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ESG and tax - Connecting the dots

Given the real estate sector’s significant carbon emissions, investors and stakeholders are increasingly using ESG parameters to screen investments. Tenants and buyers favour homes that are energy efficient and sustainable.

June 02, 2022 / 06:43 PM IST

Our globally connected world is battling climate change, social unrest, geopolitical tensions, technological disruption, fiscal deficits, income inequality, broken supply chains, and the worldwide pandemic hangover effects. In this context, environmental, social and governance (ESG) considerations increasingly dominate stakeholder discussions and institutional policy.

As many as 89 percent of investors surveyed in the 2021 Institutional Investor Survey would like reporting of ESG performance measured against a set of globally consistent standards as a mandatory requirement.

Investors and other stakeholders want better ESG disclosures to help them understand more about how a company performs, makes decisions, and creates value. They are interested in the external effects of a company’s actions, both in absolute terms and relative to other companies.

Consumers want to understand the influence of their choices on the world. Employees want to understand whether their company is driving greater equality, empowerment, better working conditions, and safer and more sustainable communities.

There is undoubtedly greater awareness and acknowledgment that companies need to have a well-thought-out ESG strategy to attract suitable investments and talent and create long-term value. While this issue has multiple facets, tax is often overlooked or underrepresented in debates within organisations.

ESG perspective

Tax has important implications for a company’s approach to ESG. Tax revenue funds the social and capital infrastructure needs of a country. Therefore, corporations paying their ‘fair share of tax’ is essential. Companies should consider how their decisions on using tax incentives to optimise their effective tax rate can impact this.

Tax is also one of the critical risks a company faces and it could have reputational consequences. A company must consider its tax policy approach, how it is articulated, and how tax risk is managed within this framework.

An ESG reporting perspective can improve transparency and influence how tax disclosures are evaluated. Combining financial and non-financial data gives a better picture of profit and loss, i.e., integrated profit and loss beyond mere financial parameters.

It also includes material aspects like emissions, government help, and subsidies that may impact the overall corporate tax profile. Therefore, integrating tax with ESG entails developing a holistic strategy that combines financial and non-financial aspects.

Calls for transparency around tax disclosures by multinational companies have been growing over the years. Consequently, the Organization for Economic Cooperation & Development, the Base Erosion and Profit Shifting (BEPS) project and BEPS 2.0 have introduced new disclosure norms.

The Country-by-Country Report provides aggregate data on the global allocation of income, profit, taxes paid and economic activity among tax jurisdictions in which a company operates.

Agreement on a minimum tax rate across all jurisdictions under the Pillar 2 proposals for multinational companies is expected to deter risky tax structures and ensure adequate tax collections for governments.

In India, there is increasing regulatory focus by the Securities and Exchange Board of India on related-party transactions within groups requiring adequate approvals and disclosures to protect minority interests. These disclosures aim to provide investors with sufficient information to make informed decisions and enhance governance standards.

Focus on a company’s carbon footprint, commitments to reduce emissions, or its use of resources from a sustainability standpoint has spurred them to reimagine supply chains. This entails considerations of carbon taxes, ethical sourcing, and pricing of intra-group transactions, which ultimately impact a company’s tax profile.

Government action on incentives, grants, and credits for using green energy can be an essential catalyst in this journey. In India, production linked incentives for solar PV modules exemplify the government incentivising renewable energy and impacting investment decisions.

Frameworks of ESG reporting are also evolving to include aspects of tax transparency. The Global Reporting Initiative, one of the popular frameworks for sustainability reporting, has a tax transparency indicator in its economic component. Financial regulators are also looking at ways to merge ESG and tax reporting.

Impact on real estate

Having an overall tax strategy aligned with the company’s values is a foundation stone for ESG. Reporting non-financial metrics like workplace diversity, corporate social contributions, and others may also have tax consequences. These disclosures and quantitative data can strengthen governance and transparency, and trust.

One prime example can be the real estate sector, where ESG is gradually gaining prominence. Due to the real estate sector’s significant carbon emissions, investors and stakeholders are increasingly using ESG parameters to screen investments. As a result, private equity real estate investment managers focus more on measuring their portfolios against ESG benchmarks.

Developers are being driven to construct net-zero assets, employ sustainable methods, and assure the asset’s longevity due to the regulatory framework and criteria to be a trusted brand in addition to their tax disclosure. Implementing these ESG standards has many other advantages for firms and is increasingly making sense commercially.

Tenants and buyers favour homes that are energy efficient and sustainable. Businesses can sell their product to investors and stakeholders as a net-zero ambition framework. There is a reasonable probability that companies in the real estate sector would soon take green loans or raise green bonds to accelerate their ESG endeavours.

Call to action

The tax team within companies must get involved to help understand, craft, and disseminate information about the interplay of tax and ESG factors.

Companies must evaluate their ESG decisions given tax considerations. They will need to understand the tax implications of their ESG-related choices and how they will be measured and translated into reported metrics. Keeping abreast of the latest metrics and requirements will aid in appropriate disclosures.

They must debate and prepare to explain how they deal with disclosures on tax, their tax strategy, and governance framework to relevant stakeholders internally and externally.

The momentum around ESG’s relevance in business will only accelerate. Tax can and should play an essential role on this path. Organisations would do well to invest time and effort to integrate tax into this critical discussion to stay ahead of the curve.

Shailesh Tyagi, Partner, Climate Change and Sustainability Services practice, EY India also contributed to the article. 
Ashwin Vishwanathan