Greening the tax system: The role of tax in building a green economy

Background

On December 8, 2021, President Biden signed his “Executive Order on Catalyzing Clean Energy Industries and Jobs Through Federal Sustainability,” directing the federal government to use its procurement power to limit greenhouse gas emissions. Through a number of proposed measures, including tax ones, the order aims to achieve a US electricity sector free of carbon pollution by 2035 and economy-wide net-zero emissions by 2050. Separately, as of this writing, over 190 countries (including the United States) have signed on to the Paris Agreement (an international treaty on climate change). Similarly, companies and investors around the world are setting carbon emissions targets to achieve a transition to a low-carbon economy.

The debate now has turned to how these goals could be attained. This raises questions about how to measure carbon emissions and track supply chains, as well as key issues around corporate governance and corporate responsibility in tax law and beyond.

This is the first in a series of blogs that highlight recent US developments related to ESG issues for tax professionals. Acknowledging that no two companies are alike when it comes to their ESG strategy, we introduce new ways of thinking about the role of the Tax department, and how traditional approaches to managing tax can continue to add value today and in the future.

The quick(er) wins

Investors increasingly are examining how businesses manage their tax footprint as an early indicator of risk — for example, taking more aggressive tax positions that may be difficult to sustain over the longer term may put pressure on other aspects of the company’s ESG strategy. Tax transparency and tax accountability by multinational corporations have been a source of significant public scrutiny over the last decade as a measure of the company’s contribution to society. These concepts often narrowly focus on income tax as the key performance metric, which can be misleading for a variety of factors. ESG can offer companies an opportunity to provide additional context in which to evaluate the broader economic impact of a company to society.

The investments in greening infrastructure scheduled to occur over the coming decade are estimated to be in the trillions of dollars (on an annual basis). These investments also extend to the workforce: providing necessary employee training and continued development opportunities is key to retention and empowers employees to contribute to a company’s ESG targets.

These changes don’t come cheap, and governments at all levels — foreign, US federal, and US state and local — are providing a range of targeted and general benefits to facilitate the transition. These include direct cash payments, renewable energy tax credits, manufacturing and production tax credits, investment tax credits, tax exemptions and holidays, research and development tax incentives, employment tax credits, rebates, grants, access to cheaper capital, and government loans.

Banking and capital markets are also looking to diversify their investment portfolios, generating new growth opportunities (and in the case of some pension funds, divest of certain shareholdings) in line with their own ESG targets. These decisions are made with the knowledge and expectation that the associated returns may not be realized in the short, or even medium term.

The ability to access capital at cheaper rates is another opportunity for the Tax department to add value as companies are looking to issue ESG-pegged debt. How a multinational gets financed and out of which jurisdiction, the choice of funds (equity or debt), and key terms such as the yield, maturity, and applicable covenants (including those linked to ESG outcomes), all have knock-on implications for Tax. By engaging early (and often) with Treasury and Finance, Tax can add or preserve enterprise value.

The Finance and Tax functions rely heavily on the existence of a digitally enabled, robust (and flexible) tax reporting strategy that is aligned with a company’s enterprise-wide data platform. Having the ability to run scenarios (alongside climate risk and decarbonisation pathways) that compute the tax cost or savings associated with financing decisions can provide valuable insights to treasury, finance, and management more generally, as they look to balance short-term cash needs with long-term investment strategies. This analysis can help quantify the impact of US and foreign tax law changes — such as interest expense deductibility, the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) changes, and foreign tax credit calculations — along with the company’s pathway to meeting its sustainability goals.

The expected baseline

How a company chooses to allocate capital and the investment decisions it makes are not only evaluated by shareholders against financial metrics, but now are under increased scrutiny by a range of other stakeholders interested in understanding a company’s environmental and social impact — including regulators, investors, banks, customers, and employees.

An important role of the Tax department in preserving enterprise value relates to tax controversy. New rules and regulations arising to implement ESG objectives, combined with increasing environmental taxes aimed at reducing and removing carbon-intensive products, if not properly measured and monitored, can give rise to costly tax audits and higher operating expenses, putting pressure on a company’s after-tax profitability. Further, on March 21, the Securities and Exchange Commission (SEC) issued proposed rule amendments to require publicly traded companies to disclose reliable, consistent, comparable, and multi-stakeholder decision-useful ESG information.

A key role of the Tax function is to manage the amount of income tax paid and to maintain relationships with local tax authorities. These goals can be achieved in a cost-efficient and effective way provided Tax has insight into the company’s total tax footprint. For example, the BEPS initiative has resulted in new transparency requirements such as country-by-country (CbC) reporting. While this information currently is not intended to be in the public domain, in November 2021, the European Union adopted a Directive to require public disclosure of select data from the CbC reports produced by large multinationals. Alignment between Tax and a company’s enterprise-wide data platform is a key to Tax’s success.

Moreover, the Tax department's input goes beyond corporate income tax and includes an evaluation of how tax charges related to property, payroll, consumption, sales, environmental, digital, customs, and trade, among others, affect the countries, states, and cities in which companies operate. The overall tax impact assessment of a company’s footprint must take into account the options and alternatives companies are considering as they transition to a more sustainable future. (See PwC’s National Economics and Statistics solutions for how you can capture the economic contributions made by your company.)

Enhanced role of Tax

During the pandemic, it became clearer how incredibly complex supply chains have become and how the myriad interdependencies can trigger hefty (and unexpected) tax bills and audits if the correct tax data is not properly captured, reviewed, and reported. These adverse impacts can include payroll tax penalties resulting from virtual working arrangements, increased customs duties because of misaligned data definitions, or a change in the character, source, or timing of recognition of income as a result of switching out components in a supply chain.

Tax in the context of ESG traditionally has been tied to governance and, therefore, transparency, but as companies shift from theory to action, Tax takes on a broader role than just reporting. When it comes to tax, companies already are expected to have a sound strategy for governance issues, such as addressing tax policy uncertainty.

The European Union is continuing work toward implementation of a “carbon border adjustment mechanism” (CBAM) designed to ensure that certain imported goods (initially including cement, fertilizers, iron, steel, and aluminum) bear the same implied price of carbon emissions as those produced in the EU. Given the collaboration with the EU on these matters, the United States may respond with its own carbon border mechanism in the future. In addition, with support from some Finance Ministers, the OECD is seeking to secure a mandate from the G20 to develop a new multilateral framework, similar to the existing Inclusive Framework, to facilitate international dialogue around a minimum level of carbon pricing, after wrapping up its digital tax project.

Risk taking is essential for growth and is balanced by management within the broader context of the company’s commercial strategy and business model. As the United States, and other governments the world over, look to achieve a transition to a low-carbon economy, the performance and viability of long-term capital investments will need to be assessed and monitored against layers of material risk, costs, and benefits that can change from year to year and country to country.

Fortunately, financial growth and sustainability need not be mutually exclusive. Companies that establish a collaborative and multidisciplinary approach to tackling risk and evaluating strategy can benefit through brand differentiation, employee retention, and customer satisfaction. Tax can play its part and contribute to the growth of the company by taking steps to see that business decisions are tax-informed. Said differently, a responsible Tax strategy, based on principles of transparency and accountability, leads to sustained tax outcomes for companies.

What’s next?

Stay tuned for the next installment. We’d love to hear from you about the US Inbound tax topics you’d like to see covered. If you would like to submit your feedback, and if you are interested in discussing the concepts outlined above in more detail, please get in touch.