In 2005 a group of financial institutions, consultants, governments, regulators, and analysts met in Zurich to examine the effect of environmental, social, and governance (ESG) considerations on long-term investments. The group concluded that long-term value is created by companies that embed ESG concepts into their strategies.
ESG components include:
- environmental concerns such as climate risk, emissions, energy efficiency, pollution, waste management, and clean technologies;
- social concerns such as labor relations, working conditions, diversity and inclusion, human rights, and tax and other contributions to communities; and
- governance concerns such as board diversity, business ethics, risk tolerance, tax strategy, and information reporting.
Tax and ESG
Increased social interest in tax and government policies and media scrutiny into whether companies are paying a fair amount of tax have led to tax issues becoming an ESG consideration. Businesses are attempting to implement tax policies that demonstrate their ESG commitments as a way to build public and stakeholder trust.
Examples of external pressure for greater transparency around a company’s tax position include government officials requesting information on low effective tax rates, analysts asking about tax risk factors described in SEC filings, media outlets accusing multinational companies of underpaying their income taxes, investment funds requiring companies to disclose their global tax policies, and employee whistleblowers providing tax strategy information to tax officials.
While not reflected in the ESG acronym, tax is central to the concept’s principles. Carbon taxes on greenhouse gas emissions and green tax incentives encourage sustainable practices.
Tax laws require companies to contribute to the societies in which they operate, which facilitates public trust in responsible corporate actors. Proper tax governance means oversight of an organization’s tax strategies and decisions to ensure they align with business objectives and tax reporting. Taxes are critical to the orderly function of a civil society and support the communities in which businesses operate.
Previously, companies focused on increasing shareholder returns and paid less attention to how business practices affected society and the environment.
Those money-centered approaches are widely viewed as no longer sustainable. To succeed in the mid- to long-term, companies must balance the interests of all stakeholders – hence, the emphasis on ESG issues.
Stakeholders include employees, customers, investors, and regulators who expect transparency of tax strategies, tax risks, total tax contributions, and country-by-country activities. They view the public disclosure of a company’s approach to tax, the amount of tax paid, and to whom tax is paid as integral to sustainable tax practices.
Consistent with that sentiment, rating agencies include in their ESG scores tax criteria that consider effective rates, tax policies, transfer pricing disclosures, jurisdictional tax laws, and government assistance (such as grants and tax relief).
Tax and ESG Disclosures
In most countries and industries, public disclosure of tax strategy information is voluntary. However, many companies choose to disclose information on their approaches to global tax that can range from a broad global tax policy statement to a detailed report on the total tax contribution. There’s no single set of standards for measuring and reporting ESG data.
ESG-focused reporting can affect tax disclosures by increasing their scope to include nonfinancial material items, such as emissions and diversity; emphasizing the link between governance and transparency; and building a narrative for the tax strategy, which helps a company manage tax incentives for environmentally sustainable growth.
For example, absent a narrative, a company whose investment in new technology allows it to claim a tax incentive may be accused of tax avoidance instead of responsible investment.
In 2020 more than 100 companies participating in the World Economic Forum agreed on a common set of metrics for reporting on sustainable value creation. Those metrics include a company’s total tax contribution, which is the total tax burden broken down by country plus any additional tax expense, including employment tax; sales and value added taxes; and taxes collected on behalf of another party.
External pressure on large multinationals has focused mainly on low effective rates, even though the total tax contribution is arguably a better reflection of a company’s overall social contribution.
Organizations familiar with their total tax contributions across several jurisdictions and their CbC activities can make data-driven tax strategy decisions that promote ESG and sustainability objectives without curtailing value creation. ESG-driven tax strategies and operations ensure that a company’s tax function evolves with increasing ESG relevance.
Criticism over misleading and fraudulent ESG disclosures has generated demands to clarify disclosure rules. There are few rules and standards for ESG reporting, stakeholders may disagree on whether sustainability is present, and sustainability requirements are subjective and hard to enforce.
There’s a gray area between quantifiable items, such as carbon dioxide emissions, and qualitative items, such as descriptions of investments in energy sectors.
Good ESG practices draw more customers and provide an advantage in capital markets. That encourages “greenwashing,” or exaggerating or providing misleading information on ESG efforts. In March 2021 the SEC created a task force to identify ESG-related misconduct and pursue tips, referrals, and whistleblower complaints.
ESG Tax Strategies
As part of increased ESG visibility, companies are paying more attention to tax risk and governance and are embedding ESG principles in their tax strategies.
Their considerations include whether the business has a process for identifying and implementing new taxes, the degree of tolerance for tax planning and risk, whether tax risks are adequately disclosed in tax returns and other documents, and whether the company should consider voluntary reporting frameworks (like the Global Reporting Initiative).
Many countries have enacted tax-related measures to encourage businesses to adopt greener business practices and sell environmentally friendly products. Those entail additional compliance burdens and affect operating profits, pricing, cash flows, and forecasting models. Examples of those incentives include:
- allowing businesses to deduct the full cost of new environmentally friendly vehicles, equipment, and machinery;
- reduced employment tax on green in-kind benefits, such as providing low-emission vehicles, electricity, and charging point reimbursement to employees;
- reduced VAT on energy-saving products;
- carbon pricing measures;
- packaging and pollution taxes;
- lower tax rates, enhanced research and development deductions, import duty exemptions, and land-related incentives for renewable energy projects; and
- enhanced deductions for green job training.