Voluntary carbon offsets: The evolution of a business expense

By Craig White, Ph.D.



  • Voluntary carbon offsets (VCOs) allow a business to create a net reduction in greenhouse gas emissions by funding atmospheric carbon reduction actions of another party. They are becoming more important as companies assess and report their environmental, social, and governance (ESG) goals and activities.
  • U.S. and international financial reporting boards and agencies including the SEC are developing frameworks for more consistent and reliable disclosure of ESG efforts by companies.
  • The tax treatment of VCOs is not well defined and varies based on the taxpayer's facts and circumstances. VCOs may be currently deductible under Sec. 162 if it can be shown that the cost of VCOs is a current ordinary and necessary expense of the taxpayer. However, if the VCO provides a long-term benefit, under Sec. 263 and the regulations, the cost may be capitalizable.
  • Some companies obtain VCOs by funding projects undertaken by a not-for-profit entity. Payments made to entities related to such projects can generally be treated as a charitable contribution to the not-for-profit. However, an argument may be made that the nature of VCOs may make these payments ordinary and necessary expenses that are deductible under Sec. 162.

The concept and implementation of carbon offsets has seen a large degree of growth and acceptance over the past 20 years.1 The approach is rooted in the idea of net reductions of greenhouse gas (GHG) emissions across the entire climate system.

The offset approach has the advantage of providing a mechanism for transferring resources to achieve reductions. Carbon offsets provide a market where one party can purchase the offsets, thereby funding projects reducing the emissions of another party. For example, a business emits carbon dioxide or other carbon compounds into the atmosphere but wishes to establish itself as a net-zero emitter (i.e., emitting none or no more than it removes). The business decides that it cannot feasibly reduce its carbon emissions or remove them enough to achieve that goal. It therefore offsets its excess emissions by paying another entity, either directly or indirectly, to reduce its emissions (or remove them) by that amount. The transfer is mutually beneficial, as the purchaser may have emissions that are very difficult and expensive to reduce, while other parties may have easier-to-achieve reductions but may lack the resources to do so. Given that emissions have a global impact, the net reduction is an overall benefit.

Carbon offsets are employed in both compliance and voluntary markets. In a compliance market, participants are allowed to use a certain amount of net reduction to meet the requirements of an applicable law or regulation. In a voluntary market, participants are under no formal obligation to reduce net emissions. These participants may do so and purchase voluntary carbon offsets as a means to satisfy environmental, social, and governance (ESG) objectives.

The focus of this discussion is on the tax deductibility of the purchase of voluntary carbon offsets (VCOs) as trade or business expenses. Given that these offsets are nonmandatory, can they be treated as "ordinary and necessary"? This question raises principles that can be applied to other expenses that emerge with the changing business environment.

A discussion of this issue first requires understanding the background on the business context of carbon offsets. The motivation and business purpose of the expenditures is key to determining their tax deductibility.

ESG reporting and voluntary carbon offsets

A growing number of companies are focusing on the climate impact of their activities as part of broader ESG objectives.2 The strategy is often geared toward measurement and reduction of emissions through both direct and indirect means. McKinsey & Co. reports that the number of companies with a pledge to reach net-zero emissions doubled from 500 in 2019 to more than 1,000 in 2020.3 Companies are adapting this emphasis to address a variety of emerging challenges in the overall operating environment.

Purpose of voluntary carbon offsets

The Taskforce on Scaling Voluntary Carbon Markets (TSVCM), an initiative of the Institute of International Finance working to establish a VCO market, estimates that demand for carbon credits, which certify an amount of atmospheric carbon reduction (including by VCOs), could increase by a factor of 15 or more by 2030 and by a factor of up to 100 by 2050. McKinsey describes the typical role of carbon credits in a company's ESG strategy:4

Under such principles, a company would first establish its need for carbon credits by disclosing its greenhouse-gas emissions from all operations, along with its targets and plans for reducing emissions over time. To compensate for emissions from sources that it can eventually eliminate, the company might purchase and "retire" carbon credits (claiming the reductions as their own and taking the credits off the market, so that another organization can't claim the same reductions). It could also use carbon credits to neutralize the so-called residual emissions that it wouldn't be able to eliminate in the future.

As an example, the Walt Disney Co. in its 2020 Corporate Social Responsibility Report (CSRR)5 identified an overall goal of reaching net-zero GHG emissions for its direct operations by 2030. The company stated that as part of this goal it supports projects by others:

We invest in high-quality, verified and rigorously vetted natural climate solutions that generate meaningful carbon reductions as well as deliver positive social and economic impacts.

To the extent the company considers these investments as a component of its overall emissions goal, they could be said to represent VCOs. The actions taken and overall reporting framework are voluntary.

Disney's CSRR is a separate disclosure from its financial statements encompassing its entire ESG strategy. There is not currently any mandated format. As discussed further below, the guidance for disclosure and appropriate risk assessment is under ongoing discussion and development.

Climate-risk financial disclosures

Given concerns that climate-related risks are systemic and therefore unavoidable, the G20 Finance Ministers and Central Bank Governors asked the Financial Stability Board6 to review how the financial sector can take account of climate-related issues. The Financial Stability Board responded by establishing an industry-led Task Force on Climate-Related Financial Disclosures (TCFD).7 The TCFD was asked to develop voluntary, consistent climate-related financial disclosures that would be useful to investors, lenders, and insurance underwriters in understanding material risks.

The TCFD issued a report of the task force's recommendations that included an analysis of the linkage between climate change risk considerations and financial reporting.8

The TCFD framework takes a traditional approach of including both risk and opportunity in a company's planning process. The report categorizes risk into "transition risks" and "physical risks." Transition risks are uncertainties a company faces as overall economies move from the current state of activities and emissions toward reductions to address global climate challenges. Within transition risks, the TCFD identifies policy and legal, technology, market, and reputation outcomes as potential impacts on companies.

Considerations regarding VCOs could fall in any of the underlying categories, but, in particular, VCOs fit into the reputation category (nonvoluntary compliance offsets would likely fall into the policy and legal group). The report defines the reputational risk of climate change during transition as "tied to changing customer or community perceptions of an organization's contribution to or detraction from the transition to a lower-carbon economy."9

The report identifies potential negative outcomes resulting from reputational damage:

  • Shifts in consumer preferences;
  • Stigmatization of sector;
  • Increased stakeholder concern or negative stakeholder feedback;
  • Reduced revenue from decreased demand for goods/services;
  • Reduced revenue from decreased production capacity (e.g., delayed planning approvals, supply chain interruptions);
  • Reduced revenue from negative impacts on workforce management and planning (e.g., employee attraction and retention); and
  • Reduction in capital availability.

Each of these risks could have major implications to a business. Resource allocations a company can make to mitigate potential negative outcomes may merit substantial investment.

Financial accounting considerations

The TCFD links its recommendations and environmental strategy to existing accounting standards. Both the International Accounting Standards Board (IASB) and FASB have issued standards to address risks and uncertainties affecting companies. The TCFD report states:

The disclosures of both contingencies and management's assessment and evaluation of long-lived assets for potential impairment are critically important in assisting stakeholders in understanding an organization's ability to meet future reported earnings and cash flow goals.10

The discussion implies that the expenses are maintained to protect reputational capital.

In most G20 jurisdictions, companies with public debt or equity have a legal obligation to disclose material risks in their financial reports — including material climate-related risks. However, the absence of a standardized framework for disclosing climate-related financial risks makes it difficult for organizations to determine what information should be included in their filings and how it should be presented. Even when reporting similar climate-related information, disclosures are often difficult to compare due to variances in mandatory and voluntary frameworks.

The SEC recognizes these issues and is focusing more on ESG reporting. Then-Acting Chair Allison Herren Lee in March 2021 called for comments, noting that the SEC is planning on updating its reporting requirements for public companies.11 Issues the SEC is seeking to address include:

  • How to provide more consistent, comparable, and reliable information to investors while also providing greater clarity on expectations of registrants; and
  • How, if at all, should registrants disclose their internal governance and oversight of climate-related issues?

Companies that are proactive in moving toward and reaching net-zero emissions combined with effective reporting may reap a number of benefits. As noted above, these businesses may have an advantage in obtaining capital, attracting customers, recruiting and retaining employees, avoiding supply chain disruptions, and other benefits. The approach is not currently a mandate; however, these considerations will likely continue to incentivize firms to implement VCOs and other climate-related strategies.

Tax deductibility or capitalization: Secs. 162 and 263

The above considerations must be put into the context of income tax principles to determine deductibility of these resource allocations. For instance, the amounts paid for VCOs must meet the requirements to be currently deductible expenses under Sec. 162 or as capitalizable expenses under Sec. 263.

Sec. 162 requires an expense incurred in carrying on a trade or business to be "ordinary and necessary" to qualify for potential deductibility. An expense is necessary for this purpose if it is appropriate and helpful to the taxpayer's business. In determining whether an expenditure is appropriate and helpful, the taxpayer's judgment should generally be respected. The relationship between an expense and the income it is matched to is key in determining a transaction's tax consequences across the Internal Revenue Code. For example, Regs. Sec. 1.269-2 states:

Under the Code, an amount otherwise constituting a deduction, credit, or other allowance becomes unavailable as such under certain circumstances ... in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer. ... The distortion may be evidenced, for example, by the fact that the transaction was not undertaken for reasons germane to the conduct of the business of the taxpayer.12

Elements of this regulation are similar in underlying tone to the requirement that a deductible expense be "ordinary and necessary" relative to the purpose of the business.

The requirement of a proximate relationship between an expenditure and deductibility is foundational to the income tax framework. An assessment of "income" is based on a measurement of the net accretion of wealth in a given period. Therefore, it is important to have a link between trade or business revenue generated and the ordinary and necessary expenses paid or incurred to generate that revenue.

Welch v. Helvering

The courts have often assessed the rationale underpinning an expense for purposes of interpreting the "ordinary and necessary" requirement. In Welch v. Helvering,13 the Supreme Court famously addressed principles regarding meeting this standard. Justice Benjamin N. Cardozo, writing for the Court, stated:

Now, what is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance. ... At such times there are norms of conduct that help to stabilize our judgment, and make it certain and objective. The instance is not erratic, but is brought within a known type. ... The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle.

Welch is relevant to the analysis of the deductibility of the payment for VCOs. Offsets, along with many other aspects of ESG implementation, are still nascent and developing but within the norm of facts-and-circumstances business judgment.

Ultimately, the Court found that the payments in question in Welch were capital in nature for the ongoing benefit and development of the business rather than just benefiting the current period: "Reputation and learning are akin to capital assets, like the good will of an old partnership."14

The payment of amounts in question in Welch was made on behalf of another party without any obligation to do so. The taxpayer made the payments to repair and enhance his reputation as he began a new business. The circumstance raises similarities to modern-day VCO payments. The payments are not required and are made to enable the emission reduction actions of another party.


The courts recognize that it is not "ordinary" that a party voluntarily pay the obligations of another. As in Welch, the analysis looks to the "why" for the transaction. In Jenkins,15 the taxpayer, the well-known singer Conway Twitty,16 repaid amounts to investors in a restaurant business, Twitty Burger Inc., upon its demise. Although he was under no obligation to make these payments, he presented a winning case that they were made to protect the existing reputation he had established in his trade or business as an entertainer with his country music fan base.

The Tax Court distinguished the situation from that in Welch in the following manner:

An exception to the general rule that one person may not deduct the expenses of another person has been recognized in those cases where the expenditures sought to be deducted were made by a taxpayer to protect or promote his own ongoing business, even though the transaction originated with another person. ... In order to determine whether the disallowed expenditures are deductible by petitioner under section 162 we must (1) ascertain the purpose or motive of the taxpayer in making the payments and (2) determine whether there is a sufficient connection between the expenditures and the taxpayer's trade or business. [citation omitted]

The court agreed that the purpose for the payments was to protect Twitty's existing, and primary, business as a country music entertainer. The payments were not made to develop the business's initial status. Rather, they were made to maintain and enhance Twitty's personal business reputation and as such were deductible expenses, the court held.

As discussed further below, VCOs provide a mechanism, even without an obligation (i.e., "voluntary"), to pay costs that will enhance the reputation of the business. Importantly, regulatory and stakeholder expectations are moving in the direction of businesses' responsibility to contribute to GHG emission reductions.

Sec. 263 and Regs. Sec. 1.263(a)-4

Sec. 263 provides that a long-term benefit is not currently deductible as an expense. This consideration achieved particular notoriety in INDOPCO.17 In that case, the Supreme Court agreed with the IRS that amounts incurred to facilitate a friendly merger were required to be capitalized, as they provided a long-term benefit.

This area can be ambiguous in that many expenditures are difficult to trace to the creation of specific assets but clearly provide long-term impact. For instance, expenditures in the areas of marketing, repairs, and research and development all may provide benefits that extend beyond the end of the tax year but are currently deductible.

Treasury sought to provide clarity in the area of intangible assets through the issuance of Regs. Sec. 1.263(a)-4. These provisions, also known as the "INDOPCO" regulations, hold that expenses that produce a separate and distinct intangible asset are required to be capitalized.18 Regs. Sec. 1.263(a)-4(b)(3) defines a "separate and distinct" intangible asset as:

[A] property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business.

The section provides an example of an amount paid that does not create a separate and distinct intangible asset or is otherwise required to be capitalized under Regs. Sec. 1.263(a)-4(b)(3) and is similar to the purpose of VCOs:19

Demand-side management.(i) X coporation, a public utility engaged in generating and distributing electrical energy, provides programs to its customers to promote energy conservation and energy efficiency. These programs are aimed at reducing electrical costs to X's customers, building goodwill with X's customers, and reducing X's future operating and capital costs. X provides these programs without obligating any of its customers participating in the programs to purchase power from X in the future. Under these programs, X pays a consultant to help industrial customers design energy-efficient manufacturing processes, to conduct "energy efficiency audits" that serve to identify for customers inefficiencies in their energy usage patterns, and to provide cash allowances to encourage residential customers to replace existing appliances with more energy efficient appliances.(ii) The amounts paid by X to the consultant are not amounts to acquire or create an intangible under paragraph (c) or (d) of this section or to facilitate such an acquisition or creation. In addition, the amounts do not create a separate and distinct intangible asset within the meaning of paragraph (b)(3) of this section. Accordingly, the amounts paid to the consultant are not required to be capitalized under this section. While the amounts may serve to reduce future operating and capital costs and create goodwill with customers, these benefits, without more, are not intangibles for which capitalization is required under this section.

This example describes an instance of a company's incurring costs on behalf of others that provide benefits to the other party. The example does not go into the elements of whether the costs are "ordinary and necessary"; however, it does show how this type of activity does not create capitalized costs.

Deductibility of VCOs and other ESG costs

Net-zero emission initiatives, VCOs, and other related voluntary activities move toward the internalization of traditional externalities.20 Participants could avoid these costs through transferring them to the entire system. Companies are beginning to attempt to measure and bear the full cost of operations, including external environmental impacts. These actions are not mandatory; however, as discussed above, the approach is becoming more and more expected from stakeholders and in terms of good management practice.

The TCFD reporting framework and the SEC discussions make it clear that although ESG actions and activities and reporting are voluntary, they are becoming de facto mandatory in many ways. There are both direct and indirect strategic impacts. Companies need to consider such areas as customer preferences, supply chain issues, and even physical location risks.

Much of this impact is taking the form of building and protecting reputational "goodwill." This aspect is particularly relevant in the case of VCOs. The purchase of the offsets is made to benefit another party; however, it has reputational implications to the protection and furtherance of the company's existing trade or business. This relationship is similar to that found in the Jenkins case discussed above. Likely, this tie will continue to grow stronger as policymakers and other stakeholders further ingrain ESG considerations into regular business operations.

The current deductibility of VCO payments is also contingent on the nature of the asset purchased and the time frame of the benefit. As in the example in Regs. Sec. 1.263(a)-4, general ESG allocations are not creating a "separate and distinct" intangible asset from the business itself. The costs are enhancing the operating viability of the business, so they are not required to be capitalized under the approach in the regulations.

A VCO, however, is somewhat different from the example in the regulations. The payments in the example are made directly to or on behalf of the third party. A VCO can be purchased on an exchange as a tradeable property right. In this case, as a property right, the VCO would be capitalized on purchase as a separate and distinct intangible asset. However, the overall net-zero intent of employing offsets results in their "retirement" once counted against the emissions of the company holding the VCO. In effect, the VCO cannot be double-counted in reporting the net reduction in GHG emissions.21

It is reasonable to conclude that other costs that companies incur to satisfy ESG objectives would also be deductible. The clear expectation and movement in policy from stakeholder groups is that these amounts are now both "ordinary and necessary." The costs would still need to be assessed in terms of the period of benefit.

Potential movement away from charitable contributions

The evolving VCO market is moving toward a greater reliance on an exchange type of approach. VCOs can be purchased on the market rather than directly funding a specific project. Alternatively, companies can directly fund projects developed within not-for-profit organizations.22

In the case of a not-for-profit organization developer, an issue may again arise as to the substance of the intent of the payments. Is the company making the payment for altruistic charitable purposes, or is there an exchange type of motivation similar to the "ordinary and necessary requirement"? The relevance of this question would be particularly important at the beginning of ESG considerations or any form of externality benefit type of expense. Is an amount voluntarily remitted to another party a trade or business expense or an amount designed to provide a general societal benefit? An examination of websites of organizations developing carbon offset credits shows that many of these organizations address this issue as a "charitable contribution." The view to this question may shift as expectations further change and mandatory requirements evolve.

Charitable contribution deductibility comes with a number of restrictions relative to normal trade or business expenses. A company's rationale and documentation for incurring costs will continue to be important in addressing issues with the IRS.

Evolving expectations

Arguably, the motivation for incurring ESG expenditures is becoming more "ordinary and necessary" over time. External stakeholders are holding companies to higher standards, with tangible effects on many aspects of business operations. VCOs are one tool in meeting the evolving net-zero expectations of regulators and other stakeholders.

What once might not have been deductible or, at best, was treated as a charitable contribution is now becoming expected as an ordinary and necessary cost of doing business. The analysis of VCOs raises a question regarding the evolution of a newer business expenditure into a deductible expense. The wisdom provided in Welch is still true: "Life in all its fullness must supply the answer to the riddle."  


1Blaufelder, Levy, Mannion, and Pinner, "A Blueprint for Scaling Voluntary Carbon Markets to Meet the Climate Challenge," report, McKinsey & Co. (Jan. 29, 2021).

2SEC Asset Management Advisory Committee, webcast and written materials of public meeting (July 7, 2021), available at www.sec.gov. See especially Background Materials, "Recommendations of the ESG Subcommittee of AMAC."

3Blaufelder et al., "A Blueprint for Scaling Voluntary Carbon Markets to Meet the Climate Challenge," citing Hsu et al., "Accelerating Net Zero: Exploring Cities, Regions, and Companies' Pledges to Decarbonize," Data-Driven EnviroLab & NewClimate Institute (September 2020).

4Id. These carbon credits come from four categories: avoided nature loss (including deforestation); nature-based sequestration, such as reforestation; avoidance or reduction of emissions such as methane from landfills; and technology-based removal of carbon dioxide from the atmosphere.

5Available at thewaltdisneycompany.com.

6The Financial Stability Board was established in 2009 under the auspices of the heads of state and government of the G20. Its mandate is to promote international financial stability "by coordinating national financial authorities and international standard-setting bodies as they work toward developing strong regulatory, supervisory, and other financial sector policies" ("Mandate of the FSB," available at www.fsb.org). 

7Other organizations and groups working to identify material ESG reporting issues and develop consistent reporting frameworks include the Sustainability Accounting Standards Board (SASB) and Climate Disclosure Standards Board (CDSB).

8Task Force on Climate-Related Financial Disclosures. Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures (June 2017), p. 8, available at www.fsb-tcfd.org.

9Id., p. 6. 

10Id., p. 37. 

11SEC, public statement by Lee (now a commissioner), "Public Input Welcomed on Climate Change Disclosures" (March 15, 2021), available at www.sec.gov.

12Regs. Sec. 1.269-2(b), applicable to acquisitions made to evade or avoid income tax, most often of a "loss corporation." 

13Welch v. Helvering, 290 U.S. 111 (1933).

14Id. at 115, likening the petitioner's payments to those for education that enables a taxpayer to "practice his vocation with greater ease and profit."

15Jenkins, T.C. Memo. 1983-667.

16The stage name of the petitioner, Harold L. Jenkins.

17INDOPCO, Inc., 503 U.S. 79 (1992).

18Regs. Sec. 1.263(a)-4(b)(1)(iii).

19Regs. Sec. 1.263(a)-4(l), Example (4). 

20An externality is a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services of the producer.

21Robust accounting procedures and controls are necessary to avoid fraudulent implementation.

22For instance, the Walt Disney Co. funds projects developed by not-for-profit organizations.



Craig White, Ph.D., is a professor of accounting at the University of New Mexico in Albuquerque, N.M. For more information about this article, contact thetaxadviser@aicpa.org.


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