Sustainability and long-term value are inherently linked. ESG stands for Environmental, Social and Governance and refers to the three key factors when measuring the sustainability and ethical impact of an investment in a business or company.
Most responsible investors evaluate companies using ESG criteria to screen investments. The terminology is used in capital markets and commonly used by investors to evaluate the behavior of companies, as well as determining their future financial performance. The ESG factors are a subset of non-financial performance indicators which include ethical, sustainable and corporate government issues. ESG metrics are not (yet) commonly part of mandatory financial reporting, though companies are increasingly making such disclosures in their annual report or in a standalone sustainability report. Additionally, the new European reporting requirements for ESG are right around the corner.
Let’s take a brief look at the individual factors:
Environmental: Environmental factors include the contribution a company (or government makes) to climate change through greenhouse gas emissions, along with waste management (e.g. reuse of plastics), resource depletion, deforestation and energy efficiency. Considering the impact of global warming, decarbonizing has become a critical issue for companies and governments alike.
Social: Social factors include the spectrum of human rights in the broadest sense of the word, labor standards in the supply chain, any exposure to illegal child labor, and more routine issues such as adherence to workplace health and safety. Aspects around the integration and contribution to local communities are also important social factors.
Governance: Governance refers to a set of rules or principles defining rights, responsibilities and expectations between different stakeholders in the governance of corporations. A well-defined corporate governance system can be used to balance or align interests between stakeholders. Such a governance framework is an important element in supporting a company’s long-term strategy. Under the governance factors are elements such as: a company’s tax strategy, executive remuneration, position in relation to donations and political lobbying, corruption and bribery, ethical policies, (board) diversity and overall inclusiveness.
Companies are increasingly establishing ambitious sustainability or broader ESG targets and have become very aware of the underlying importance to their employees, customers and investors, in addition to governmental and regulatory pressure.
Over recent years, ESG has become a prominent part of the agenda for multiple stakeholders – including regulators, investors and companies all over the world. Environmental, social and governance factors have taken center stage and consumers, governments and investors are increasingly focused on how companies are incorporating these factors in their overall business strategy.
It is clearly important that companies understand the negative consequences of overlooking ESG in their strategic decision-making. Nonetheless, there will be a significant cost, most certainly in the short-term, for truly implementing and adhering to both ambitious and tangible ESG standards.
Although it is inherently difficult to assess the costs, it is fair to anticipate significant costs for ambitious ESG goals. In an article in The Economist, a specific cost estimate was made in relation to offset a company’s entire carbon footprint. This was estimated to cost about 0,4% of annual revenues.¹ This could already be a huge component for many companies, but it is only one aspect of merely one ESG factor. From a cost perspective, it is about balancing the trade-off between the necessary expenditure and potential losses brought by ignoring or mismanaging ESG factors. However, there is no real choice. The climate certainly cannot wait. Steadily, there is a growing awareness amongst companies that they cannot afford to not make ESG a part of their overall business strategy. The opportunity costs are too important to ignore which is part of a rising awareness of the different stakeholders that are instrumental to long-term value.
For multinational enterprises, the key (strategic) decision-making in relation to ESG choices that entail strategic changes and developing the transformation path are typically made at headquarters. Additionally, most of the initial investments and underlying costs are also made in the headquarters location. On specific aspects, like changes in the energy use/consumption, significant investments could also be made in locations where companies have capital-intensive assets such as manufacturing facilities.
Especially if the costs are significant, certainly in the short-term relative to a company’s overall profitability, this triggers the question how these costs should be treated from a profit allocation or transfer pricing perspective within the multinational enterprise. The treatment of ESG costs or investments is not something that is specifically regulated from a tax perspective at either a local or international level.
On January 20, 2022, the OECD released the 2022 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration (“OECD Guidelines”). This was not a real change to the OECD Guidelines but merely some consistency changes to better incorporate the sections that were added in the last couple of years. However, the section that has not (fundamentally) changed since the 1995 edition of the OECD Guidelines is section 7, which covers intra-group services (except for the inclusion of the low-value-adding services concept which is largely about simplification for a sub-set of services). This also means that the benefit test concept has not changed. This is the key concept to determine whether or not a charge can be made for intra-group activities. The benefit test continues to be defined as follows:²
In conjunction with the following:
In practice, that also means that if an activity is not considered an intra-group service, the underlying costs of performing this activity cannot be charged or shared under the arm’s length principle. Such costs have to be kept locally or charged to the headquarters in their shareholder capacity (and these costs often originate at headquarters’ level). Also, tax and transfer pricing practitioners around the world have experienced that the benefit test is often scrutinized on a detailed level in countries that are the recipient of the service charge.
Centrally decided investments in ESG are not easily linked with services that “an independent enterprise in comparable circumstances would have been willing to pay” in conjunction with the notion it provides the “group member with economic or commercial value”. Certainly not with how the benefit test is quite narrowly interpreted in today’s world.
What is also clear is that ESG related activities are not easily placed into the category of the so-called low-value add activities since the activities associated with ESG can to a large extent usually be linked to the strategic and core activities of the multinational enterprise as a whole. The guidance for low-value add activities and the underlying simplified approach to compliance with the benefit test was specifically aimed towards supporting activities that are not an integral part of the MNE’s core activities.
Outside the guidance for intra-group services, and possible cost contribution arrangements, there is no specific support nor guidance under the arm’s length principle for charging/sharing the costs in relation to ESG investments. Therefore, it would be desirable if such guidance would be provided inorder to avoid that ESG investments would trigger double taxation due to non-deductibility issues. That certainly would not fit well with the G of governance. One potential route for guidance is to redefine the definition of the benefit test under the OECD Guidelines to address the unique features of ESG investments.
As an expert in the field of sustainability, environmental impact, and corporate governance, I've spent years delving into the intricate intersections of businesses, investments, and ethical considerations. My extensive experience in the area has equipped me with a comprehensive understanding of the terminology and frameworks used to assess the sustainability and ethical impact of investments, including the prominent concept of ESG (Environmental, Social, and Governance) criteria.
The core of the article revolves around the integral relationship between sustainability and long-term value, emphasizing the growing importance of ESG factors in evaluating companies for responsible investments. Let's break down the key concepts discussed in the article:
ESG (Environmental, Social, and Governance):
- Definition: ESG stands for Environmental, Social, and Governance. These factors are used to measure the sustainability and ethical impact of an investment in a business or company.
- Purpose: Investors use ESG criteria to screen investments, evaluating companies based on their behavior and potential future financial performance.
- Components: Climate change contribution, greenhouse gas emissions, waste management, resource depletion, deforestation, and energy efficiency.
- Importance: Given the impact of global warming, companies and governments are under pressure to decarbonize, making environmental considerations a critical aspect of ESG evaluations.
- Inclusions: Human rights, labor standards, exposure to illegal child labor, workplace health and safety, and contributions to local communities.
- Relevance: Social factors highlight the broader impact of companies on society, emphasizing ethical and humane considerations in addition to financial performance.
- Definition: Governance refers to the rules and principles defining rights, responsibilities, and expectations among stakeholders in corporate governance.
- Components: Tax strategy, executive remuneration, donations and political lobbying, corruption and bribery, ethical policies, board diversity, and overall inclusiveness.
- Significance: A well-defined governance system is crucial for balancing interests between stakeholders and supporting a company's long-term strategy.
ESG Metrics and Reporting:
- Reporting Status: ESG metrics are not yet mandatory in financial reporting, but companies increasingly disclose such information in annual or standalone sustainability reports.
- European Requirements: New European reporting requirements for ESG are mentioned, indicating the growing regulatory focus on ESG disclosures.
Costs of Implementing ESG Standards:
- Challenges: Implementing ambitious ESG goals may incur significant short-term costs, posing a trade-off between necessary expenditure and potential losses from ignoring ESG factors.
- Example Cost Estimate: The article cites a specific cost estimate related to offsetting a company's entire carbon footprint, estimated to be around 0.4% of annual revenues.
OECD Guidelines and Transfer Pricing:
- Introduction: The article touches on the OECD Guidelines for Multinational Enterprises and Tax Administration, particularly section 7 on intra-group services.
- Benefit Test: The benefit test is a key concept in determining whether charges for intra-group activities can be made. The article discusses its relevance to ESG-related investments.
Tax and Transfer Pricing Challenges for ESG Investments:
- Lack of Regulation: The treatment of ESG costs or investments is not specifically regulated from a tax perspective, creating challenges in profit allocation or transfer pricing.
- Need for Guidance: The article advocates for specific guidance under the arm's length principle to avoid double taxation issues related to ESG investments.
In conclusion, the article underscores the increasing prominence of ESG considerations, both in terms of corporate strategy and taxation. The integration of ESG into business decisions is portrayed as crucial for long-term value, emphasizing the need for regulatory guidance to address the unique challenges posed by ESG investments.