ESG in transfer pricing

ESG areas – tax and transfer pricing

First of all, let’s anchor the discussion in concrete facts by identifying three ESG areas where we see most activity and thus might be most relevant in terms of tax and transfer pricing.

1. Net zero – half of world’s largest 2000 groups announced their net zero targets. When weighted by sales, this grows to 2/3 of the world’s top 2,000 companies;
2. Establishing a central ESG function and running group-wide social and governance programmes around diversity and inclusion, community engagement, transparency, accountability, board oversight and others; and
3. Proactive compliance with new ESG-driven laws or regulations, e.g. CBAM and trends, e.g. ESG bonds – the global regulatory framework is still very much patchwork-like, so we increasingly see multinational groups trying to establish one approach that covers as many territories and businesses as economically feasible.

The projects being analyzing with respect to three areas
 

1. Procuring green electricity – in particular through corporate Power Purchasing Agreements and offsets;
2. Investments, including:
   
   
   1. “Hard” investments, i.e. spend on new environment-related technologies such as sustainability, resource efficiency, waste reduction, etc.
   2. “Soft” investments, i.e. spend on programmes around governance, relationship management, compliance, integrity, transparency, health, safety and environment;
3. Financing those through issuing ESG-linked bonds and such.

A vast majority of these projects are initiated, run from or controlled tightly by the Group’s centre which is also where most related costs initially sit.
 

ESG question related to transfer pricing

Recharges of costs:

• We see the local tax authorities (and/or statutory auditors) challenging whether the activity corresponds to the service or rather is stewardship or shareholder in nature. If it indeed is a service, the next challenge is to document that it was in fact provided, beneficial and not duplicative. When that is done, one must show that it was charged in an arm's length fashion;
• Ticking those three boxes in the local compliance documentation is a tough challenge in itself because in many cases the local businesses – limited risk distributors, contract manufacturers, contract service providers – have not got a say in ESG spend at first and might not be able later to explain what was done and how exactly it benefits them;
• Even if all that was done, tax authorities could potentially still claim that at arm’s length a “routine” business would not purchase such “extravagant’ and non-critical support and thus challenge a cost allocation as non-arm’s length;
• This challenge again is material as it is not easy to show that an entity with narrowly defined local limited functionality e.g. one that distributes products on a margin would agree at arm’s length to bear a share of costs related to de-carbonising large manufacturing businesses it sister OpCos run on a cost-plus.

Investments in green power or technologies:

• One part of that challenge is tangential to the abovementioned, i.e. tax authorities challenge why the local business, which was doing fine on the “old” solution, should suddenly start incurring the costs of centrally driven investments. To the extent that the standard cost-plus does not allow to recover multi-year investment and their funding, this is again a powerful argument tax authorities can use;
• Even if that is done, a residual challenge remains as to how to price such arrangements, in particular green Power Purchasing Agreements, or sustainability-related investments. Quite often we see these replace the historic, well-tested set-up (e.g. local procurement) so the centre is taking over the related function and replaces it with something new, better. That means re-visiting the old TP and, in some cases, (e.g. new better technologies that result in savings) a split of related costs / profits / or savings might turn out to be a better method than what was used in the past (e.g. cost-plus).

The financing of activities through ESG bonds and similar financial instruments

Discussion around this topic would follow conclusions draw on comparability of such funding vis-a-vis the options realistically available and possibility of attribution of the investments and services costs to the local businesses, i.e. financial costs should be linked by the local subsidiary to rationally expected benefit from the corresponding initiatives.

The summary

We see multinational entities spending a lot of money on ESG-related initiatives. As we see the related costs floating around the groups in search of an arm’s length “home”, we note significant TP challenges related to:

• Deciding what is the most appropriate arm’s length treatment of those costs – in particular, whether any of them should be recharged to the local activities or rather kept in the centre as shareholder or stewardship activities (or principal risk taker);
• Deciding what to do with the resulting savings, losses, or profits – in particular, whether the fact that new activities such as sustainability, input purchases, or modern technologies are driven from the centre, means that the legacy arrangements might not be arm’s length anymore and should be replaced with a gainsharing or profit split mechanism.

The outcome of those decisions should be properly documented and incorporated into local compliance documentation to enable defending arm’s length compliance of the costs (or savings) allocation to the local subsidiaries.