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Transfer Pricing: optimising policies in light of Environmental, Social, and Governance changes to business models

Finance Dublin's Irish Tax Monitor - August 2022

With the increasing influence of ESG strategies on business models it is timely for multinational companies to assess how their Transfer Pricing policies might be adapted or revised to take ESG-influenced business changes into account writes Zarene Viljoen.

The International Sustainability Standards Board (ISSB) recently issued sustainability exposure drafts, which demonstrate the need for Reporting Standards to be more transparent in its disclosure requirements regarding Environmental, Social and Governance (ESG) impacts on an entity’s financial performance. Given this, it is timely for transfer pricing (TP) models to also take ESG into account and consider whether intercompany arrangements require revisions or changes to adapt.

Often, the tax (and TP) implications of an ESG strategy would not be a high priority. However, the pressure to ensure alignment between the business (i.e., ESG) strategy and tax model will increase if ESG is being quantified. Indeed such quantification offers the opportunity to build business (and tax) models around ESG assets in a way that has been challenging to date.

ESG brings new risks and opportunities that will impact the financial performance of groups. Such risks broadly include the physical impact that the group has on the environment, reputational damage, regulatory penalties, and operational and market risks which all need to be managed and mitigated.

Mitigating risks, and knowing upfront what they are, is important to ensuring the commercial objectives and tax model are aligned. The ‘green’ conversation in TP is still in its infancy stage and TP policies around ESG are not well developed as yet. TP can be critical to ensuring a group’s business model operates efficiently and reward is aligned to functions, assets and risks across the group. Simultaneously, TP models are commonly set up strategically for a group to operate effectively from both a cost and tax management perspective. Given that various governments are starting to introduce more green incentives, supply chains within traditional business models might not be sufficiently agile to make optimal use of such incentives.

Decision-makers need to navigate the trade-offs resulting from the ESG strategy and the impact that it has on the financial performance, people, economy and the planet. As such, ESG strategy can lead businesses in a different direction to existing business strategy, for example making use of more expensive inputs with green credentials. TP policies need to take account of this and consider where existing TP policies require change.

Creating an exhaustive list of TP implications might not be practical as each change in the value chain or business model would need to be analysed on a case-by-case basis. For illustrative purposes of EGS-TP interactions, a short list of more common examples is outlined below.

Functional analysis: The heart of the application of the arm’s length principle entails a detailed functional and comparability analysis. Considering who sets the ESG strategy, controls the risks and bears the costs thereof in the group is an important starting point.

After establishing the facts regarding who in the group performs the ESG related functions, bears these risks and employs its assets, it is important to determine whether the ESG strategy creates IP, represents a service and/or is driven by shareholder concerns. These different characterisations impact how the transfer pricing model should deal with ESG related activities.

  • Intellectual Property (IP): In some cases, innovative technologies and new concepts are being created as a result of adopting ESG strategies. This could represent valuable IP for which users of the IP would or should pay. ESG efforts may also impact brand value, where for instance reputational damage may arise as a result of adverse ESG events/publicity and questions around who controls this risk and should bear the costs.
  • Intercompany Services: Even where not creating IP, additional ESG related costs, resources and knowledge are being employed. These costs might be incidental benefits to the group entities and might not be seen as services for which a charge can be made from a local subsidiary perspective. However, due regard should also be given where a deliberate and concerted group effort is made that results in the group generating a distinct advantage over the other market players.
  • Restructuring: The ESG strategy may require a change in the key functions performed within the group’s supply chain that result in a transfer of profit potential within the group. Such change can be seen as restructuring for TP purposes.
  • Intercompany Loans: The banking industry is addressing climate change by changing the way it adopts lending practices. Credit agencies developed new techniques for modelling and analytics by incorporating the impact of climate change in these credit rating models. A new concept called ‘greenium’ arises as a result of the difference in interest rate spread between sustainable bonds and ‘traditional’ bonds, demonstrating investors willingness to lend at a lower rate to those companies with higher ESG credentials. TP questions may arise as to how to take account of lower borrowing costs and who should benefit from such savings.

Given the momentum around ESG is ever increasing and is impacting business models, multinational entities should review the impact of their ESG strategy on their global functions, assets and risks to ensure they are applying the appropriate and optimal TP policies. It is better to be proactive to allocate resources to TP implications now, rather than to store up difficulties for years ahead.

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