As the global transition to a low-carbon and socially responsible economy accelerates, tax is becoming an increasingly important factor for businesses and investors to consider. Whilst there have been tax measures in this space for a considerable time (for instance the UK has had a climate change levy since 2000) we are now seeing a significant ramping up in the scale and magnitude of tax measures being deployed compared to before. There has undoubtedly been a growth in tax measures which discourage and penalise harmful behaviors such as the climate change levy and plastic packaging taxes, and arguably the EU’s Carbon Border Adjustment Mechanism also falls into this bucket (as to which see our briefing here). But this briefing focuses on the carrot rather than the stick and looks at how tax is increasingly being used to provide a positive incentive to invest in sustainable behaviors. And indeed, we are seeing a noticeable shift from tax policy being used to gently “nudge” sustainable behavior to becoming a major tool in funding the transition to a sustainable economy. However, it is not all plain sailing. We will also examine some of the risks, such as complexity, uncertainty and new compliance obligations, and illustrate why it is always important to be aware of broader picture.
US Inflation Reduction Act tax credits
One of the most high-profile examples of tax incentives to encourage investment in decarbonisation is the US Inflation Reduction Act (IRA) tax credits, which were enacted in August 2022. The IRA tax credits expanded and extended the existing tax credits for a variety of renewable energy assets, such as solar, wind and fuel cells, and introduced new tax credits for emerging asset classes, such as standalone storage, hydrogen, and sustainable aviation fuel (SAF).
The IRA tax credits are dollar-for-dollar reductions in US federal income tax liability, which can be used by direct project owners, monetised in a joint venture structure in exchange for development capital, sold to a third party, or in some cases exchanged for a cash refund from the US government. The flexibility and transferability of these tax credits makes them a very powerful tool.
The IRA also introduced new labour requirements, for instance there are incentives to pay what is in effect a minimum wage to access increased tax credit value, and "bonus tax credits" for projects in areas where Congress wanted to incentivize development, so in addition to environmental policy, the tax credits also target social policy goals.
The IRA has also brought significantly more certainty to the market, as the tax credits will exist at the current rates until at least 2032. The IRA tax credits have also provided a significant boost for newer asset classes that have high potential but come with high costs and risks, such as carbon capture, hydrogen, biogas and SAF, as capital is moving off the sidelines to invest in these projects. The tax credit sale market is also really taking off in the US, following the issuance of tax guidance in the last few months.
However, benefiting from the IRA tax credits does come with some challenges and complexities, such as questions related to the implementation of certain provisions as well as the interaction with other tax rules and policies (if any), such as the potential new global minimum tax and the EU’s new foreign subsidies rules (as to which see below).
How has the EU responded?
The EU has a strong ambition and commitment to achieve a green and digital transition, as reflected in its Green Deal, which sets out a comprehensive and integrated policy framework to make the EU climate-neutral by 2050 and to promote sustainable growth and social justice. The Green Deal includes a number of tax-related measures and initiatives, such as CBAM and the revision of the energy taxation directive.
However, the EU does not have a direct equivalent to the US IRA tax credits, with a focus instead on subsidies through the Innovation Fund which has been established to support sustainable investments, especially in the renewable energy and infrastructure sectors. The EU does have some tax incentives for sustainable investments, such as the zero or reduced VAT rates for certain green products and services, and many Member States offer enhanced tax deductions for R&D and innovation expenditure, however these are not harmonised across the EU and were historically subject to EU state aid rules which normally restrict the ability of Member States to grant selective advantages to certain businesses or sectors.
The EU is concerned about the US IRA local content requirements which potentially incentivize certain businesses to leave the EU and invest directly in the US to qualify for the tax credits. One way the EU has responded, perhaps with an eye to levelling the playing field, has been to relax the state aid rules. The Temporary Crisis and Transition Framework, originally set up in 2020, was therefore extended and expanded to allow Member States to grant aid in certain situations, including, until 31 December 2025, to foster the transition to a net-zero economy. This means that Member States can introduce tax incentives or other measures to support sustainable investments, subject to the approval of the Commission. Several Member States are looking to take advantage of this opportunity, and various national tax measures have already been approved by the Commission.
For instance, the French Finance Bill 2024 includes a new tax credit system available to companies in the battery, solar wind and heat pump sectors. This is estimated to generate EUR 23billion in private investment by 2030 in France, and could create up to 40,000 jobs. In Belgium, there is already an increased tax investment deduction tax credit system, and in October, the government announced an increase in those tax benefits for sustainable and socially responsible investments. So Member States are each looking at how they can encourage investment in this area, and this is at least partly in response to the US IRA.
The UK position
The UK's official response to the IRA and its plans for green taxation are not expected until the end of November, when the Chancellor of the Exchequer will deliver his Autumn Statement. The UK's current tax policy is to reward all investment in national infrastructure, regardless of its environmental impact. This means that there are no specific tax incentives for green investments as such at the moment in the UK, although there are a few areas where the UK imposes additional taxes to discourage unsustainable behaviors, such as the plastic packaging tax and the climate change levy. However, this could change in the future, with a general election on the horizon and the potential for a change in approach if a new government is elected. For instance, the Labour party has committed to invest up to GBP 30 billion in the energy transition if they are elected, which could mean new tax support, especially for hydrogen, carbon capture, hydrogen, onshore wind and electric vehicles.
What else is happening globally?
Across the rest of the world there is a huge array of tax measures being deployed to encourage sustainable investments, alongside other policy and regulatory measures. There are tax incentives and other fiscal measures being introduced at the moment to support large scale renewable infrastructure projects and many have a large hydrogen element to them. Whilst these aren’t necessarily a response to IRA, the US’s actions have perhaps led to an acceleration in the pace of change in this area. In June 2023, Canada introducing USD 26 billion worth of tax credits in relation to generating and emitting green energy, Japan has raise USD 150 billion under its Green Transformation Act to push nuclear renewable energy infrastructure alongside other renewable energy sources. And we have seen similar measures in Brazil, and South Africa as well. Of course, it is not just energy transition driving this, with a lot of discussion also centring on energy security as well, with these considerations also pushing countries to reduce reliance on traditional fossil fuels.
Like the EU, some of these countries are also concerned with the local protection angle to the US IRA rules, and we are seeing discussions throughout those countries about how to respond to the provisions within IRA which require work to be done locally or employ local businesses or individuals. Jurisdictions are considering responding in kind, for instance, the Canadian Federal Government recently issued a consultation about how to respond to those elements of the IRA and what the impact of Canada following in kind would have on local businesses. So this is something that is causing concern.
We are also seeing a shift in the way tax measures are being used. For instance, in the electric vehicle (EV) sector, early adopters were focused more on tax incentives for the purchase of EVs. Whereas now, in those countries there is a shift towards encouraging the supply side, such as in Korea who are ramping up the tax credits for manufacturing batteries, whilst phasing out some of the purchase incentives. However, there are still those focusing on the demand side, for instance in June 2023 China announced a package worth USD 72 billion, which includes a two-year extension of the tax exemption for the purchase of EVs.
And tax is not just being used to encourage the green transition. We are also seeing examples of tax being used to encourage social change. As with the US IRA, some countries are introducing tax reductions if you pay the minimum wage. Others are looking at enhanced tax deductions for those who upskill their employees whilst some have lower tax rates that apply to those who foster greater participation amongst under-represented groups, such as women or those with disabilities. In the UK we have recently had tax changes to encourage social impact investing, something the US has been doing for a long time. So there are increasing opportunities for tax to be used to encourage social change.
Understanding the broader context
Businesses need to be aware of how tax incentives are structured and whether they will be respected under the OECD/G20’s global minimum tax (also known as “pillar two” as to which see our webpage here). This is an international plan to ensure that multinational enterprises pay an effective tax rate of at least 15% on their global profits, regardless of where they operate or locate their assets. The plan was endorsed by 136 countries in October 2021 and is currently being implemented in many jurisdictions across the world.
Broadly, if the tax incentives that a group is relying on are not structured in a particular way, then to the extent that they bring the effective tax rate of a group in a jurisdiction below 15%, then a top up tax is applied to bring the tax rate back up to 15%. This could have the effect of wiping out the tax benefit that a national government is trying to bestow. The global minimum tax could therefore have a big impact on the value of tax incentives and, initially, the US IRA credits would have fallen foul of this rule, and it is only following successful negotiations and lobbying by the US that these have been protected. Tax incentives of other countries may not enjoy the same protection, particularly those enacted before these minimum tax rules were introduced.
Businesses relying on non-EU tax incentives should also be aware of the potential challenges and risks that may arise from the EU's new rules on foreign subsidies (as to which see our briefing here). These rules extend EU state aid rules to cover certain transactions that involve "foreign financial contributions", including tax exemptions, reductions and credits. Although not directed at the IRA tax credits, it is thought that these and other non-EU tax incentives would be in scope. These rules, introduced earlier this year, allow the Commission to require notifications and/or scrutinize certain transactions that involve foreign financial contributions. This could slow down transactions, bring uncertainty and compliance obligations for non-EU businesses looking to invest in the EU.
Concluding thoughts
Tax incentives for sustainable investments are a key element of the global transition to a low-carbon and socially responsible economy, and they offer significant benefits for businesses and investors. We expect to see continued growth in the number and scale of opportunities in this space over the coming year. However, it is essential for businesses and investors to be aware of the international tax landscape and the implications of the tax incentives in the jurisdictions where they operate or invest, and to plan and execute their sustainable investments accordingly.
