Exploring the intersection of Tax and the EU Taxonomy

Why tax is a critical component to ensure alignment with the EU Taxonomy

To support CSRD disclosures on the Taxonomy, tax departments will need to demonstrate that their organisations adhere to certain minimum safeguards on tax, including a requirement to comply with the letter and spirit of the law.

In the second release of our Tax & Corporate Sustainability Reporting Directive (CSRD) series, we explore the challenges presented by the tax minimum safeguards and the steps that organisations need to take to ensure compliance.

What is the EU Taxonomy?

The Taxonomy is a detailed classification system for sustainable economic activities which aims to define which of an organisation’s economic activities are environmentally sustainable and to provide a common language for investors, companies and regulators. The goal of the Taxonomy is to channel capital to sustainable investments.

The Taxonomy, as with CSRD, is a component of the EU’s Sustainable Finance Framework and both regulations are closely aligned. Notably, an organisation that is required to report under CSRD is also in scope of the Taxonomy. Specifically, the organisation will need to disclose in its CSRD report whether it is Taxonomy aligned.

The Taxonomy is based on six environmental objectives:

1. Mitigation of climate change
2. Adaptation to climate change
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy
5. Prevention and limitation of environmental pollution
6. Protection and restoration of biodiversity and ecosystems

An activity carried out by an organisation will only be classified as a sustainable economic activity where the activity contributes to at least one of the above environmental objectives and does not violate any of the remaining objectives. Importantly, as well as meeting one of the above objectives, an organisation must carry out the activity in compliance with certain minimum safeguards.

Challenges for tax departments

The tax minimum safeguards will present some challenges for companies in scope of the Taxonomy.

Compliance with the letter and spirit of the law is a subjective and evolving concept with no universal guidelines. Interestingly, the report notes that “the emerging understanding of tax compliance is no longer limited to tax evasion, but also includes tax avoidance through aggressive tax planning”.

The report also references that court determinations could be used as a means to assess whether a company has failed to comply with minimum safeguards. It is important that this is considered in the context of the tax system where tax courts or tribunals typically serve to opine on the interpretation of complex legislation.

Greater clarity is required on the practical application of these aspects of the minimum safeguards. One aspect that is clear, however, is that companies will need to be able to demonstrate an intent to comply with the safeguards. This means implementing internal procedures and policies to mitigate the risk of non-compliance with tax laws.

In addition, the report recommends that the endorsement of GRI 207 is used as an indicator of a company’s “more ambitious understanding of tax fairness”. GRI 207 is a specific tax standard released by the Global Reporting Initiative (“GRI”) to enable companies to disclose on tax as part of their sustainability reporting.

What actions can tax teams take to ensure compliance with the minimum safeguards?

In preparation for CSRD reporting, finance and sustainability leaders within organisations are now considering disclosures on Taxonomy alignment. As part of that process, they will be seeking assurances from tax departments that the tax minimum safeguards have been met. There are some steps that tax departments can take to evidence this.

1. Formulate the tax strategy

With regard to the minimum safeguards, an organisation should have a tax strategy document which clearly articulates its commitment to compliance and provides an overview of the internal tax governance and procedures in place. With stakeholder expectations on tax disclosures continuing to evolve, it is also timely to re-assess whether additional narratives on tax could be included in the strategy, particularly by reference to GRI 207.

2. Assess existing control framework

Undertake a current state assessment of the organisation’s Tax Control Framework to determine if it is fit for purpose in meeting the core principles in the tax strategy. This should include a review of the overarching tax governance framework and also the effectiveness of operational procedures for managing day-to-day risk across all taxes.

3. Formalise operating procedures and controls

In many cases, tax departments will have a general awareness of their operating policies and procedures but they may not be documented. This will create challenges in evidencing compliance with the minimum safeguards. It is important that policies and procedures are formalised in documents such as written policies; process maps; and tax risk and control matrices which are useful in mapping out the controls in place to manage key risk areas. Developing a testing and monitoring programme is also key to ensure that internal procedures are still fit for purpose and are being adhered to.

The Taxonomy and CSRD are both far broader than tax and will ultimately drive accountability and transparency on an organisation’s broader sustainability initiatives. Compliance with these regulations is critical for organisations. While Chief Financial Officers and Chief Sustainability Officers may be taking the lead in driving compliance, tax departments have an important role to play in that process.