Companies are increasingly establishing ambitious sustainability or broader ESG targets.
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.
The (opportunity) costs of ESG
If ESG costs are significant, this triggers the question how they should be treated from a profit allocation or transfer pricing perspective within the multinational enterprise.
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.
The OECD transfer pricing guidelines
It would be desirable if guidance would be provided in order to avoid that ESG investments would trigger double taxation.
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
Under the arm’s length principle, the question whether an intra-group service has been rendered when an activity is performed for one or more group members by another group member should depend on whether the activity provides a respective group member with economic or commercial value to enhance or maintain its business position.
In conjunction with the following:
This can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-in-house for itself. If the activity is not one for which the independent enterprise would have been willing to pay or perform for itself, the activity ordinarily should not be considered as an intra-group service under the arm’s length principle.
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 in order 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.
Repurposing the benefit test – recognizing the benefits of sustainability
The framework for allocating costs in relation to long-term sustainable goals and specific ESG investments requires a different perspective on the benefit test recognizing the impact on our planet and societies.
Specifically in relation to ESG, it should be possible to call out the underlying activities and possibly even recognize a separate “ESG service” category. It is good to recognize that the benefits of realizing ESG ambitions are broader than specific long-term value goals of corporations but that realized ambitions should benefit the environment and society as whole. That is certainly also a long-term value business perspective in today’s society. Under such a premise, it should be possible to specifically recognize/acknowledge this in the benefit test definition for (specific) ESG investments.
Under such a model, it would be easier to have an acknowledgment that the underlying costs should be shared/allocated within a multinational enterprise. It goes without saying that under an indirect approach for charging costs, companies should still find the right allocation keys that can be aligned with a broader benefit test definition for ESG costs. However, within the framework of the current OECD Guidelines there is sufficient flexibility to determine appropriate allocation keys.
One could argue that calling out ESG costs and specifically linking this to an enhanced definition of the benefit test triggers more interpretation questions and arguably subjective judgment around the classification of costs. However, since we are heading towards common reporting standards for ESG, there will be much more clarity around what should be considered. To illustrate, the IFRS Foundation also announced the creation of the International Sustainability Standards Board ‘ISSB’ whilst the European Commission (EC) adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD). Thus, therefore it would be timely if there is international transfer pricing guidance that provides companies with the right basis for how to treat the cost of ESG within their organization. One possible route is the introduction of ESG safe harbor thresholds for defined ESG activities that are considered to meet the benefit test standards.
The benefits of ESG are clear and demonstrable. What the international tax community needs is one additional step to reflect this in the benefit test and provide a fair basis for allocating the underlying costs within a multinational enterprise based on commonly accepted rules and principles.
¹ How do you make your company carbon-neutral? The Economist, published November 10, 2020.
² Paragraph 7.6 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022 edition
There are significant financial costs involved in realizing new sustainability ambitions. Certainly in the short-term, the costs will outweigh the financial benefits in a number of cases. This begs the fundamental question: who benefits from the transition to sustainable goals such as carbon-zero? This article touches upon this question and makes a plea for repurposing the benefit test to recognize that realizing true ESG goals benefit our planet, our people and societies. This requires a rethinking of how the benefit test should be approached and applied.