With investor demand for environmental, social and governance (ESG) products and services increasing in the market, businesses are under increasing pressure to adapt their policies and operations to meet investors’ requirements. Serena Lee, tax partner, and Thomas Hill, trainee solicitor at law firm Akin, write

With decision-making increasingly and indirectly controlled by investor demands, corporate governance policies are often shaped by those providing institutions with capital.

At the same time, governments are implementing more and more ESG legislation, seeking to promote what are deemed to be beneficial ESG behaviours.

While decisions based on social and environmental factors are perfused with tax considerations, the most immediate impact of taxation is on governance: taxation operates as an effective tool for the government to encourage and dissuade certain behaviours and inherently affects corporate decision-makers’ approach to governance.

While tax strategies need to be frequently reviewed in order to reflect changing international tax law and to minimise risk, tax planners are facing increasing pressure to integrate ESG considerations into their structures as part of a broader ESG strategy.

More generally, governance is impacted by:

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  • Tax risk policy;
  • Tax transparency and reporting;
  • Increasingly, tax integrity.

Tax risk – governance in the face of expanding global tax rules

The introduction of global tax measures, largely driven by the Organisation for Economic Cooperation and Development (OECD)’s Base Erosion and Profit Shifting project, and supported by the EU through its Anti-Tax Avoidance Directives 1, 2 and (potentially) 3, has closed down a number of previously commonly used and accepted tax planning strategies.

Furthermore, if Pillar Two, which seeks to implement a global minimum effective tax rate of 15%, is implemented as intended, there will be much less scope for cross-border tax structuring for the biggest multinational groups.

Governments are also becoming increasingly stringent on ‘economic substance’ requirements in order to satisfy tax residency tests or benefit from particular tax treatment. These substantive rules have also been supplemented by additional rules on advisers or service providers who advise on or assist with tax avoidance schemes.

The court of public opinion’s input, fuelled by leaks like the Panama Papers and media stories seeking to expose the low effective tax rates of multinational groups, has also resulted in investors becoming much more wary of offshore jurisdictions like the Cayman Islands, as well as structures that could expose them to reputational risk. Given the strength of the investor voice, businesses are being pushed to adhere to investors’ values and conduct their operations accordingly.

All this means that companies now have less and less room to manoeuvre when it comes to tax structuring. It also means that strong governance is growing in importance in ensuring compliance with increasingly stringent tax rules: for example, updating constitutional documents to reflect best practice, ensuring board meetings are attended and documented correctly, with appropriate records obtained, and where applicable, using local directors with sufficient experience and input.

But action now will still not entirely extinguish the risk of tax authorities – as well as the court of public opinion – seeking to pursue groups for their historic tax planning.

ESG and tax: a case of paying for your virtues

With investor demand for environmental, social and governance (ESG) products and services increasing in the market, businesses are under increasing pressure to adapt their policies and operations to meet investors’ requirements. Serena Lee, tax partner, and Thomas Hill, trainee solicitor at law firm Akin, write

Transparency and reporting requirements

With evolving requirements lead by the US Foreign Account Tax Compliance Act and the OECD Common Reporting Standard, companies are facing increasing reporting and disclosure obligations in respect of their tax affairs.

Many measures, such as the UK’s Code of Practice on Taxation for Banks and obligations to publish a tax strategy, are intended to target large companies and multinationals, but they do go beyond this.

For example, the EU’s DAC6 rules impose reporting obligations on cross border transactions with certain features that are so broadly drafted that they will also catch a number of ordinary commercial transactions. However, despite these legislative requirements, the market standard is also shifting toward enhanced and voluntary reporting standards.

Often perceiving legislative disclosure and transparency standards as inadequate, investors are increasingly favouring privately established metrics used to assess ESG implementation and performance.

Such initiatives include the Global Reporting Initiative 207 tax standard, the Sustainability Accounting Standards Board industry-specific standards and the proposed International Financial Reporting Standards’ Sustainability Disclosure Standards.

That said, despite public enthusiasm for increased standards, inconsistent metrics and approaches to measuring ESG impact and implementation result in the absence of any realistic benchmark. Such nebulous ESG standards makes it difficult for businesses to comply and investors to assess and compare different corporate groups or investments.

Profit agendas and philanthropy

Although international mandatory tax legislation has a clear impact on institutions’ behaviour in respect of their tax planning, whether further voluntary substantive tax considerations are likely to be integrated within broader ESG policies is less certain.

Ultimately, tax planning serves the financial purpose of reducing a group’s tax bill and results in a lower financial contribution to local jurisdictions where the majority of profits may in fact arise from. A decision to engage in less aggressive tax planning would entail a larger tax bill and reduce profitability.

Fundamentally, where businesses only seek to implement ESG policies that will lead to greater profits, it follows that they are unlikely to undertake measures that will result in an increased tax bill. The idea that ESG is fundamentally a profits-driven concept is particularly prevalent – despite a degree of political backlash to the very idea of ESG – in the US, as seen with some major banks stating that investing in ESG products as a method of preventing climate change “is a matter of value, not values”.

Taking such an interpretation of ESG, decision-makers in respect of tax, unless structuring is altered for the purposes of mitigating risks of potential later fines and penalties, would not implement material tax changes beyond the minimum standard imposed by legislation.

If, however, ESG policies are implemented for the purposes of investors’ virtues, with a willingness to sacrifice profits to achieve such a goal, tax structures could feasibly pay, or rather not be designed to avoid paying, appropriate rates of tax in jurisdictions from which the majority of profits arise.

Practical implementation of this ideology has been most recently observed in Caisse de dépôt et placement du Québec (CDPQ)’s 2022 rejection of seven investment opportunities due to “inadequate” tax practices.

Having made taxation “one of the pillars of its social commitment”, CDPQ’s decision that investments must be “subject to a consolidated tax rate of at least 15%”, taken alongside its influential market position, has the potential to shape tax structuring within the private equity market.

That said, market enthusiasm for an increased tax bill founded on notions of appropriate social commitment is yet to be properly tested: absent a willingness to sacrifice profits in furtherance of the ESG agenda, there is no real incentive for decision-makers to behave in such a manner, ultimately owing a duty to investors to maximise profits within the boundaries of what investors deem acceptable behaviour.

The voluntary embrace of voluntary ESG tax measures ultimately consists of investors being prepared to pay for their virtues.