Transfer pricing and the new sustainable tax landscape

In an ever-changing business world, tax, sustainability and the link between them is becoming an increasingly crucial area for many large multinational enterprises (MNEs).

There is an expectancy that large MNEs present how they are working with regard to strategic tax matters and how they allocate profits, losses and costs in the global market in which they act. Some countries, such as the UK and Poland, have already introduced mandatory rules on public tax strategies for large MNEs. There is also significant pressure from the EU on large MNEs to disclose their key financial data through measures such as public country-by-country reporting (CbCR).

Presenting tax metrics in environmental, social and governance (ESG) reporting is rather new but may be used as an efficient tool to quantify a business’s contribution to the economies in which it operates. Having sound tax governance and being viewed as a fair taxpayer may be used as an indicator of an MNE’s standing in society.

Hence, it is important to consider that even though the new tax landscape is complex to navigate and potentially administratively burdensome, there is an opportunity for MNEs to become known as being leaders in the green transition.

This article will discuss, on a high-level basis, some of the effects that are arising from the new tax landscape, where sustainability aspects have a more critical role than ever before, and what impact this can have on tax and transfer pricing.

MNEs are trying to adhere to disclosure requirements such as those established by the EU, and the guidance provided by independent organisations; for example, the Global Reporting Initiative (GRI). There is also a public expectation of, and increased pressure from shareholders regarding, a higher degree of tax transparency that the MNEs need to take into consideration.

As a result, several MNEs are addressing how they are working with taxes and tax agencies in their daily course of business. These topics may be presented in the MNEs’ sustainability reports or, in some cases, in separate tax policies or tax governance documents.

During recent years, the EU has adopted:

• The Public CbCR Directive;

• The Regulation on sustainability-related disclosures in the financial services sector; and

• The Corporate Sustainability Reporting Directive (CSRD).

The Public CbCR Directive requires MNEs to disclose their CbCR publicly. The directive has already been implemented in Romania as of 1 January 2023 and will come into effect in the remaining member states in the upcoming years (depending on when the directive will be transposed into national legislation).

The CSRD will replace the directive on reporting on non-financial information and will be implemented gradually, depending on the size of the company, with 2024 as the first financial year covered.

With the coming into force of the CSRD, the existing sustainability aspects of ESG reporting will be expanded and standardised. The number of companies within the scope of the CSRD will increase significantly compared with the existing reporting directive, because sustainability is positioning itself as a core part of business reporting. Moreover, reporting under the CSRD will be aligned with the GRI standards to a larger extent than before.

The Regulation on sustainability-related disclosures in the financial services sector aims to achieve more transparency on how actors in the financial market consider sustainability risks in investment decisions and advice. A sustainability risk is defined as an ESG event that could have a negative impact on an investment.

As mentioned, sustainability reporting under the CSRD will leverage the GRI standards to a larger extent. The GRI standards are guidelines related to how to identify important sustainability areas and how to present these in a sustainability report.

In 2019, the GRI introduced a new global reporting standard, GRI 207: Tax 2019. Tax has always been part of the sustainability agenda but through GRI 207, tax is now formally an area which should be considered when deciding on the topics to disclose and describe in a sustainability report. GRI 207 was introduced on the basis that taxes are deemed an important source of government revenue and are central to the fiscal policy and macroeconomic stability of countries.

GRI 207 contains guidance on how an MNE’s tax affairs and management should be presented in sustainability reports published after January 1 2021. However, even before that date, some MNEs elected to apply GRI 207 on a voluntary basis.

In the event that GRI 207 has been elected, meaning that tax has been identified as an important area for the business, the MNE would be required to disclose information on its approach to tax, including tax governance, and disclose certain financial information (for example, revenue from third-party sales and intra-group transactions with other jurisdictions, profit or loss, number of employees, tangible assets and corporate income taxes paid) on a country-by-country basis.

Given that the information would be available in the MNE’s sustainability report, it can be concluded that GRI 207 endorses a form of public CbCR similar to the EU's Public CbCR Directive.

Given that tax is increasingly positioning itself as an important area within sustainability, it is important for MNEs to consider and assess how these two areas interconnect.

In the near future, the tax department and sustainability department will likely have a closer collaboration than ever before to ensure that tax policy reporting as part of sustainability reporting is carried out in a structured manner that is coherent with how the MNE would like to be perceived by the public. If, for example, the GRI 207 standard is adopted in sustainability reporting, the descriptions of the tax policy, tax governance and the relationship with the tax authorities need to be aligned with the data shown in the CbCR.

It is therefore crucial that there is an alignment between the tax policy and the CbCR and that any anomalies are properly managed in a transparent manner.

The Public CbCR Directive is one of the EU’s cornerstones in its work regarding tax transparency. Through the directive, the EU expects to strengthen corporate transparency and enhance public scrutiny. This would, in turn, promote a better-informed public debate around the level of tax compliance of certain MNEs and the impact of tax compliance on the real economy.

There are already a number of MNEs that have pre-emptively adopted the new regulations and addressed the coming public CbCR obligations by publishing their public tax strategies, including CbCR data. Being proactive may prove useful, because it will position the MNE as a market leader and it also provides an opportunity to address potentially sensitive information, for example.

Similar to when submitting the non-public CbCR, it is important to analyse the data and address potential red flags. This will be even more crucial for the public CbCR because the public will have access to the information. Thus, any explanations and descriptions of the data presented in the CbCR should be treated very carefully to limit any potential bad will. General red flags that should be addressed include high profit in a jurisdiction with a low headcount and limited tax paid in a jurisdiction with high profits.

Sustainability and value creation is already, and will be in the future, more intertwined, given that MNEs will need to provide significant amounts of data under CSRD sustainability needs to be interlinked with the business model and strategy. To adapt to this new future, MNEs may need to alter their transfer pricing models to reflect on the sustainability aspects.

During the past few years, the number of sustainability-driven business restructurings has increased. MNEs are reviewing their supply chains with the aim of reducing, for example, their CO₂ footprint. As a result, MNEs may consider relocating their production activities from jurisdictions which traditionally have been characterised by cheap labour but with low transparency; for example, activities connected to CO₂ emissions, the use of certain raw materials that may be linked to child labour, etc.

In the decision-making process of such restructurings, it is important to analyse the impact it will have on the transfer pricing models related to the activity and assess the need for valuations of the restructuring itself. The analysis should also outline which MNE entities will benefit from the restructuring and how to allocate the transformation/restructuring costs connected to transitioning to a more green/sustainable business model.

Sustainability is also impacting the brand value and trademarks developed by MNEs. Thus, one needs to consider whether, for example, sustainability-linked marketing intangible property should give rise to additional compensation. One would also need to consider differences in B2B and B2C brands and the value added when adapting to a more sustainable business model.

An assessment of the impact of other taxes will also be relevant as part of the CSRD.

It is paramount for MNEs to demonstrate that they operate a sustainable business model because this is essential for attracting funding and to retain positive goodwill in the eyes of the public.

Moreover, it is becoming increasingly important for companies and investors operating in the financial sector to demonstrate that their investments should be qualified as ‘sustainable investments’. Sustainable investments are defined in Article 2:17 of the EU Regulation on sustainability-related disclosures in the financial services sector as an investment in an economic activity that contributes to an environmental objective that does not significantly harm any of the objectives and there is also a specification that the investee companies follow good governance practices; for example, in relation to tax compliance.

Thus, there is also a link between sustainable financial aspects and tax matters which needs to be considered. There is a trend that large companies are pricing sustainability- or impact-linked bonds to obtain external funding. There is also increased activity in emitting impact-linked financing to, for example, high-risk start-ups. Under such arrangements, the interest rate would be linked to sustainability performance targets and if the targets are not reached, the interest rate could be increased.

Such loans may need to be priced in line with the arm’s length principle, even in the event that the impact-linked loan is provided to an external party. This could, for example, be the case for foundation structures that are investing in external parties, because foundations need to adhere to certain fulfilment obligations to ensure that any incurred revenue is exempt from tax.

Identifying arm’s length interest rates for impact-linked financial structures may become difficult. Pricing the changes in interest with a downwards or upwards adjustment as a result of fulfilling or missing a sustainability target is rather uncharted territory and will surely lead to discussions.

The importance of considering sustainability and ESG goals, and how these aspects impact business models and strategies, is increasing. If the green transition is not properly aligned with MNEs’ tax strategies and models, various risks may arise and opportunities may be lost.

Transfer pricing and sustainability-driven changes are closely interlinked, so it is necessary to consider the entire transfer pricing operating model when driving the transition into more sustainable supply chains.