Marrying ESG initiatives to business tax planning

Editor: Greg A. Fairbanks, J.D., LL.M.

Environmental, social, and governance (ESG) initiatives by businesses provide investors, customers, employees, and other stakeholders with insight into a company’s position, strategy, and performance on sustainability-related topics. ESG focuses on how companies prioritize and monitor key nonfinancial areas that impact success and valuation through effective governance structures designed to manage the risks and leverage the opportunities associated with ESG matters. Companies must now focus on how ESG initiatives affect their financial performance, market position, and ability to execute strategy. A key component, especially as stakeholder interest and disclosure requirements increase, should be tax policy and planning.

ESG background

The ESG landscape covers overlapping environmental, social, and governance topics that must be addressed to ensure a company’s future success. ESG components include:

• Environmental concerns, including climate risk, emissions, energy efficiency, air and water pollution, waste management, and clean technologies;
• Social concerns, including working conditions, labor relations, diversity and inclusion, human rights, and tax and other contributions to communities; and
• Governance concerns, such as oversight of ESG matters, board diversity, risk tolerance, business ethics, information reporting, and tax strategy.

As a term, ESG was coined in 2005 in a milestone study, Who Cares Wins. This report was compiled based on the request of United Nations Secretary-General Kofi Annan. Its mission was the development of guidelines and recommendations on how to better integrate ESG issues into the current business environment. The areas covered included asset management, securities brokerage services, and associated research functions. At the same time, the “Freshfields Report” (Freshfields Bruckhaus Deringer, A Legal Framework for the Integration of Environmental, Social and Governance Issues Into Institutional Investment (2005)) revealed that ESG issues are also relevant for financial valuation. These two reports formed the backbone for the launch of the Principles for Responsible Investment, a United Nations-supported organization that encourages investors to incorporate ESG considerations into their investment decisions.

Today’s ESG is no longer just a buzzword resulting in the ticking of boxes on a checklist; instead, ESG is a set of standards used to assess a company’s behavior by socially conscious investors. Until recently, most investors made decisions without considering the impact their investment portfolio might have on the environment, society, communities, or the overall well-being of stakeholders. However, a significant and growing number of investors are now considering these impacts as part of their decision making process.

The coordination of federal income tax and ESG principles

As ESG matters grow in relevancy, public support, and government regulation, there can be no doubt that they are integral to an organization’s bottom line. When one assesses an entity’s financial performance, tax liabilities and effective tax rates are often areas of focus. But, while not reflected in the ESG acronym, tax elements are central to each of the ESG principles, too. Consider the numerous federal income tax credits and incentives, whether existing, extended, or newly introduced, that align with ESG topics. The impact this legislation has on taxpayers cannot be understated.

Environmental behavioral tax incentives and credits aimed at addressing greenhouse gas emissions and remediation, renewable energy, and energy efficiency (discussed below) are crucial to businesses because they reduce tax liabilities, but they also drive more sustainable behavior. A growing number of businesses are acknowledging that proper ESG tax planning provides a mechanism for companies to contribute to their communities and build public trust as a responsible corporate actor. Tax governance must now evaluate tax strategy along with business objectives and stakeholder communications around tax reporting.

“Stakeholders” means those who are most important for the success of the business or organization. Broadly, they include employees, customers, investors, and regulators, and today they expect transparency of tax strategies, tax risks, total tax contributions, and country-by-country activities. All stakeholders are increasingly expecting — and in some cases requiring — public disclosure of a company’s approach to ESG, including sustainable tax planning, amounts of tax paid, and jurisdictions where the tax is paid. Additionally, global sustainability rating agencies such as the Global Reporting Initiative include a tax component in their ESG scoring criteria that considers, among other inputs, the environmental impact of a business’s tax policies.

The increased governmental focus on climate change has generated recent legislation that is paving the way for tax policy to significantly impact an entity’s ESG framework. As such, tax departments are becoming increasingly relevant in environmental business decisions and initiatives.

The Inflation Reduction Act of 2022, P.L.117-169, was signed into law on Aug. 16, 2022. The act features $370 billion in spending on energy and climate change, including tax incentives and related provisions affecting transportation, manufacturing, and many other industries. The Inflation Reduction Act’s tax incentives are designed to encourage renewable energy use and reductions in greenhouse gas emissions. Leveraging these opportunities can be an important component of an ESG strategy for companies that want to incorporate ESG principles in their projects and initiatives while also generating significant tax benefits.

Below are examples of tax incentives created or extended by the Inflation Reduction Act that encourage companies to develop an ESG-compliant tax strategy. The discussion here focuses first on opportunities for the energy industry and then on those available to taxpayers more generally.

Renewable opportunities for the energy industry

For the energy industry, the Inflation Reduction Act reinstates the 30% tax credit for investing in a qualifying advanced energy project under Sec. 48C, with a new $10 billion allocation. Taxpayers must apply for a portion of the credit allocation.

The credits are potentially available to taxpayers who invest in clean energy property that:

• Generates energy from renewable sources;
• Reduces carbon oxide emissions and greenhouse gases;
• Produces electric, fuel cell, and hybrid vehicles; or
• Conserves energy.

New Sec. 45X for the first time provides a credit for manufacturers selling eligible components, rather than just the taxpayer placing the property in service.

Eligible components generally include:

• Solar energy components;
• Wind energy components;
• Certain inverters;
• Qualifying battery components; and
• Applicable critical minerals.

The credit amount varies depending on the eligible component, and the taxpayer eventually placing the property in service may also be eligible for a credit.

Sec. 45V provides for a new credit related to the production of qualified clean hydrogen that is produced after 2022 at a qualified facility. Qualified clean hydrogen is produced through a process that results in a lifecycle greenhouse emissions rate of four kilograms or less of CO₂e (carbon dioxide equivalent) per kilogram of hydrogen. The credit amount is computed in an amount equal to (1) the kilograms of qualified clean hydrogen produced by the taxpayer during the tax year at a qualified clean hydrogen production facility during the 10-year period beginning on the date such facility was originally placed in service, multiplied by (2) the applicable amount. The applicable amount is $0.60 multiplied by the applicable percentage. The resulting credit amount is multiplied by 5 if the qualified clean hydrogen facility meets certain requirements. Limitations apply for taxpayers also claiming benefits under Sec. 45Q.

The Sec. 48 investment tax credit (ITC) provides a federal income tax credit for qualifying energy-related investments. The credit is established as a percentage of the project owner’s (taxpayer’s) basis in the eligible property. Under the act, certain renewable energy projects that begin construction prior to Jan. 1, 2025:

• Will be eligible for a 30% ITC, provided the projects meet certain eligibility criteria; and
• May qualify for additional ITC enhancements that could amount to up to a 50% ITC for projects located in communities impacted by the green energy transition.

Renewable energy projects that begin construction on or after Jan. 1, 2025, will be eligible for similar “technology neutral” ITC credits, provided the projects result in zero greenhouse gas emissions.

The Sec. 45 renewable electricity production tax credit (PTC) is per kilowatt hour (kWh) for electricity generated by qualified renewable energy resources. The act:

• Extends the PTC for wind and solar projects that are placed in service after Dec. 31, 2021, and begin construction before Jan. 1, 2025;
• Provides a base credit rate for the PTC of 0.3 cents/kWh and a rate of 1.5 cents/kWh if the project meets prevailing wage and apprenticeship requirements; and
• Extends the carryback period for excess applicable ITCs and PTCs from one year to three years and the carryforward from 20 to 22 years for tax years beginning after 2022.

Renewable opportunities for everyone

Turning now from the energy industry to opportunities available more generally, Sec. 45Q provides a credit for taxpayers that capture and permanently sequester carbon oxide. The credit rate depends on how the captured carbon is used or stored. The credit provides a substantial economic incentive to install carboncapture equipment in manufacturing processes and industries that generate substantial carbon emissions. There is also an increased rate for direct air capture, an emerging technology designed to capture carbon dioxide currently in the atmosphere.

The previously expired Sec. 30C credit for alternative fuel vehicle refueling property is reinstated by the Inflation Reduction Act, with certain modifications. The credit provides for a maximum benefit of 30% of the cost of an item of property deemed to be a qualified alternative vehicle refueling station, with a limit of $100,000 per item of property. Alternative fuels generally include ethanol, natural gas, liquefied petroleum gas, and hydrogen. Further, mixtures containing biodiesel, diesel, and kerosene may also qualify. Lastly, the alternative refueling property must be located in an eligible census tract, which generally includes low-income communities and tracts that are not located in urban areas. Thus, there is a higher cap in 2023, but its availability is much more limited geographically.

Newly created Sec. 45W provides a credit for qualified commercial clean vehicles. A qualified commercial clean vehicle is propelled to a significant extent by an electric motor or power derived from one or more cells. The credit is the lesser of (1) 30% of the basis of a vehicle not powered by a gasoline or diesel internal combustion engine, or (2) the incremental cost of such a vehicle (which is defined as an amount equal to the excess of the purchase price for such a vehicle over the price of a comparable vehicle). The credit is capped at a maximum credit of $7,500 for vehicles with a gross vehicle weight rating of less than 14,000 pounds or $40,000 for vehicles over 14,000 pounds. Finally, there are no battery and mineral sourcing requirements that make the general electrical vehicle credits unusable.

Sec. 179D allows commercial building owners who make their footprint more energy efficient to deduct the costs relating to the installation of energy-efficient commercial building property (EECBP), rather than capitalizing and depreciating such property. EECBP must generally be part of (1) interior lighting systems; (2) heating, cooling, ventilation, and hot water systems; or (3) the building envelope. The maximum deduction amount is $5 per square foot. The Sec. 179D deduction has a rolling three-year cap.

Regulatory disclosures

In addition to the recent legislation, the SEC proposed “Rules to Enhance and Standardize Climate-Related Disclosures for Investors” in March 2022. The new rules, in whatever final form they take, will require disclosures of a publicly traded company’s climate change strategy, including risks and material impact of its operations on the climate, greenhouse gas emissions, additional qualitative and quantitative climate risk disclosures, and governance of climaterelated risks and risk-management processes. While the exact timing of the rules and their application remain uncertain at the time of drafting this item, the SEC has proposed a phasing in of requirements, starting with large, accelerated filers and later adding in limited and reasonable assurance over some of the information.

Now what?

Considering the recently enacted tax legislation and the forthcoming SEC disclosure requirements, taxpayers need additional implementation guidance. The Inflation Reduction Act granted Treasury broad authority to prescribe regulations or other guidance that may significantly affect how the incentives are implemented. As companies await this guidance, leaders of an organization’s tax function, along with C-suite members, are revisiting their tax strategies and incorporating ESG principles into their tax planning. The ESG-related tax opportunities available to taxpayers are numerous and complex. As such, entities need to assess their current ESG tax policy, their ability to effectively identify and implement the available opportunities, and any required or optional disclosures.

As ESG initiatives become more widespread, it is crucial for companies to involve tax professionals to help build and implement an efficient, sustainable, and responsible tax program that is unique to the company. This can take time and requires careful consideration of the tax department’s integration, goals, and anticipated contribution to business initiatives. Developing a strategy that incorporates tax in a company’s overall ESG strategy begins with defining and articulating the entity’s social and environmental purpose and values. Next, the company must ensure that the tax strategy is aligned with the organization’s business strategy through a robust governance, control, and risk management framework. Finally, the company should address ESG reporting requirements, which may include a description of its tax policies and resulting contributions to its sustainability efforts.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.