How does tax fit into the ESG landscape and what does this mean for businesses?

Environmental, social and governance (ESG) issues are continuing to be a key consideration in corporate boardrooms. The range of ESG issues is extremely broad and permeates business strategy. This means that boards must have methods to measure, assess and manage ESG risks and opportunities, particularly in view of the position that investors, lenders, regulators, employees and other stakeholders increasingly expect to understand how ESG fits into a group’s strategy. 

Fiscal policy and tax measures are not usually at the top of the ESG topic list, but these macroeconomic tools are one of the most powerful ways to influence the behaviour of businesses and other market participants. In this context, it is critical to understand how tax fits into the ESG landscape. 

A panel of our international partners recently hosted a client webinar discussing the tax elements of the ESG landscape. Highlights from this webinar and details of how to access a recording are set out below.  

“E” - Increased use of environmental tax measures

One of the most common ways for governments to implement environmental initiatives is through tax measures designed to encourage businesses and individuals to behave in a more sustainable and environmentally friendly way. That can be through tax exemptions or incentives to bolster certain types of investment, for example, the US Inflation Reduction Act introduces and expands a number of clean energy orientated tax credits, particularly in the electric vehicle and renewable energy production spaces. In contrast, new or increased taxes can be designed to discourage certain behaviour, for example, plastic packaging taxes or air passenger duties.

Last December the EU announced a climate protection package called “Fit for 55” because the EU has set itself the climate target of reducing greenhouse gas emissions by 2030 by 55%. This package included a number of green tax measures including reforms to the EU emissions trading system (ETS) and the introduction of the EU Carbon Border Adjustment Mechanism (CBAM) that have now been adopted. 

The EU ETS is a “cap-and-trade” system that puts a price on greenhouse gas emissions. Each year entities within scope of the ETS have to procure ETS allowances corresponding to their emissions. The reforms mean a lower level of allowances will be available and the regime is being expanded to cover new sectors. The overall effect of these reforms is that 75% all EU CO₂ emissions will be tied to allowances from 2030 onwards and this will have a significant impact on both high emission industries as well as the wider economy (for further details, see our briefing: Carbon Capture – The Current State of Play in the European Union). 

CO₂-intensive industrial sectors such as iron, steel or aluminium are further targeted by the new EU CBAM which has just started its three-year transitional phase. The EU CBAM puts a price on imports of certain goods (including cement, iron, steel, aluminium etc) from third countries without comparable climate protection requirements and adds on the difference between the CO₂ price paid in the country of production and the higher carbon allowance price in the EU (for further details, see our blog post: CBAM: go-live of transitional phase). Other jurisdictions are toying with similar measures, for example the UK is considering potential policy measures to mitigate carbon leakage risk, including the introduction of a UK CBAM. 

“S” - Push for more fairness in the tax system

There is increasing pressure on businesses, particularly large multinational businesses, to pay their “fair share” of tax and this has ultimately led to the OECD’s wide-ranging Pillar 1 and 2 proposals for global tax reform. 

Pillar 1 – moving away from physical presence for the right to tax

A key component of Pillar 1 is an ambitious proposal to ensure there is a “fair” distribution of profits between the jurisdiction in which entities are located and those in which they do business. For those multinational groups that are in scope (there is a high threshold and initially it will be multinationals with over EUR20bn annual revenue and profitability above 10%), a proportion of residual profit (referred to as ‘Amount A’) will be allocated to certain market jurisdictions from which the group derives revenue, regardless of whether the multinational has any physical presence there.

Progress on the Amount A proposals has now been delayed a number of times. In October 2023, the OECD released the latest version of the text of the Amount A multilateral convention (MLC). However, the MLC is not yet fully agreed and there are ongoing discussions to try and find compromises on the outstanding points. Further delay on agreement risks the introduction of new digital services taxes (DSTs) once the current agreed DST standstill period expires at the end of 2024. (For further background on the trade implications of domestic DSTs, see our podcast: Digital taxes and trade wars – will the OECD/G20 agreement bring tax peace?)

Pillar 2 – a global minimum tax rate

Pillar 2 seeks to ensure that multinationals are subject to tax on their global income at a minimum rate of 15%, with the aim of reducing the incentive to shift profits to low tax jurisdictions. 

In contrast to Pillar 1, domestic implementation of the Pillar 2 rules in key jurisdictions (including the EU, UK, Australia, Japan and Canada) is now well underway with key aspects of the rules taking effect from 1 January 2024. A notable exception to progress with domestic implementation is the US, where it appears very unlikely that the US will implement the Pillar 2 rules in this Congress.

The Pillar 2 rules will require considerable changes to the tax reporting processes of in-scope groups (that is multinationals that have consolidated revenues of at least EUR750 million in at least two out of the previous four years). These rules are also going to significantly impact international M&A transactions, including new consequences for financial modelling, deal structuring and risk allocation, as well as particular intricacies for joint venture arrangements (for further details, see our blog post: What you need to know now about the impact of the OECD's global minimum tax on M&A transactions).

Windfall taxes

Another tax measure that qualifies as a societal measure is the imposition of windfall profit taxes (or similar measures). Recent high energy prices resulted in energy companies making unexpectedly high profits, with governments then facing pressure to take action to support those struggling with the rising costs, including calls for temporary taxes on these windfall profits. In the EU, this took the form of the “EU solidarity contribution” under which excess profits of companies in 2022/23 in the oil, gas, coal and refinery sectors will be levied at a rate of 33%. But this type of measure is not restricted to the EU – for example the UK introduced an Energy Profits Levy which (temporarily) increases the headline rate of tax on the profits of oil and gas companies operating in the UK from 40% to 75%.

“G” - Shift towards greater transparency in tax matters

Tax transparency measures have been identified as a key tool to support many of the tax measures under the “S” heading. For example, if a multinational group breaks down its activities, including details of revenue and profits generated and amounts of tax paid, between the jurisdictions in which it operates and reports that information to the relevant tax authorities, those tax authorities will be better placed to make sure the “right” amount of tax is being paid in each jurisdiction in which the group operates. That is the aim of the country-by-country reporting (CbCR) rules as mandated by the OECD and already in effect in many jurisdictions. The EU has taken this a step further and has adopted a directive to impose public CbCR under which in-scope groups are required to publish – including on their websites - the amount of taxes they pay in each Member State. 

Other tax transparency measures relevant to businesses include: 

• tax disclosure and information exchange rules for certain cross-border tax arrangements – under either the OECD Mandatory Disclosure Rules and/or the EU “DAC6” regime; 
• rules requiring digital platform operators to collect and report information about sellers that use their platforms, typically with associated information exchange obligations;
• recently adopted EU proposals to bring crypto-assets within the scope of existing EU tax reporting and information exchange obligations (referred to as “DAC8”); and
•  the proposed EU “Unshell” directive – this targets the (perceived) misuse of shell companies for tax purposes.

Outside of tax specific measures, the EU is also increasingly keen to link ESG reporting with tax transparency. Businesses should be aware of non-tax reporting standards incorporating some tax criteria, including the EU’s broader sustainability disclosure framework. 

(For further details on these measures see our blog post: ESG and tax transparency: the next frontier of tax disputes?) 

Horizon scanning: possible business risks of ESG tax measures

With the increasing use of environmental tax measures, businesses will need to monitor the impact of these measures and keep up to date on the latest developments. The reforms to the EU ETS and the introduction of the EU CBAM means that businesses with EU presence that do not change their production processes to adopt more CO₂ emission friendly methods and/or still need additional emission allowances will pay higher prices and it seems likely that these additional costs will be passed on to their customers, with the potential for making such businesses less competitive going forward.

It is anticipated in the longer term that implementation of the Pillar 2 rules will result in increased tax investigations and disputes, primarily due to likely inconsistencies in domestic implementation, and subsequent application and interpretation, of the rules.

Increasing levels of tax transparency and a push for more fairness in tax systems mean that in the medium to longer term:

• tax authorities around the globe will be better informed about how much tax multinational groups have (or have not) paid and this is expected to result in both more targeted tax audits/challenges and also an increasing level of tax challenges; and
• key stakeholders will have a better idea of the approach businesses are taking to tax risk and compliance and will have more opportunity to voice their concerns if they think a business is not being a “good” taxpayer. Possible business impacts include adverse reputational issues (which could consequently devalue businesses) and increased risk of shareholder activism. (For further details, see our blog post: ESG and tax transparency: the next frontier of tax disputes?) 

The points outlined above were recently discussed in more detail during a client webinar exclusively available to our contacts. A recording of this webinar is available – please contact Stuart Royle at stuart.royle@freshfields.com for further details.