International - Tax and ESG: How tax represents one of the most tangible representations of ESG in action

It is well known that Environmental Social and Governance (ESG) factors can provide a framework for evaluating a business’ performance beyond its financial profitability by assessing the impact of the business in each of these three broad areas. There has been considerable discussion about a move from “shareholder capitalism” to “stakeholder capitalism.” The components in ESG can be summarised as follows:

  • Environmental factors measure a business’ impact on the natural environment. This will include its use of natural resources, emissions, waste generation and its ability to manage environmental risks (and embrace environmental opportunities).
  • Social factors measure a business’ impact on, and perception in, wider society. This will include its interaction with employees, customers, suppliers and the external community.
  • Governance factors measure a business’ internal governance structures and practices. This will including its overall strategy, leadership, ethics, transparency and accountability, and risk management.

At its core, ESG is about sustainability—it helps identify companies that are more sustainable and, therefore, better positioned for long-term success, because they manage their impact on the environment, interact positively with society and adopt robust governance practices. So, where does tax fit? On at least one level, tax represents one of the most tangible representations of ESG in action available.

Why tax matters

At its most fundamental, a tax is a contribution made by citizens to a nation’s government in exchange for the security, transport, health care, education (and all the other societal) benefits provided by that state to its citizens.

Tax is the consideration payable under a social contract; the people collectively agree to surrender a proportion of their personal income and gains to the state, acknowledging that the pooled contributions can do more good than individual payments. A similar analogy could be used in relation to a business: the taxes a business pays on the profits it earns are the price of access to, and for operating in, a market made available to the business by the state.

Of course, there is political debate about how much the government should do and how much tax needs to be collected. There will also be debate over tax rates, how to delineate the tax base and the level of acceptable administrative compliance costs: these are all component parts of identifying a taxpayer’s fair share or tax justice. However, all sides will (normally) agree that at least some form of centralised government is a necessity, and very few will argue convincingly that taxation is unwarranted.

Most will agree that paying taxes owed in accordance with the law represents a societal good; the law is, after all (in democratic societies at least), a culmination of a nation’s collective moral and ethical decision-making. It follows that meeting the challenge of climate change is, conceptually, a societal good equal to the provision of schools or hospitals or roads and railways. By extension, the efforts of a few to illegally evade or abusively scheme to avoid paying tax must be socially unacceptable as a breach of the social contract that will create, and exacerbate, inequality.

Over the past few decades, both tax evasion and abusive tax avoidance have been on the rise. Globalisation has challenged the ability of the sovereign nation state—confined within its territorial borders—to continue to collect tax revenues on the economic activities that take place within those borders. This is because globalisation has facilitated profit shifting by multinational enterprises and internationally mobile individuals that are able to operate and move between multiple jurisdictions.

The result has been that the tax base of the state has been eroded, and the extant international tax framework, put in place over a century ago, has been tested to the point of destruction. In tax technical terms, the nexus between economic activity, value creation and the levying of taxation has broken down.

The digitalisation of the global economy and the growth in the importance of intangible assets (e.g., intellectual property) has exacerbated this disjunction because it is increasingly difficult to identify where taxable income, profit and gains are generated. In short, the complexity of an interconnected digitalised global economy has made it increasingly difficult to clearly identify the “right” place to levy tax. The result can be either double non-taxation (i.e., profits that are either not taxed at all or, if they are, at a very low rate) or double taxation (i.e., profits that are claimed as taxable in two or more jurisdictions). Neither consequence is desirable and inevitably leads to increased controversy, disputes and costs.

Over a broadly similar period, the global economy has encountered a series of serious headwinds, including the financial crisis of 2007-2009, the COVID-19 pandemic, the Russo-Ukrainian war and a mounting climate crisis. All have required, and continue to require, substantial state intervention, which ultimately can only be funded through stable, sustainable taxation.

It is unsurprising then that governments around the globe have attempted to crack down on tax evasion and abusive tax avoidance. They have introduced new rules to realign economic activity and value creation with the charge to tax. They have introduced new laws that require greater transparency from taxpayers, strengthen reporting and compliance obligations, and facilitate the exchange of tax-related information across governments and between states.

On the environmental side, tax policy continues to evolve as an instrument to tackle climate change and reach net zero. Some sort of pricing mechanism for carbon emissions (to disincentivise the use of fossil fuels) seems inevitable, but the expansion of tax-driven incentives that promote green technologies and business are equally likely (see, for example, the tax credits introduced in August 2022 as part of the U.S. Inflation Reduction Act (for prior coverage, see the article in the August 2022 issue of Corporate Tax News). There will be obvious tax risks and tax rewards in the climate transition.

Sustainable tax

It is hardly surprising then that taxation has become a regular agenda item for the boardroom. It is an issue of both public and private reputational risk. It demands procedural rigour internally and considered presentation externally. In addition, green taxation will present new costs, but also new opportunities, for all businesses.

The long-term sustainability of a state’s revenue will depend on sustainable taxation. That in turn will require taxpayers to ensure their tax processes are sustainable. Developments across tax in ESG will require careful tracking and agile procedures capable of quickly absorbing obligations, and taking advantage of openings, as they arise.

Irwan Kusumanto 
BDO in Indonesia

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