ESG — environmental, social, and governance — has made its way to the top of boardroom agendas of companies across the globe due to its growing importance to shareholders, investors, consumers, and employees. Organizations from middle-market to Fortune 100 companies must become actively engaged through policy and action in all these areas as a business imperative. All too often, companies leave tax out of the conversation when discussing ESG, even though tax, especially in the United States, in and of itself represents an ESG strategy employed by the country's government. However, tax must be part of companies' strategy and sustainability objectives going forward.
Transparency in tax reporting is not mandatory at this point, but many businesses are preparing for potential future requirements. The European Union (EU) has already put some measures in place for country-by-country reporting and sustainable tax policy, which has forced companies to disclose information that might make a difference in stakeholders' decisions. Even the United States has seen policy movement related to tax transparency with Title I of the ESG Disclosure Simplification Act of 2021, H.R. 1187, which would have required disclosures of tax havens and offshoring. The act was passed by the House of Representatives but failed to pass in the Senate.
The risk of the current EU measures and the potential U.S. measures being discussed is that they do not tell the full story of a multinational enterprise's (MNE's) overall contribution to society through tax. For example, simply disclosing effective tax rates by country shows a snippet of the taxes a company pays and can paint an organization in a negative light if that rate is lower than what society expects.
Businesses now operate in a world where tax is considered a moral issue, with headlines frequently appearing on social media or in the news regarding how businesses manage their tax affairs. Increased media scrutiny of the level of taxes paid by worldwide groups, and tax relief claims made by businesses in the wake of the COVID-19 pandemic, are also leading to an increased social interest in taxation and whether organizations are acting in a socially responsible way.
This trend is expected to continue as a consequence of environmental and sustainability matters becoming everyday topics of conversation, increasing pressure for organizations to share tax information with all stakeholders.
Tax credits and incentives
Governments use taxes to steer and incentivize behavior. The various taxes, credits, and other incentives already present in the Internal Revenue Code are there to encourage businesses to adopt greener or more societally beneficial practices, and more were added in the recently enacted Inflation Reduction Act, P.L. 117-169.
Companies can be more focused on the "E" of ESG and consider environmental incentives:
- Energy-efficient commercial building property deduction.
- Soil and water conservation and endangered species recovery expenditures.
- Renewable electricity production credit.
- Plug-in electric vehicle credit.
- Alternative fuel vehicle refueling property credit.
- Enhanced oil recovery credit.
- Energy conservation subsidies.
Or the behavior can be more focused on the "S" of ESG to consider social factors:
- Payroll taxes including Medicare and Social Security.
- Opportunity zone credit.
- Work opportunity credit.
- Employee retention credit (during the COVID-19 pandemic).
- Charitable contribution deduction.
Not only do we see these types of mechanisms to steer corporate behavior at the federal level in the United States, but also state and local governments have put in place many more incentives and credits that organizations can take advantage of to further their strategic objectives.
We can expect further ESG credits, incentives, and taxes (to deter activities) to be implemented over the next few years. Businesses and finance functions therefore need to be prepared and have adaptable processes to be able to manage the additional compliance burden and the effect on their operating profits, pricing, cash flow, and forecasting models that these and any other new taxes will bring.
Institutional investors, private-equity investors, and fund managers now use ESG as one of the criteria to inform their investment decisions. Some institutional investors are excluding companies from their selection criteria where such companies are perceived to be noncompliant from an ESG and tax transparency perspective. Others, not wishing to be associated with any negative media publicity, are publicly divesting businesses that have weak tax reporting strategies or are perceived as not paying the right amount of tax in the jurisdictions in which they operate.
An organization's ESG considerations also need to be sincere and appropriately embedded within its strategy, not as obvious "greenwashing," which can cause more harm than good to an organization's reputation.
Recognition of this trend in tax governance scrutiny and social responsibility will become increasingly important not only to MNEs but also to small and medium-size businesses that are seeking to attract diverse workforces and innovate, expand, and grow.
As companies continue to establish operations internationally, they will need to proactively monitor and adapt their strategy to ESG-related policies and taxes in each overseas territory in which they operate. No uniform set of ESG taxes is currently applied across all jurisdictions.
Each country is making its own commitments in relation to meeting its environmental, sustainability, and social responsibility for its citizens. Therefore, each will potentially be taking a different route in the way that it achieves its objectives, depending on the socioeconomic factors that are relevant to the country's population.
ESG will also put significant pressure on the operational structure of MNEs by forcing an analysis of what functions drive business profits and create value and in what jurisdiction and manner that value is taxed. This pressure will create an impact on transfer-pricing models as well.
What should companies do?
As a consequence of the shift in ESG considerations, many large and owner-managed businesses are increasing their focus on tax risk and tax governance, ensuring robust processes and controls are in place.
The following list includes some actions that can be taken and questions boards should answer as they start embedding ESG in their tax strategy:
- Does the organization have a process for the identification and implementation of new taxes that will have an impact on the business?
- What is the organization's appetite for tax planning and tax risk?
- Is the tax finance/tax department adequately staffed, or, if not, has the tax compliance work been appropriately outsourced?
- Does the organization have a risk-aware training program?
- Does the organization have a tax risk statement?
- Are tax risks adequately disclosed in tax returns and other documents?
- Is tax risk considered as part of the board's overall strategy toward risk management?
- Does the organization use complex (tax) structures, and could they be simplified?
- What voluntary reporting frameworks, like the Global Reporting Initiative, should the organization be reporting under, and what tax disclosures are required under those frameworks?
As ESG matters increase in importance, companies will need robust processes and controls in place so that they can identify and monitor the changes that are likely to affect their business and ensure they adapt to those changes in terms of new procedures, payment of additional taxes, or compliance obligations.
These changes could include:
- New supply chains;
- Adapting systems to deal with tax authority digitalization;
- Handling new environmental taxes; or
- Increased compliance requirements from entering new markets.
Tax will be a critical tool in the development of ESG governmental policies, and not keeping abreast of changes in this area is likely to put organizations at a disadvantage compared to their competitors. Those organizations that are forward-thinking and able to embrace ESG for the benefit of the business, their employees, and wider communities should be able to achieve positive reputational benefits and a real competitive advantage.
— Victor Sturgis, CPA, is a partner at Crowe LLP and serves as the ESG tax services leader and racial equity fellow. Mike Gumbleton, CPA, is a senior tax accountant at Crowe. To comment on this article or to suggest an idea for another article, contact Lisa Asbell at Lisa.Asbell@aicpa-cima.com