Integrating transfer pricing and ESG: Practical considerations

Editor: Howard Wagner, CPA

Companies of all sizes continue to grapple with how to understand and apply the evolving cluster of principles and concepts that have come to be known as ESG, or environmental, social, and governance. ESG is fast becoming an integral (yet sometimes amorphous) part of the regulatory and evaluative fabric that shareholders, stakeholders, investors, regulators, and others are using to measure, evaluate, and grade corporate enterprises. ESG has come to touch virtually every corner of a company’s business operations — and transfer pricing matters are no exception.

ESG principles affect a company’s profit allocation, supply chain choices, and transfer pricing model. As such, close communication and consultation between the stewards of transfer pricing operations and ESG managers have become critical. Enhanced visibility — both internally and externally — of a company’s ESG “score” has driven company boards and C-suite executives to mandate closer coordination between these professionals to develop methodologies, metrics, and criteria for evaluating and embedding ESG factors into transfer pricing analyses.

Although the integration of ESG principles into transfer pricing operations is an evolving area, consistent guidelines and uniform standards exist. Multinational companies (MNCs) are at different stages of their ESG integrations and thus are approaching ESG considerations differently, often based on corporate size, geographic footprint, industry dynamics, and whether a company has a well-articulated ESG strategy.

Against this background, this item outlines a framework and approach for in-house tax professionals to consider when endeavoring to align transfer pricing operations within the broader context of ESG strategy. The following questions are considered:

• What is the impact of regulations on the transfer pricing model and process?
• How should the transfer pricing model be modified to include ESG factors?
• How should transfer pricing functional analysis be modified to include ESG factors and considerations?
• How should ESG factors be included in transfer pricing methodologies?
• How should transfer pricing documentation be modified to include ESG factors and considerations?

What is the impact of regulations on the transfer pricing model and process?

Companies are currently not required to undertake ESG reporting, as few, if any, compulsory regulations are in effect (although the Corporate Sustainability Reporting Directive will apply to some European Union organizations starting in financial year 2024). There are, however, several recognized frameworks that help companies with their ESG reporting, e.g., those of the Global Reporting Initiative, the Sustainability Accounting Standards Board, and the Task Force on Climate-Related Financial Disclosures.

Similarly, no specific regulations are in place that directly govern transfer pricing from an ESG perspective, although the tax transparency legislation proposed by the Australian Tax Office features a level of transparency that includes intercompany transactions. ESG considerations are increasingly becoming part of the broader regulatory language, and tax authorities and policymakers are recognizing the need to integrate ESG factors into various aspects of corporate governance, including transfer pricing.

In recent years, tax authorities have increasingly requested additional information on ESG-related activities, especially for industries with significant environmental or social impacts. MNCs should consider including ESG-related information in their transfer pricing documentation to demonstrate compliance, substantiate value creation, and address any potential tax risks related to ESG factors.

How should the transfer pricing model be modified to include ESG factors?

Transfer pricing models can broadly be characterized as centralized or decentralized, while the particular transfer pricing model a company adopts may be somewhere in the middle. From an ESG perspective, the extent to which a transfer pricing model realizes ESG outcomes generally depends on the impact of ESG on the value chain. Transfer pricing rules and guidelines emphasize the importance of aligning transfer pricing practices with economic substance and value creation. Thus, when ESG factors influence the allocation of profits on the value chain, the transfer pricing arrangements and policies must reflect these ESG-related contributions.

For example, a manufacturer may decide to source raw materials from a more sustainable source, which may help it achieve a better outcome on an ESG rating scale. However, this may result in additional manufacturing costs. If this manufacturer operates as a toll or contract manufacturer, these additional costs will typically be transferred to the principal (i.e., the intangible property owner), in a standard cost-plus model. Similarly, the labor practices that a manufacturer adopts may reflect a more “social” parameter but may, once again, affect the transfer pricing and profit reallocation. How can these ESG-related costs translate into an ESG benefit that is allocated to the appropriate company within the group?

Another common example is the recharge of management or administrative fees. MNCs implementing management fee recharges may now include ESG-related services. Should these costs be recharged to other companies within the group? And if so, how would the benefit to the service recipient be modeled and substantiated? What would be an appropriate markup to reflect these activities?

The transfer pricing model also depends highly on the tax incentives provided for ESG-related activities. Many jurisdictions offer tax incentives to encourage ESG-related activities, which MNCs then incorporate into their transfer pricing models and policies. For example, if a company within a group engages in renewable energy production or research and development into environmentally friendly technologies, transfer pricing arrangements should reflect the value of these activities to access tax benefits. It is important to note that tax laws and regulations vary across jurisdictions, and the treatment of ESG-related activities with transfer pricing can differ.

How should a transfer pricing functional analysis be modified to include ESG factors and considerations?

The functional analysis, which evaluates the functions performed, assets employed, and risks borne by the parties to a related-party transaction, is the cornerstone for any transfer pricing analysis. The functional analysis process should account for ESG factors in the following manner:

Functions performed: The scope of the functional analysis will include an assessment of ESG-related functions performed by each entity. This involves identifying and documenting activities related to environmental stewardship, social impact, corporate governance ensuring compliance with environmental regulations, sustainability reporting, employee welfare programs, etc.

Assets employed: ESG-related activities typically generate value for the overall organization. It is necessary to evaluate the tangible and intangible assets that contribute to generating value in the ESG space. Such assets may include renewable energy infrastructure, patented sustainable technologies, trademarks of ecofriendly products, or a company’s reputation for ethical business practices.

Risks borne: This involves identifying and assessing the potential impact of ESG risks on the financial performance and value creation of the companies within a group. ESG-related risks include those related to climate change, supply chain ethics, and regulatory compliance in ESG-related industries. In the traditional sense, these may collectively be classified as reputational risk. However, the Organisation for Economic Cooperation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations have outlined how a robust process for analyzing risk in a related-party transaction is needed to accurately delineate the actual transaction with respect to that risk. Thus, the starting point for this analysis is to identify the economically significant risks for the specific transaction in question.

By integrating ESG considerations into the functional analysis process, MNCs can better align their transfer pricing policies with sustainable and responsible business practices.

How should ESG factors be included in transfer pricing methodologies?

Five broad transfer pricing methodologies are used in a transfer pricing analysis. The application of each methodology may need to be modified to include ESG factors. Examples include:

Cost-plus method: When incorporating ESG factors, MNCs could include in the cost base the costs associated with environmentally friendly production methods or socially responsible labor practices. This can incentivize entities to adopt sustainable practices and reward them for their ESG investments.

Comparable-profits method (CPM): When companies incorporate ESG, the CPM should include consideration of the impact of ESG factors on the profitability of comparable transactions, which may not be immediately evident. As noted earlier, embracing ESG factors may result in higher costs. However, entities that demonstrate better ESG performance might also command higher profit margins due to their sustainable practices.

Comparable-uncontrolledtransaction method: In this methodology, the key question is whether the taxpayer adopted similar ESG practices (e.g., sustainable sourcing, fair trade practices, and adherence to specific environmental standards) as the tested transaction. This analysis should help align intercompany prices with the market prices that reflect the ESG performance of the transactions.

Profit-split method: In applying the profit-split method, it is critical to understand and model how ESG-related factors affect the factors that govern the profit split. Entities that implement sustainable practices, reduce environmental impacts, or enhance social value creation can be recognized and allocated a proportionate share of the profits to reflect the key transfer pricing principle of profits being taxed where value is created.

Resale-price method: The application of this method will reflect the value add from ESG attributes (e.g., ecolabeling, fair trade certification, and ethical sourcing practices) into the resale price of the product or service, justifying a potentially higher resale price.

While it may be conceptually possible to introduce ESG-related factors into an existing transfer pricing methodology, data limitations may make it difficult to practically model this. As ESG-related reporting is more widely adopted, with legislation introduced on ESG regulation and reporting, this challenge could be addressed.

How should transfer pricing documentation be modified to include ESG factors and considerations?

Transfer pricing documentation is the culmination of each of the above questions — i.e., describing the ESG-related functional analysis, adopting a transfer pricing model modified for ESG factors, and integrating ESG into the transfer pricing methodology. From a documentation perspective, it is necessary to ensure that ESG-related considerations and their impacts on the functional analysis are well documented in the transfer pricing reports. Documenting ESG considerations provides transparency, supports compliance efforts, and helps address potential tax risks related to transfer pricing and ESG.

Ethical, sustainable, and compliant operations

Overall, transfer pricing and ESG operational issues are interconnected, and companies need to consider both aspects to ensure ethical, sustainable, and compliant business practices. Taxpayers should ensure that their transfer pricing policies and pricing decisions align with their ESG objectives. This means considering the environmental, social, and governance impacts of their intragroup transactions and adjusting pricing accordingly. By considering these aspects, taxpayers can ensure that their transfer pricing practices support their ESG goals, align with regulatory requirements, and demonstrate transparency and accountability in their business operations.

Editor Notes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky. For additional information about these items, contact Wagner at howard.wagner@crowe.com. Unless otherwise noted, contributors are members of or associated with Crowe LLP.