ESG (Environmental, Social, and Governance Strategies) is the current megatrend in boardroom discussions due to its growing impact on all stakeholders.
Having far-reaching consequences, companies across fora are now actively engaging in ESG policies as it is now a business imperative.
However, tax teams are often left out of the conversations on ESG strategies even though tax is an integral tool in the advancement of ESG. It has a profound impact on the value chain of companies and, resultantly, their tax and, specifically, their transfer pricing set-up. Ignoring tax while formulating ESG strategies will put companies at a disadvantage compared to their competitors.
At the outset, companies are now required to examine their overall impact on their sustainable development goals. This involves an overall evaluation of the measures needed to manage their sustainable development goal:
Tax departments are key players in helping drive the ESG policies of companies. They can foster this change in the following ways:
- Benefitting from government incentives, in form of grants or credits, with respect to clean energy;
- Utilizing indirect tax incentives on sales tax, property tax, excise duty, etc. for taking efficiency initiatives;
- A company’s value chain is an integral part of its environmental strategies. A change in sourcing strategies often carries income tax ramifications – positive ones when companies strive to invest in sustainable technologies; and
- In cases of acquisition, focusing on and assessing targets that would not jeopardize their existing tax incentives or disrupt their ESG-based supply chain.
Regardless of the policy decisions by a company in respect of ESG, it will have a significant impact on their transfer pricing set-up. ESG norms will potentially give rise to new discussions within a company from a transfer pricing perspective. Some foreseeable transfer pricing issues pertaining to ESG-based decision-making include:
- Consequent to a business or supply chain restructuring culminating from ESG-based policy decisions, some transfer pricing issues that could arise are:
- Reanalysis of manufacturing functions or usage of intangible assets in accordance with OECD transfer pricing principles. Furthermore, any supply chain restructuring for the purpose of reducing the global emission footprint will also have to be reassessed;
- The change in the functional, risk, or asset profiles of a manufacturing company for ESG-driven aggregation will require adjustment in its transfer pricing method;
- Any significant change in the group’s value creation to become a more centralized ESG risk management entity will have to be reassessed;
- Asset and risk allocation based on domestic regulation and requirements to comply with ESG standards will see the following changes that may require a reconsideration from a transfer pricing standpoint:
- Change in an individual entity’s costs to comply with its domestic ESG requirements;
- Assumption of ESG-related risks at various levels; and
- Change in supplier contracts.
- Preparation of ESG reporting and branding, viz., cost allocation. This shall include the following:
- Publishing sustainability reports;
- Drafting ESG and KPI reports for financing purposes;
- Preparation of country-by-country reporting; and
- Other mandatory and non-mandatory communications.
ESG is currently one of the most important movements in the world economy, which has its own tax implications. If you need help understanding the impact of ESG on your company’s tax functionality, contact our team of well-versed advisors.
Author: Ameya Dadhich, Transfer Pricing Trainee, TPA Global