Initial IRS Guidance Addressing EU Cap-and-Trade Systems, Subpart F Rules

By Lauren M. Janosy, J.D., LL.M., Washington, DC, and Alexandra K. Helou, J.D., Washington, DC

Editor: Annette B. Smith, CPA

In Letter Ruling 200825009, the IRS addressed for the first time the subpart F treatment of gains on sale of surplus carbon dioxide (CO2) emissions allowances.

The taxpayer took the position that such gain does not give rise to foreign personal holding company income (FPHCI) within the meaning of Sec. 954(c). The taxpayer argued that CO2 emissions allowances should be viewed as commodities for purposes of the Sec. 954(c)(1)(C) exception from FPHCI or, alternatively, that such allowances should be treated as property that does not give rise to income within the meaning of Sec. 954(c)(1)(B) (iii). The IRS specifically did not address the taxpayer’s argument that the allowances should be viewed as commodities, instead adopting the taxpayer’s alternative argument in concluding that the gain from the sale of surplus CO2 emissions allowances does not give rise to FPHCI.

The Service indicated that although it currently was studying whether CO2 emissions allowances are commodities, “[n]o inference is intended as to whether CO2 allowances are properly considered commodities for purposes of Code section 954 or any other section of the Code.” Pending any further IRS guidance, the inclusion of this “no-inference” language may be significant to many taxpayers who may seek to treat CO2 emissions allowances as commodities under various Code sections. Moreover, the “no-inference” language suggests that the IRS may address in future guidance whether the definition of commodities under Sec. 954 (and other sections of the Code) includes CO2 emissions allowances.


The letter ruling involved a U.S. corporation that indirectly owned a controlled foreign corporation (CFC) and a membership interest in a controlled foreign partnership (CFP), each of which had manufacturing operations within European Union (EU) member states. Both the CFC and the CFP were granted allowances under the EU’s Emissions Trading Scheme (ETS), the cap-and-trade system implemented by EU member states to regulate CO2 emissions and other greenhouse gases within certain industries.

The EU ETS required the CFC and CFP to surrender their allocated allowances on a yearly basis in amounts equal to their CO2 emissions. If the businesses had excess allowances in a given year, they could sell the surpluses to another person; however, if they exceeded their allowances, the EU imposed a fine. During the years at issue, both the CFC and the CFP had surplus allowances that they sold to unrelated parties.

IRS Analysis

The IRS focused on the taxpayer’s alternative argument that CO2 emissions allowances are property that does not give rise to income within the meaning of Sec. 954(c)(1)(B)(iii), concluding that gain from the sale of surplus allowances could be excluded from FPHCI as Sec. 936(h)(3)(B) intangible property used in the CFC’s active trade or business (see Regs. Sec. 1.954-2(e)(3)(iv)). The Service noted that possession of the CO2 allowances was necessary for the taxpayers to operate in their industry. Thus, because the CO2 emissions allowances permitted the CFC and the CFP to engage without penalty in business activity that otherwise would be unlawful and the values of the allowances are independent of the performance of any services by any individual, the allocation of CO2 allowances represented the grant of intangible property rights.

Significance of “No-Inference” Language

The importance of the no-inference language in the letter ruling is apparent in light of the ordering rule applicable to the categories of FPHCI (see Regs. Secs. 1.954-2(a)(1) and (2)). That rule determines into which category of FPHCI an item of income, gain, or loss falls when it is described in more than one category. Regs. Sec. 1.954-2(a)(2)(ii) specifies that gain or loss from a commodities transaction has a higher priority than gain or loss from certain property transactions, including property that does not give rise to income. Thus, gain that could be considered both gain from a commodities transaction and gain from property that does not give rise to income must be categorized as gain from a commodities transaction (i.e., the higher priority category of FPHCI).

Except for the no-inference language, the letter ruling might have been interpreted to mean that the IRS had analyzed the FPHCI priority rule and concluded that the CO2 emissions allowances did not fall within the higher priority commodities category of FPHCI. By incorporating the no-inference language in the letter ruling, the Service has indicated that it is considering whether CO2 emissions allowances may be considered commodities for purposes of Sec. 954 and other Code provisions.

Relevance to Other Taxpayers

Commodities dealers that trade emissions allowances might also be able to exclude such activities from subpart F income under the dealer exception in Sec. 954(c)(2)(C) if CO2 emissions allowances constitute commodities. In addition, dealers might benefit from treating CO2 allowances as commodities to the extent they elect under Sec. 475(f) to mark to market their commodities positions so that they could treat all their commodities positions consistently. Nonresident taxpayers engaged in commodity trading activities in U.S. markets might also be able to qualify their trading activities in CO2 emissions allowances for the commodities trading safe harbor under Sec. 864(b)(2) (B) so that their trading activities do not constitute a U.S. trade or business.

Without the no-inference language, the letter ruling could be interpreted as embodying the Service’s conclusion that CO2 emissions allowances are not commodities under Sec. 954(c). By indicating in the letter ruling that it had not addressed the question of whether CO2 emissions allowances constitute commodities under Sec. 954(c) or any other provision of the Code, the IRS has held open consideration of the issue for future guidance, which could benefit many taxpayers and promote the development of trading markets in emissions allowances.


Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or

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