSON: A penalty tax, Mr. Butler, for speculators?

MR. BUTLER: I don't think that's the right answer. I don't think tax policy is the way to achieve it. Speculation is an issue that this committee is trying to deal with and the legislation is trying to deal with. I don't think tax policy is the right way to do it.

SEN. NELSON: With regard to the sulfur dioxide trading program, traders and investors are generally treated the same for tax purposes and the users of the credits. There are some exceptions for depreciation, involuntary conversion, and penalties. Under a cap and trade carbon program, should we alter the general tax rules that apply under the sulfur emissions trading program?

MR. BUTLER: As I pointed out in my testimony, I think this is an issue that really needs to be dealt with. It's not clear in the current tax policy as to whether these are treated as ordinary or capital and can change depending upon how these are dealt with by the taxpayer itself. So I think this is the area that probably is most important to put some real clarity around.

SEN. NELSON: Thank you, Senator.

SEN. GRASSLEY: I have no further questions. Other members that can't come so some may submit questions for answer in writing, so the record will stay open for a little while, and we'd ask you folks if you get questions to cooperate by answering them.

And I want to apologize for the chairman, Senator Baucus. He had an emergency and had to go and won't be back. So he asked me if I would close the meeting, and so we do that by thanking you once again for your expert testimony and your cooperation. Thank you very much.

Meeting adjourned.


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