Carbon Projects & Conservation Easements California Council of Land Trusts Conservation Law Forum November 16, 2016 Misti Schmidt mschmidt@coblentzlaw.com Jim Clark jimclark@ncrm.com
Agenda 1. Overview by Jim Clark, North Coast Resource Management What is California Cap & Trade How does an offset project work Recent national and state developments 2. Interaction of Conservation Easements with Carbon Projects Funding ARB Requirements CE Language 3. Tax Treatment of Carbon Credits
California Cap & Trade Overview by Jim Clark, North Coast Resource Management 1. What is it 2. How does an offset project work 3. Recent national and state developments
Interaction with CEs Famed Bundle of Sticks Development Access Air Water Crops Occupancy Timber Minerals Carbon?
The analogies continue! Layer cake of rights and funders Retained Carbon: ARB Retained Development: Owner CE Extinguished Rights: State Agencies and Donors
Carbon Carla - 1 A Hypo 8,000 acres in Napa County 5,000 acres of timberland Some grazing and row crops Six existing homesteads, but county zoning permits one residence per 144 acres Outstanding estate tax bill of $10 million Fair market value of the property is $40 million: $20 million attributable to timber, $20 million attributable to development rights Easement value extinguishing development and timber harvest rights is $20 million
Carbon Carla - 2 A Hypo Carla approaches Landsaver Land Trust to sell CE for $20 million. Potential funding sources? What if Carla approaches Landsaver Land Trust to sell CE for $10 million and retains the right to do a carbon project to conserve timber? Traditional funders only fund $10 million. Remaining $10 million in conserved timber value can be covered via carbon.
Carbon Carla - 3 A Hypo Carbon funds attributable to any timber preserved by the easement can be allocated to Landsaver s purchase price. Carbon funds attributable to Carla s improved forest management above and beyond what the CE requires can be used by the family as a sustainable source of income to cover property carrying costs (and future estate taxes).
ARB Requirements and Interaction with CEs Timing Qualified Easement ARB as third party beneficiary of the CE Increased number of credits due to lower risk of violation
Sample CE Language Protect continued good forestry Recital: Grantor and Grantee recognize that the Conservation Values of the Property exist today in large part because of the past practices and sound stewardship of Grantor. Both Grantor and Grantee desire to maintain these Conservation Values in perpetuity, by the continuation and adaptive evolution of Grantor s land-use practices pursuant to the terms of this Conservation Easement, including those practices relating to Grantor s natural resource, rangeland and timber management, agricultural operations and other uses, in accordance with the terms and conditions of this Conservation Easement.
Sample CE Language Conservation Values / Purpose Values: Forest as more particularly defined in the baseline report and summarized as [describe existing forest conditions]. Purpose: Conserve, manage, and protect the conditions of the Property which allow it to serve as a critical ecological refuge against the impact of climate change and the ability of the forest to store atmospheric carbon as a means to mitigate global warming.
Sample CE Language Reserved Rights: Forest Management Sample 1: Grantee has approved and recognized Grantor s desire to manage forestland to create a healthy and more fireresistant, sustainably-managed forest that is capable of producing a periodic income from carbon sequestration projects, timber harvesting and production of other forest products. Accordingly, Forest Management activity, including the pruning and removal of trees, is not prohibited [insert reasonable restrictions, but not complete prohibition].
Sample CE Language Reserved Rights: Forest Management Sample 2: Maintenance of a healthy forest and tree cover is integral to wildlife, wildlife habitat, and water quality. Forest Management which meets the laws and regulations of the State of California, and as well as the specific requirements of this Section (Forest Management) shall be permitted. Consistent with the Easement Purposes, it is the intent of any Forest Management undertaken by Grantor to manage through time the complex native forest in balance with the environment (the Performance Goal ). The following goals shall be emphasized to achieve the desired future conditions of the Property: i. Sustainable forest management allowing for generation of periodic income; ii. Increase forest inventory by cutting less than periodic growth; etc.
Sample CE Language Reserved Rights: Carbon Rights Project and Baseline: The terms and conditions of this Conservation Easement are intended to support the development, verification, registration and maintenance of a project at the Property (a Project ) pursuant to the Compliance Offset Protocol U.S. Forest Projects adopted by the California Air Resources Board on October 21, 2011 or any successor thereto (the Protocol ), including, but not limited to, any federal program that is consistent with or preempts the Protocol. The terms and conditions of this Conservation Easement, except for the Forest Management provisions contained in Section 5(d), shall be taken into account when calculating the baseline/business as usual of the Property for purposes of establishing carbon credits or other emissions offsets that Grantor proposes to authorize, create, sell, exchange or transfer.
Sample CE Language Reserved Rights: Carbon Rights Agency/Grantee Oversight: Grantor will notify Grantee at least thirty (30) days prior to the listing of a Project under the Protocol and Grantee shall promptly furnish a copy of such notice to WCB. Grantee shall include in its annual monitoring report, a summary of any activity by Grantor to establish carbon credits or other emissions offsets with respect to the Property, and Grantor shall provide Grantee with such further information as Grantee may request regarding such activity. No later than twenty (20) days following written request by Grantee (which request shall be made no more than once annually), Grantor shall provide Grantee with copies of all inventories, harvest records, audit materials, and other related documentation compiled for the purpose of establishing or maintaining carbon credits in the previous twelve (12) months.
Sample CE Language Reserved Rights: Carbon Rights General Reservation: Subject to the foregoing, Grantor exclusively reserves all carbon rights appurtenant to the Property as may exist on the date of recordation hereof or as may be granted, discovered, created, declared or developed in the future, including but not limited to the right to trade, sell, transfer, or lease these rights, and the right to store, sequester, and accumulate carbon within the Property to the extent such storage, sequestration and accumulation is consistent with the Easement Purposes and the Conservation Values and is captured as a natural consequence of the exercise of the uses permitted herein.
Sample CE Language Reserved Rights: Carbon Rights Broad definition: For purposes of this Section, carbon rights and carbon as described herein are rights that currently exist or may come to exist in the future and are associated with the absorption by plants of carbon dioxide from the atmosphere and its conversion to carbon stored in trees and plants on the Property or stored in wood products extracted pursuant to forest management activities permitted herein, and trees and other vegetation and associated roots, surface duff, and organic elements in the soil on the Property.
Sample CE Language Reserved Rights: Mitigation N/A to Carbon: Note in Mitigation Credit section that the Carbon Project section governs carbon, not the Mitigation Credit section: The parties acknowledge that Section [X] shall govern Grantor s right to develop, verify, register and maintain a carbon Project and nothing in this Section [Y] shall affect any carbon rights appurtenant to the Property
Sample CE Language Avoided Conversion? WCB/SCC: Notwithstanding the foregoing, the Property and the restrictions contained within this Conservation Easement shall not be eligible for an Avoided Conversion carbon project. An Avoided Conversion carbon project is a type of forest project consisting of specific actions that prevent the conversion of privately owned forestland to a nonforest land use by dedicating the land to continuous forest cover through a conservation easement or transfer to public ownership.
Sample CE Language ARB Required Language Qualified CE. This Conservation Easement is intended to be a Qualified Conservation Easement as defined in Section 3.5 of the Compliance Offset Protocol U.S. Forest Projects adopted by the California Air Resources Board ( ARB ) on October 21, 2011. To that end, if a Project is registered under the Protocol, then during the Project s Project Life (as such term or similar term is defined in the Protocol existing as of the date the Project is registered), ARB shall be a third party beneficiary of this Conservation Easement with the right to enforce all obligations hereunder and all other rights and remedies conveyed to Grantee, including but not limited to standing as an interested party in any proceeding affecting this Conservation Easement. For purposes of clarification, ARB s rights as a third party beneficiary pursuant to this Section 20 will (a) only arise once a Project is registered with the Protocol and (b) terminate concurrently with the termination of the Project s Project Life.
Tax Treatment of Carbon Credits & Sales Proceeds When? Issuance and Sale or Sale Only How much? Ordinary or capital asset? Basis of zero or a portion of the underlying land?
When? Issuance and Sale Carbon Credit as Cash Equivalent - Cowden Factors: Whether there is an unconditional promise to pay, Whether the promisor is solvent, Whether the contract is assignable to a third party, Whether the contract is subject to a set-off, Whether the contract is readily marketable, and The amount of risk involved. Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961)
How much? Unclear Tax is generally paid on income, whether ordinary income received in single year for sales or services or short-term or long-term capital gain received upon disposition of a capital asset. Ordinary/Short-Term Capital Gains Rate: ~40% Long-Term Capital Gains Rate: ~25%
How much? Unclear Character of Property: Intangible property right issued by the government or credit equivalent to an ecological value Rev. Proc. 92-92 Acid Rain Emissions Credits Private Letter Ruling 9612009 Mitigation Credits George H. Tempel, et ux., 136 TC 341 (Apr. 5, 2011)
How much? Unclear Intangible property right, but see California Code Regs. Tit. 17 Sec. 95820(c): Each compliance instrument issued by the Executive Officer represents a limited authorization to emit up to one metric ton in CO2e of any greenhouse gas specified in section 95810, subject to all applicable limitations specified in this article. No provision of this article may be construed to limit the authority of the Executive Officer to terminate or limit such authorization to emit. A compliance instrument issued by the Executive Officer does not constitute property or a property right.
How much? Unclear Credits as capital or ordinary asset? Rev. Proc. 92-92 Acid Rain Emissions Credits Capital. Private Letter Ruling 9612009 Mitigation Credits Capital. George H. Tempel, et ux., 136 TC 341 (Apr. 5, 2011) Capital. (VERY) general litmus test is whether the property is held for sale to customers in the ordinary course of a trade or business. If the recipient of the credit is a dealer in credits, then the asset will be ordinary.
How much? Unclear Even if capital, (1) what is the holding period and (2) can the costs of the underlying property and/or the costs of the project be capitalized as part of basis and offset the tax?
How much? Unclear Holding Period Rev. Proc. 92-92 Acid Rain Emissions Credits Not payable on issuance, since credits were a permit for the recipient to operate. However, on sale, holding period measured from date of issuance. Private Letter Ruling 9612009 Mitigation Credits Granting of perpetual conservation easement extinguishing all value in the underlying fee is a disposition of the real property, so gain is calculated against basis in the real property and real property s holding period applies. George H. Tempel, et ux., 136 TC 341 (Apr. 5, 2011) Not payable on issuance, since credits were a tax deduction usable by the recipient. On sale, holding period measured from date of issuance.
How much? Unclear Basis Rev. Proc. 92-92 Acid Rain Emissions Credits Not payable on issuance, since credits were a permit for the recipient to operate. However, on sale, basis included cost to acquire the credits, including purchase price. Private Letter Ruling 9612009 Mitigation Credits Granting of perpetual conservation easement extinguishing all value in the underlying fee is a disposition of the real property, so gain is calculated against basis in the real property. On sale, cost of additional mitigation activities is included in credit basis. George H. Tempel, et ux., 136 TC 341 (Apr. 5, 2011) Not payable on issuance, since credits were a tax deduction usable by the recipient. On sale, no cost was incorporated into basis since the credits were not purchased. Conservation easement costs were allocable to the conservation easement, not tax credits.
How much? Unclear: Underlying Property & Costs? Cost Argument The costs of the process resulting in the issuance of the credit can be used to offset the income received: Attorney and consultant fees Project registration fees Commissions Purchase price The property rights given up?
How much? Unclear: Underlying Property & Costs? Ecological Value Argument Each credit is property and represents a legal entitlement to the holder equivalent to an ecological value nurtured over time. Gladden Expectation Argument If the property owner acquired the underlying property with the expectation that carbon credits would be obtained, the premium paid for that expectation over the basic cost of the land can be apportioned to the value of the carbon credits.
How much? Unclear: Underlying Property & Costs? 1031 Exchange Argument for Underlying Property Allocation Basis of sold property can be transferred to the new property Not applicable in California since the credits are not an interest in real property. Timber Argument IRC 631(b) permits landowner to sell (upon election) standing timber and offset proceeds against the underlying property s basis.
Questions? Misti Schmidt Legal and CE Questions Coblentz Patch Duffy & Bass LLP (415) 772-5753 mschmidt@coblentzlaw.com Jim Clark Project Questions North Coast Resource Management (NCRM) (707) 485-7211 ext. 211 jimclark@ncrm.com