How is India building a compliance carbon market without a supporting tax architecture

With the first compliance year for obligated entities under the Carbon Credit Trading Scheme (‘CCTS’) closing in April 2026 and declarations filed by July 2026, preparations for trading of carbon credit certificates (‘CCCs’) is heating up. The strategic question of buy, sell or bank are being raised, but the tax teams still seem to be waiting at the gate. Why? Because India legislated the Indian carbon market through the Energy Conservation (Amendment) Act, 2022 and re-legislated its entire Income-Tax Code in 2025 but forgot to connect the two.

A quick recap to bring things into perspective. Under the compliance market, obligated entities are given greenhouse gas (‘GHG’) intensity targets to be met by reduction of emissions as compared to the baseline year of 2023-24. In the first compliance year of 2025-26, it will be seen as to which entities/units are able to meet the targets. If the targets are met in exact numbers (rare! worth rechecking!), then no action is to be taken. If any unit exceeds expectations and goes beyond the target reductions, then it will be eligible to receive CCCs. If any unit does not meet its target, then it has to buy CCCs from the carbon market. Such sale by a unit (say, Seller S) holding CCCs to another unit (say, Buyer B) which fails to meet its target is the transaction in focus for this discussion.

Let us examine the clarity, or its lack thereof, that income tax law extends from the point of view of Seller S and Buyer B. Particularly, in reference to the fact that India has announced its ambitious climate goals of being net-zero by 2070 and the carbon market operations are intended to be a major contribution to the country’s decarbonisation plans, and one may be compelled to think that carbon markets would get the preferential treatment it deserves.

Seller's orphan: CCCs are outside the 10% regime

One way of closing the discussion in this section is by turning to the fact that taxability of income from sale of carbon credits is pending before the Supreme Court[1], based on the view taken by various High Courts that such revenue is capital receipt and not revenue receipt and thus, not chargeable to income tax. However, that would be incomplete.

On the one hand is a general provision under Section 28 of the Income Tax Act, 2025 which inter alia covers income related to Duty Remission Schemes like DEPB, DFRC; duty drawback; and other profits and gains arising out of business or profession. This discussion focusses on the provisions specifically carved out for carbon credits.

Section 194(1) of the Income tax Act, 2025 provides for a reduced rate of 10% on income by way of transfer of carbon credits, with no deduction in respect of any expenditure or allowance. Sub-section (2) defines ‘carbon credit’, in respect of one unit, as reduction of one tonne of carbon dioxide emissions or emissions of its equivalent gases which is validated by the United Nations Framework on Climate Change (UNFCCC) and which can be traded in market at its prevailing market price. The provisions are identical to Section 115BBG of the Income Tax Act, 1961. Does this mean that the legislature has been thoughtful enough to extend a lower rate of income tax at 10% to Seller S when it sells CCCs to Buyer B, as a contribution towards enabling India to meet its climate goals? No. The reason: the legislature forgot that UNFCCC has no way of validating CCCs or may be the legislature forgot about the CCTS despite the scheme having been introduced only 2 years before the revamping of the direct tax law. Or, has the legislature explicitly intended to extend a reduced rate only for international carbon credits?

It would be relevant to highlight that CCCs are defined[2] as certificates issued by the Central Government or any authorised agency and as per the scheme, CCCs will be issued by BEE based on recommendations of the Steering Committee. However, there will be certain carbon credits (called internally transferred mitigation outcomes-ITMOs) generated in India that will be allowed to be sold to international buyers through the same Indian carbon market portal and will be governed by the provisions of Article 6.2 of the Paris Agreement; and there will be carbon credits governed by Article 6.4 of the Paris Agreement that will be issued by UNFCCC which is the Paris Agreement Crediting Mechanism’s registry administrator. Without going into what ‘validation’ under Section 115BBG should engulf, it appears that of the three categories of carbon credits where the Government of India will be involved, only one set of credits may hold a chance of being covered by the definition of ‘carbon credits’ under the Income tax law, past or present.

Whether the distinction is an error or intentional, it is clearly contrary to the larger climate action plan of the country. What remains to be seen is if a purposive interpretation can be made given that the definition has been borrowed from the previous law when CCTS did not exist and the carbon market has been operationalised by the Government itself as opposed to a voluntary market?

Till the time there is any clarification or amendment, if CCCs sold by Seller S to Buyer B in the compliance market of the CCTS, they will not be subject to the reduced rate of 10%, and the next question we would return to would be if they can be considered to be capital receipt and wait for the Supreme Court’s decision.

Buyer’s void: the unexamined side of the trade

If the tax authorities are taking a position that the income in the hands of the Seller S will be a revenue receipt, the logical consequence is that the purchase should be a deductible business expense for Buyer B under Section 34(1).

But here is the catch, Section 34(2) disallows an expenditure incurred for any purpose which is an offence or is prohibited by law. The reason that Buyer B will have to buy CCCs is because it fails to meet a regulatory stipulation. Will this be a compliance cost or a remediation of a statutory default. The question becomes even more relevant when juxtapositioned against the environmental compensation that becomes payable if and when, Buyer B is not able to buy enough CCCs and has to pay an amount equivalent to shortfall x 2 x average price at which CCCs is traded during the trading cycle of such compliance year[3]. Further, when such environmental compensation is not paid, then a penalty may be imposed[4]. Therefore, whether the environmental compensation payable is merely a differential price or penalty is a question that requires clarity.

Further, the question of which year can the deduction be made, whether it is when the intensity shortfall crystallizes or at the time of compliance filing, or at surrender of CCCs? Applying the principles followed under the mercantile system of accounting[5], the year in which the liability is materialised is relevant, but the larger question is as to when will the liability materialise? This is because end of the compliance year is only for achieving targets, the fact that there is a liability, and whether they will be met through surrender of CCCs or by purchasing is a call that will be taken subsequently, and on top of it there has to be validation by the ACVA and determination of average price by BEE. This is a question that the accounting team in the organisation as well as the tax team will have to address, until there is further clarity from the Government.

Many questions remain unanswered

There are also other questions that come up. For example: Whether the banked CCCs will be a stock in trade or capital assets and what will be the valuation of those credits? Whether CCCs can be traded after purchase and in such a case, will it be stock in trade and what will be the income tax implications thereof? Like always the positions taken in GST will influence income tax positions as well and the questions that will be raised under GST law are reserved for a separate discussion. And so on.

International perspective

Looking for certain legal positions is not asking for too much. Given that carbon credits have been around for a while, many jurisdictions have addressed the taxability of carbon credits more comprehensively. For example, Singapore has explicitly stated that general income tax principles will apply and a company that purchases carbon credits to comply with regulatory obligations will be regarded as having purchased the carbon credits for use in its business and deduct the same as expenses, subject to other provisions.[6] Similarly, the Australian Tax Office has issued clear instructions on the income tax treatment of carbon credits covering the position about deductibility, valuation etc.[7] New Zealand categorically recognised the need for clear tax policy and brought in amendments to assert that emissions units would generally be deductible on acquisition, but added back at cost at year-end to the extent they are still on hand and income from the receipt of emissions units from government is assessable on an accruals basis.[8] Recognising the complexities well in time and issuing comprehensive clarifications will encourage an ecosystem more conducive for carbon market operations and growth.

Recommendations

Drawing from the above discussions, a few steps that the Government can take are to amend Section 194(2)(a) of the Income Tax Act, 2025 and extend the scope of ‘carbon credit’ to credits issued under the CCTS or validated under Article 6 of the Paris Agreement or consciously carve CCCs into business income with expense deductibility. Further, CBDT circular is welcome on: buyer-side deductibility, timing, banked-credit valuation with deductibility confirmation on environmental compensation. And importantly, transitional protection for FY 2025-26 positions taken in good faith.

Conclusion

Carbon markets run on price signals and unquantifiable tax risk is noise in the signal. If India wants CCC prices to drive decarbonization and the carbon market to be a successful tool in the climate goal achievement roadmap, the tax cost of a tonne of carbon cannot itself be a matter of litigation. The last definitional war took a decade, but this one is avoidable.

[The authors are Senior Partner and Partner in Direct Tax and Sustainability practices, respectively, at Lakshmikumaran & Sridharan Attorneys, New Delhi]