The Changing Landscape - ESG and Taxation

As first appeared in Bloomberg Tax, 22 April 2022

ESG - environmental, social and governance, is the term that is now commonly being used as the banner under which investments, activities and practices designed to lead to sustainable, ethical and responsible outcomes are being badged. Organisations need to be seen to be taking an active interest in, and having policies in relation to, all these areas.

ESG has now therefore been established as a boardroom agenda item and one with which organisations need to actively engage, as a business’s ESG policies and activities become ever more important to investors, shareholders, employees, consumers and the wider communities in which businesses operate.

Net Zero

Reducing emissions and achieving net zero is crucial to limit global warming to 1.5°C above pre-industrial levels and avoid the most catastrophic impacts of climate change. An increasing number of organisations have now realised the strategic role that net zero plays in addressing climate change, and they are working to align their business strategy and activities with a net zero path.

Organisations are engaging with their customers, employees and regulators, understanding the nature and scale of their climate risks, and setting ambitious yet achievable targets. By considering the opportunities afforded by a lower carbon economy, organisations are also updating their products, services, and employment approach to be aligned with changing demands, and thereby seeking to obtain a competitive advantage.

Successful businesses will be those that make commitments, set targets to achieve them, and are able to adapt, innovate and identify opportunities so that they can add value for their customers, employees, and local communities.

Taxation

In addition to ESG, tax has become a reputational risk to businesses. Organisations now operate in a world where tax is considered a moral issue, with headlines frequently appearing on social media or in the news with regard to how a business manages its tax affairs. Consequently, many boardrooms and owner managers are focused on ensuring that their tax status is seen positively by their stakeholders, employees and society, and that they do not face any negative publicity from their tax affairs.

The increased scrutiny by the media as to the level of taxes paid by business leaders, worldwide groups, and tax relief claims made by businesses in the wake of the COVID-19 pandemic has prompted even greater interest in taxation.

The increased focus on inflation as a daily news item, linked with commentaries around sustainability, recycling, and reuse is going to ensure that the green agenda and taxation remain topical areas of consideration in the short to medium term.

Tax is therefore becoming pivotal in the ESG debate, as the majority of actions which an organization undertakes will have a tax consequence. Highlighted below are four themes we are seeing and which will increase in importance during 2022 and beyond.

Investors

Institutional investors, private equity investors, and fund managers now view ESG as one of the criteria used to inform their investment decisions. Some institutional investors are excluding companies from their selection criteria where such companies are perceived to be non-compliant from an ESG and tax transparency perspective. Others, not wishing to be associated with any negative media publicity, are publicly divesting businesses which have weak tax reporting strategies or are perceived not to be paying the right amount of tax in the territories in which they operate.

An organisation’s ESG considerations also need to be sincere and appropriately embedded within its strategy, and not be seen as obvious ‘greenwashing’, which can cause more harm than good to an organisation’s reputation.

Recognition of this trend in tax governance scrutiny and social responsibility will become increasingly important, not only to multinational organisations but also to small and medium-sized (SME) businesses that are seeking to attract diverse workforces, innovate, expand, and grow.

Environmental

Like many countries, the UK government has introduced a range of taxes, levies and other measures over the last couple of years as a mechanism to incentivise businesses to adopt improved environmental and sustainability strategies. The measures largely consist of additional taxes and reporting obligations, as well as additional incentives to encourage businesses to adopt greener practices, and purchase and sell environmentally friendly products.

Environmental Taxes

Currently the UK’s environmental taxes include:

• Climate Change Levy
• CRC Energy Efficiency Scheme
• Emissions trading scheme (UK ETS)
• Increased taxes in relation to Landfill Tax and Aggregates Levy
• Plastic Packaging Tax

The government released its Net Zero Strategy: Building Back Greener following COP26 in Glasgow. The Prime Minister outlined the UK’s 10-point plan for a “Green Industrial Revolution” to ensure that the UK meets its climate change objectives by 2050 by focusing on cleaner energy sources, transport, nature, and innovative technologies.

To meet these objectives, we can expect further environmental taxes to be implemented over the next few years. Businesses and finance functions therefore need to be prepared and have adaptable processes in place to manage the additional compliance burden these will bring, along with analysing how any new taxes will impact their operating profits, pricing, cash flow, and forecasting models.

Tax Incentives

The other way to change behaviours is to offer tax incentives. The UK government is seeking to provide reliefs to different types and sizes of business, which includes those that use a lot of energy, small businesses, or those businesses that purchase energy-efficient technologies, electric or low-emission vehicles. Current incentives include the following:

Capital Allowances

These are first year capital allowances which enable a business to deduct the full cost of new and unused assets, which are not used for leasing, against their taxable profits in the accounting year of acquisition. Current eligible assets include:

• zero-emission goods vehicles
• equipment for electric vehicle charging points
• gas, biogas and hydrogen refuelling equipment
• electric cars and cars with zero CO2 emissions
• plant and machinery for use in a freeport tax site.

Employment Taxes

To incentivise employers to provide, and employees to choose, ‘green’ transportation options, there are reduced benefit-in-kind charges for electric, hybrid, and low-emission vehicles provided to employees.

This benefit extends to the installation cost of a charging point at an employee’s home with the provision of a company car. For the charging of pure-electric company cars, companies also can provide the electricity to employees without a benefit in kind arising.

With the government’s plan to ban the sale of new petrol and diesel cars and vans from 2030, and media and environmental campaigners focusing on this area, we can expect to see further changes in the coming months and years.

Value-Added Tax

There is reduced VAT at the rate of 5% on certain energy-saving products installed in homes for those people over 60 years of age, or who are entitled to one or more government benefits, such as housing benefit, income support or disability living allowance. Products that qualify for the reduced rate include:

• ground-source and air-source heat pumps
• controls for central heating and hot water systems
• insulation for doors and windows
• micro combined heat and power units.

The UK Chancellor also announced a zero-VAT rate, reduced from 5%, on home solar, wind, and water turbines in March’s Spring Financial Statement.

Clearly these tax incentives go some way to encouraging businesses to invest in the production of, and people to buy, energy efficient products. However, there needs to be a fundamental shift by government if we want to change the decision making and buying habits of the wider population, especially with the cost of living and inflationary pressures households are currently facing.

International Expansion

As companies continue to operate and establish operations internationally, they are going to need to proactively monitor and adapt their strategy to ESG-related policies and taxes in each overseas territory in which they operate. There is no uniform set of ESG taxes that is being applied across all jurisdictions.

Each country is making its own commitments in relation to meeting its environmental, sustainability and social responsibility obligations for its citizens. Therefore, each will potentially be taking a different route in the way that they achieve their objectives depending on the socioeconomic factors that are relevant to their country’s population.

Reporting and Transparency

Large companies already have a requirement to consider and publish their tax strategy and provide transparency around their taxation affairs. We are seeing a shift away from not just being compliant and reporting a tax strategy, but to organisations seeking to proactively demonstrate why an approach has been adopted and how this links to their wider purpose and ESG strategy.

This approach is also starting to be mirrored by some SME organisations, which may not have an obligation to report, but wish to disclose their approach in order to demonstrate their sustainability and social capital credentials within the community in which they operate. Such an approach is also seen as good governance from a morality-of-tax perspective, insofar as they are demonstrating their approach to taxation.

What Should Organisations Do Now?

ESG ultimately needs to become an embedded part of any board’s strategy. In our experience, actions we recommend businesses take to ensure that the full range of benefits from their ESG initiatives are delivered include:

• linking their ESG path to their organisation’s purpose and strategy and ensuring that tax risk is considered as part of the board’s overall risk management strategy
• keeping their activities practical, with a clear destination in mind. The best firms focus on those areas that their firm can realistically change and influence, particularly in relation to the E and S components of ESG
• having a process in place for identifying and implementing new taxes that will have an impact on the business
• understanding and addressing regulatory and taxation obligations, but driving their ESG programs from a business perspective, with the knowledge of the regulatory constraints and taxation impact
• thinking about what they have learned from COVID-19, in terms of operational resilience, a greater sense of social good, and the need to innovate and develop new products and services
• ensuring their approach to ESG is integrated, both across its components and across their organisation, so that the approach and benefits are consistently applied
• involving their third parties so that they understand and meet expectations. This can help to ensure stakeholders do not see the activities as conflicting with the defined ESG and taxation approach and messages
• continuing to focus on regular communications, investor reporting and any cultural challenges, these are often the hardest part to get right
• reviewing their existing tax structures and considering whether affairs can be simplified and made more transparent
• tracking progress and the delivery of the benefits, being honest about failures, and sharing successes.

The pace of change is increasing as ESG matters continue to escalate in significance, so it will be important for organisations to have robust processes and controls in place to enable ESG and tax to be integrated into their enterprise-wide risk management framework, in order to identify and monitor the changes that are likely to affect their business and ensure they adapt to those changes.

This could, for example, be changes within the business such as new supply chains, handling new environmental taxes, identifying and maximising reliefs from available tax incentives, dealing with increased compliance requirements from ESG reporting and tax digitalisation, or entering new geographical markets.

Conclusion

Overall, ESG is a relatively new banner within the area of corporate governance, although it is one that is going to become even more prominent and important over the next few years. What we do know is that there will certainly be a lot of change in this area and some of it is likely to move at quite a rapid pace driven by the media and campaigning by interested stakeholders.

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 lead to organisations being on the back foot compared to their competitors. Those organisations that are forward-thinking and are 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.