When formulating your ESG strategy, don’t forget your tax department

Reversing climate change is everybody’s business and environmental, social, and governance (ESG) issues were high on the agenda for Asia-Pacific CEOs even before the pandemic. In EY’s 2019 CEO Imperative Survey, when questioned about climate change, more CEOs in Asia-Pacific than anywhere else in the world saw this as a major global challenge.

This focus has only increased. In the EY 2022 CEO Outlook Survey (via ey.com Japan), 74% of respondents cited ESG as an important driver of value over the next few years and 33% said they have sustainability key performance indicators (KPIs) for creating long-term value.

Company leaders are increasingly looking to create shareholder value and gaining stakeholder support through ESG initiatives, with growing demand from the public and investors as well.

Market and societal forces – from global climate change and biodiversity loss, to increasing stakeholder capitalism and the fight for racial equity and social justice – have heightened the importance of a company’s ESG strategy. Results from the 2022 General Counsel Sustainability Survey, co-authored by EY teams and Harvard Law School, show that 66% of the public believe that CEOs should take the lead on ESG change rather than waiting for governments and that 78% of institutional investors are conducting structured ESG evaluations, up nearly 50 points from 2018.

Stakeholders – customers and employees alike – are paying close attention to companies’ ESG activities and messaging. EY research shows that investors are incorporating ESG into their investment decisions at unprecedented levels.

Consumers, too, are looking at how companies address sustainability and social issues. They are making purchasing and brand loyalty decisions based on the information they find, with 42% of consumers surveyed as part of the General Counsel Sustainability Survey reporting they would stop buying from a company that did something that was not socially or environmentally appropriate (see Rhett Power, “How to Attract Conscious Consumers to Your Business”, Forbes, September 6 2020).

Demands are coming from all directions, but too often the role the tax department could have in the strategy is overlooked. To stay relevant, companies need a balanced, holistic ESG strategy that is integrated into their operational DNA – and the tax department has a role to play in designing that strategy.

The tax department has not historically been involved in ESG strategy conversations. Increasingly, however, tax intersects with ESG matters, particularly around a company’s:

• Effective tax rate (ETR) and approach to taxation;

• Support for sustainability and social polices funded by taxes;

• Carbon footprint and climate mitigation strategies;

• Decisions around using available tax incentives and credits; and

• Overall tax transparency and reporting.

Tax is often used as a lever to drive (and fund) economic and policy change, and a company’s decisions around tax engagement, tax incentives, and tax disclosures may have implications for its ESG strategies and potential reputation.

In addition, it is expected that there will be increased pressure to disclose more tax information to more stakeholders. Key players shaping the ESG reporting ecosystem include:

• Corporate reporting standard-setters that provide guidance for ESG disclosures;

• Data aggregators that structure publicly available data or that request data from companies via questionnaires;

• Rating agencies that create assessments of companies based on public and/or private information to sell to investors; and

• Regulators, such as the Securities and Exchange Commission (SEC).

Finally, we should not forget that this massive shift in focus and the importance of ESG to a multinational company (MNC) has impacted the overall value chain and consequently, as a minimum, how that should be reflected in the overall transfer pricing policy must be considered. While that sounds obvious, it can be a complex activity that requires the tax department to have a detailed understanding of the overall ESG strategy.

With so much at stake, tax departments need to be at the table to help companies to consider, construct, and communicate the tax implications of ESG-related decisions. This requires understanding the company’s values and value proposition – and how these elements are reflected in its tax policies.

For some companies, incorporating the tax perspective will simply require adjustments to the existing ESG strategy and communications. For others, it will require a deeper analysis of the company’s current state and future ESG targets. The following questions should be considered when deciding how to embed tax into a company’s ESG strategy.

Companies should consider the following questions regarding tax principles and disclosures:

• What is the process for discussing tax-related ESG issues within the organisation? Is there a process for involving the tax department in any tax-related ESG disclosure?

• What is our overarching approach to tax? How do we communicate this approach inside and outside the organisation?

• How do we measure our ETR in each jurisdiction in which we operate? How is this information communicated within and outside the organisation?

• What is our level of transparency around tax disclosures? Where is this information documented? How is it communicated internally and externally?

• Do we have a position on carbon tax policies? Do we know our carbon footprint?

• What is our position on tax policies related to health and/or social justice? How has that been established and communicated?

• How is tax represented in our company’s ESG ratings? What is the internal process for obtaining, analysing, and reflecting this tax data? When is the tax department brought into the conversation?

• To which ESG rating agencies do we report our ESG measures? How many agencies are we reporting to? Where are they located?

• What voluntary reporting frameworks are we planning to report under, and what are the tax disclosures required by those frameworks?

• Do we plan to engage with ESG rating agencies, standard setters, and regulators as they design and refine tax metrics?

• How do we benchmark ourselves against other companies in relation to ESG generally and tax specifically?

• Would we be better off disclosing our total tax contribution?

The use of credits and incentives should be assessed in the following ways:

• What sustainability strategies, targets, and goals have we implemented? What role do tax credits and incentives/grants play in meeting those targets by providing funding? Are we active enough in this space?

• Which tax credits and incentives do we use? How are decisions made about which credits to use and which to forgo? As part of this analysis, have we considered our approach to using credits in fiscally stressed jurisdictions, the volume and level of our credit use, and the use of credits for investments and activities regarding which there is uncertainty about the outcome? Where and how is this policy memorialised?

• How are tax credits and incentives/grants reflected in our ESG disclosures?

Companies should ask the following questions when analysing supply chains and revenue targets:

• How is ESG factored into our supply chain decisions? What role does tax have in those discussions?

• What impact do energy and environmental taxes have on our supply chain?

• Many governments are expected to introduce new behavioural taxes (carbon, labour, or health-related taxes) – do we understand how that might impact our value chain, do we need to do something different, and are our enterprise resource planning (ERP) systems ready for the additional compliance?

• Do we know how ESG-related taxes impact our revenue targets and competitiveness? How are we measuring this impact?

These questions are not all-encompassing but can provide a good starting point for defining and shaping the tax elements of a company’s ESG strategy.

As ESG becomes more central to companies’ global business strategies, tax should play a role in defining and shaping ESG approaches and reporting. A company’s ‘tax creed’ – articulating its overarching approach to tax and tax disclosures – should be memorialised and reflected in its overall ESG approach. This policy should be integrated into a company’s corporate governance and communicated broadly across the organisation.

As the global tax landscape evolves, tax departments should include themselves in ESG conversations to help to manage messaging, educate company executives about the tax considerations of ESG-related decisions, and evaluate potential risks.

Companies that include the tax department in these conversations will be better positioned to manage potential risks; communicate with stakeholders, customers, and regulators about ESG tax issues; and unlock the often significant prospects for financial support through incentives/grants and credits.

This article has been adapted from an article published as “When Formulating ESG Strategy, Don’t Forget to Leverage Your Tax Department”, Corporate Compliance Insights, June 24 2021, and we would like to thank Cathy Koch and her team for the original article.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms.