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Transfer pricing, ESG, and the road to net zero

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Iva Gyurova and Gonçalo Dorotea Cevada of Deloitte Luxembourg analyse the taxation considerations for businesses as they are increasingly compelled to focus on environmental, social, and governance issues.

Climate change and sustainability are the shared defining concerns of our time. Governments, policymakers, investors, employees, and consumers are converging with determination towards a net zero economy. In this context, businesses and multinational enterprises (MNEs) are no exception and are also joining forces to fight the current climate emergency.

In July 2021, the European Commission presented “Fit for 55”, which comprises a package of proposals to transform the European economy – including proposals on climate, energy, land/building use, transportation, mobility, and tax – with the aim to reduce net CO2 emissions by (at least) 55% by 2030 compared with 1990 levels. Then, in November 2021, the Glasgow COP26 international climate conference set four goals:

  • Secure global net zero emissions (‘net zero’) by 2050 and slow global warming to 1.5°C;

  • Adapt to protect communities and natural habitats;

  • Mobilise at least $100 billion in climate finance annually; and

  • Finalise the Paris Rulebook to accelerate action to tackle the climate crisis through collaboration between governments, businesses, and civil society.

On this basis, ESG – i.e., environmental, social, and governance – is the common initialism and framework to transform how MNEs operate, produce, buy, sell, and set their sustainability goals. ESG is also a source of new value drivers (for example, brand differentiation, innovation, operational efficiency, capital access, risk mitigation, and talent attraction/retention) and new tax implications.

The list of impacts is broad and includes MNEs’ tax strategy, environmental taxes and incentives, R&D credit and tax depreciation considerations, patent box regimes, new reporting obligations, workforce, value chain alignment, and operating models. This article focuses on the transfer pricing implications flowing from the environmental dimension of ESG.

Tax impacts of ESG-driven changes

Considering the scope and particularities of transfer pricing, MNEs should consider the tax impacts of sustainability-driven changes to the value chain and the reorganisation of supply chains and business models. Also, what key transfer pricing issues are linked to these changes?

Some of these impacts include:

  • Any transformation to an MNE’s operating and business models to integrate ESG objectives and impacts;

  • Considerations around brand value and how that might differ between a business-to-business (B2B) and a business-to-consumer (B2C) model and the impact on the MNE’s final brand valuation exercise;

  • The role of public subsidies from the EU and EU member states, particularly which entity within an MNE is the beneficiary of those funds and what is the respective risk matrix;

  • Any change to the MNE’s supply chain, particularly its manufacturing footprint and distribution channels;

  • The allocation of transformation/implementation costs driven by the green transition and how those should be allocated between associated enterprises within the same MNE; and

  • The allocation of future profits and their link with the risks assumed by the various related parties.

With the above impacts in mind, MNEs should give particular attention to business restructuring and operating model transformations driven by ESG goals. Each MNE is unique, but any centralisation or decentralisation of functions – particularly regarding manufacturing and distribution – will necessarily lead to a new allocation of profits/losses and to a new transfer pricing policy that aligns the new business reality and its tax implications.

Special consideration should also be given to the allocation and assumption of ESG-related restructuring costs. For example, it is important to understand if a contract manufacturer located in a particular jurisdiction will reduce its CO2 footprint due to local requirements or due to a wider MNE green transition led by a principal located in another country. In parallel, consideration should also be given to the EU Emissions Trading System (EU ETS) and Carbon Border Adjustment Mechanism (CBAM), as well as non-EU carbon emission trading systems that may impact the value chain.

Transfer pricing questions

MNEs should also ask themselves the following:

  • What are the transfer pricing consequences from any change to the distribution channels; for example, by reducing the geographical distance between producer and consumer markets;

  • How will the development of new key performance indicators (KPIs) affect the MNE’s transfer pricing policy; and

  • When will be the right time to review existing intragroup agreements to include ESG-related clauses, particularly those on the assumption and allocation of risks.

Another key consideration is the creation of an ESG department and the hiring of a department lead. MNEs that are in this process should consider the strategic role of this team and assess the respective tax and transfer pricing consequences. In fact, any MNE with a clear ESG implementation strategy will inevitably rethink its entire supply chain and set of risks. Therefore, the transformation must be reflected in a new or revised group transfer pricing policy.

The green imperative

In a nutshell, many MNEs are being compelled to accommodate ESG goals and consequences into their business strategy as part of their net zero journey. Proper alignment between the green transition and MNEs’ tax and transfer pricing position must be part of that journey.

The time to act is now.

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