ESG and tax: what you need to know

TaxTalk - September 2023

read timeRead time: 24 mins

Recent developments in tax disclosure requirements and environmental tax incentives are shining a new light on ESG. We provide an up-to-date guide on what your company should do and when.

The term ESG was first used in the UN’s Global Compact Who Cares Wins white paper in 2004. This led to the 2006 UN Principles for Responsible Investment, which now has more than 3,000 signatories who manage more than US$3tn in assets.

The three components of the ESG framework are:

  1. ‘Environmental’, which concerns our impact on the world we live in and considers climate change, pollution and clean technologies.

  2. ‘Social’, which concerns our contribution to the communities we operate in and considerations like fair labour practices, working conditions and diversity and inclusion.

  3. ‘Governance’, which is our license to operate and considers matters like responsible tax strategy and transparency.

What is the impact of the ESG framework on tax policy?

Tax plays an important role in the ESG framework. In recent years, there has been increased pressure on businesses to disclose more information about their taxes. This particularly applies to businesses operating in multiple jurisdictions (MNEs). Governments around the world are using tax policy to motivate a transition to ESG-compliant business models and have launched coordinated efforts to ensure that MNEs pay their ‘fair share’ of tax (see our Pillar 2 article).

These efforts have led to global tax reforms, including the requirement that large companies report to tax authorities on taxes paid in each jurisdiction where they do business (country-by-country reporting.)

In addition to playing an important role in component 3 of the ESG framework (Governance), tax has also been used to help address environmental concerns in component 1. Governments have introduced tax measures that incentivise businesses to improve their environmental strategies and deter them from continued use of unsustainable practices. Measures introduced by the UK Government include:

  • The Climate Change Levy – an environmental tax on a business’s electricity and gas use, designed to encourage businesses to be more energy efficient in their operations.

  • Capital allowances on energy efficient items – these are available when a business purchases energy efficient or low to zero-carbon technology.

  • The UK Emissions Trading Scheme – the Government sets a total carbon price to incentivise investment in low-carbon electricity generation and technologies and to make sure that polluters pay for their emissions.

  • The Plastic Packaging Tax – a tax on finished plastic packaging components that contain less than 30% recycled plastic.

What are the recent developments?

Public country-by-country reporting (CbCR)

In 2015 the OECD and G20 countries formally adopted CbCR as part of the OECD’s base erosion and profit shifting (BEPS) initiative which was established to address mismatches between tax systems in different jurisdictions. Under the rules, MNEs with a global turnover of at least €750m must submit an annual return to local tax authorities that shows key elements of the group’s financial statements per jurisdiction.

In December 2021 a new EU directive came into effect which requires MNEs with a global turnover of €750m for two consecutive years, whether headquartered in the EU or not, to publicly disclose on their websites information such as profits, number of employees and taxes paid across EU and non-EU countries. Member countries are required to bring public CbCR legislation into force by mid-2023 and the rules will have effect from 2024. The first report will therefore be due in 2025.

Corporate sustainability reporting

The EU’s Corporate Sustainability Reporting Directive (CSRD) was formally adopted by the European Council on 28 November 2022. Almost 50,000 companies will be subject to mandatory sustainability reporting. This includes non-EU companies which have subsidiaries operating within the EU or are listed on EU-regulated markets. The CSRD will include the requirement to report in line with the EU taxonomy (a tool that directs investment to economic activities that are in line with the European Green Deal objectives).

Companies already subject to the Non-financial Reporting Directive (NFRD) will have to report under CSRD reporting from 2024. From 2025, the new reporting rules will also apply to companies not currently subject to NFRD reporting. Listed SMEs, small non-complex credit unions and captive insurance entities will be included from 2026.

The CSRD will apply to all large companies (listed or non-listed) where two or more of the following thresholds are met:

  • Number of employees is 250

  • Turnover of €40m

  • Total assets of €20m

What are the current reporting requirements?

In the UK most of the ESG reporting requirements are provided for in Companies Act 2006. But there are additional requirements for listed companies contained in other pieces of legislation.

There are currently no mandatory disclosures for smaller companies. But given the increasing relevance of ESG to consumers and investors alike, these companies often report voluntarily on ESG matters.

Organisations such as the World Economic Forum (WEF), the Global Reporting Initiative (GRI) and the Principles for Responsible Investment (PRI) have developed tax reporting guidelines and standards in this area. Although voluntary, many businesses are adopting them. More than 10,000 organisations in 100 jurisdictions are using the GRI standards, which include reporting on tax. More and more companies are joining the WEF’s International Business Council, which has made tax disclosures a core component of its ESG reporting metrics.

How can we help?

A business’s tax department has a pivotal role to play in its transitional strategy, as tax transparency requirements continue to grow.  And while additional reporting requirements may increase the administrative burden, they can also offer significant benefits. More and more investors are interested in how businesses manage their tax affairs. It’s even becoming a key factor in deciding which businesses they would like to invest with.

In order to prepare for the new tax reporting rules, businesses should take the following actions:

  1. Early review. Identify what information is required and start gathering and processing it from each entity. As this process can be timely, it should be done early.

  2. Understand the tax position. Many businesses are using tax incentives and reliefs to finance (in whole or in part) the business’s transitional strategy. The board of directors and management teams need to understand these measures and be aware of all taxes paid by the business (e.g payroll taxes) and the impact these will have on their tax strategy.
  1. Tax departments across the entire business should collaborate to ensure that the overall tax strategy of the business aligns with the tax strategy of each component entity. Almost all business decisions have a tax impact and, with increased tax disclosure requirements in ESG reporting, these impacts will be more visible to stakeholders and the public.
  1. Effective communication. Tax disclosures are often read by individuals who are not familiar with the terminology used by tax professionals, so it’s important that businesses avoid using overly complex language in their reporting.
  1. Future planning. Businesses should consider how their tax strategy and reporting compare with those of their competitors, and correct any deficiencies in their model. It’s also important to monitor the changing views of stakeholders and any proposed or upcoming changes to tax reporting requirements.
  1. Alignment of ESG and tax. If a business has already implemented a tax strategy for ESG, it should check that its sustainability reporting and tax reporting are aligned. For example, a company may be required to prepare a master file for transfer pricing purposes and this should reflect the information provided under ESG reporting requirements. Inconsistencies between reports may lead to queries from stakeholders and tax authorities.

If you would like further information or support on any of the issues raised in this article, please contact Justine Sacarello, Catherine Heyes or Jacinta Noone.