The role of tax in ESG

ESG stands for environmental, social and governance criteria, which represent risks and opportunities that will impact a company’s ability to create long-term value. To date, tax has largely been absent from the ESG conversation – yet tax has a pivotal role within each pillar of ESG.  It is critical for companies to understand both the tax risks and the opportunities within each of these pillars.

Environmental

The environmental pillar is more than just climate change. It extends to biodiversity, land use, waste and water usage. Many companies are focused on net zero commitments, implementing decarbonisation plans (including a review of supply chains) and managing climate/transition risk.  Tax policy (both a ‘carrot’ and ‘stick’ approach) can play a key role in driving change and mobilising investment in decarbonisation, green innovation and green research and development (R&D). Some topical examples of the ‘stick’ approach include increasing carbon taxes (including the introduction of the carbon border adjustment mechanism (CBAM), which aims to equalise the price of carbon paid for EU products operating under the EU Emissions Trading System (ETS) and imported goods) and the introduction of plastic taxes. On the flip side, there are many opportunities which include an increasing number of green tax incentives and subsidies, such as R&D tax credits for the development of new clean-tech or carbon capture technologies as well as accelerated capital allowances for investment in energy-efficient equipment. Tax incentives can generate tax deductions, which can lead to cash tax savings and in turn result in more cash to invest in businesses – not to mention increased returns to key stakeholders and investors.

A good understanding of green taxes and incentives can positively influence investment decisions and potentially enable faster progress to net zero. Taxes (including VAT and transfer pricing) and incentives should always be factored into business decisions, and this is no different when looking at ESG/sustainability projects. The tax opportunities and the potential tax cost of ‘getting it wrong’ need to be explained in a meaningful way to the business teams charged with leading sustainability workstreams.

Social

The social pillar looks at an organisation’s contribution to fairness in society. This includes:

• company purpose

• values and culture

• socially responsible investments

• products and supply chain strategies

• inclusive workplaces and workforces

Topical themes here include equal pay and gender pay gap reporting. Total tax contributions are also relevant. Tax is a key indicator of an organisation’s contribution to society, but it is a complex area and often misunderstood.

Tax contributions are an area of interest for many stakeholders and can become a reputational issue. Recent headlines include shareholders calling for increased tax transparency at AGMs and shareholder resolutions claiming that a lack of tax transparency poses a material risk for long-term investors. There are significant upsides to getting this narrative right. Embedding tax within ESG through sustainable tax practices and promoting meaningful tax transparency allows an organisation to take control of its tax narrative. This can increase trust in the market and promote an organisation’s overall purpose and values.

Governance

The governance pillar focuses on the processes in place for decision-making, reporting and ethical behaviour. This also extends to tax, as meaningful tax strategies and disclosures – along with robust tax governance and control frameworks – are key to driving sustainable tax practices and promoting transparency and trust in the market. Conversely, tax risk combined with a lack of robust tax controls can lead to increased tax audit activity (and the possibility of financial penalties), a lack of trust and an erosion of value in the market.

Regulation, including the Corporate Sustainability Reporting Directive (CSRD), mandates more detailed sustainability reporting and the publication of ESG investment policies across all industries. As a result, tax disclosures will need to be considered. By including tax strategy, tax policies and tax contribution as part of the sustainability report, companies can ‘tell their story’ to stakeholders on their approach to tax and highlight the positive contributions made to society. It should also ensure alignment between a company’s ESG reports and information disclosed to key stakeholders, including tax authorities.

The four key actions to take now

The key actions every business should consider now are:

1. Communication and collaboration

Bring tax to the table early for all ESG / sustainability projects. Understand the tax cost and tax opportunities for all options under consideration as well as the impact on the tax structure of your business. Ensure that tax is appropriately factored into the decision-making process.

2. Oversight of tax contribution

Be aware of all taxes paid by your business. This extends beyond corporation tax to all taxes including payroll taxes and environmental taxes. Ensure that your total tax contribution is disclosed in a meaningful way to key stakeholders and avoid misunderstandings.

3. Alignment of ESG and tax

If your business already has an ESG strategy, consider whether it aligns with your tax strategy. It is equally important to ensure alignment between sustainability reporting and tax reporting. For example, CSRD will require in-scope companies to explain and articulate their business model and how it will evolve to deal with climate change. From a tax perspective, a company might also be required to set out and explain its business model in a master file for transfer pricing purposes. If there are discrepancies between these reports, increased scrutiny – particularly from tax authorities – could follow.

4. Technology

The role of technology is becoming increasingly important in extracting and monitoring relevant tax data. Companies should investigate the potential of technology solutions to track and monitor global tax compliance obligations, global tax contributions by jurisdiction, data analytics and modelling to understand and report on key tax developments (including the implementation of Pillar Two rules).