Chapter 1
Supply chain reorganization
ESG-driven business restructuring can raise exit tax issues due to changes in profit potential, or transfer of functions, assets and risks.
ESG-led transformations can be in the form of changing locations of manufacturing units to address environmental needs, consolidation of procurement functions, creation of a central recycling entity, central management of logistics to track global emissions, movement of green intellectual properties (IPs), consolidation of R&D efforts, etc. Changes to operations can also be made in connection with the EU Emission Trading System (ETS), Carbon Border Adjustment Mechanism (CBAM), deforestation rules, Packaging and Packaging Waste Directive (PPWD), packaging measures, etc. See chapter 4 for more details on CBAM.
Such changes could be considered as business restructurings under Chapter IX of the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines (OECD TPG), potentially leading to exit taxes (which may have a substantial cash tax impact) in the transferor country. As such, a thorough analysis of matters such as loss of profit potential, transfer of something of value, pre- and post-functional profile, options realistically available, etc., is recommended.
The framework provided in Chapter IX of the OECD TPG becomes essential for assessing exit tax implications.
Chapter 2
Modern technologies and intangibles
An accurate IP framework for ESG-related intangibles is essential to ensure relevant contributors are adequately rewarded.
As organizations strive to create unique intangibles aligned with global ESG strategies, they must ensure that the developers of such intangibles are adequately rewarded. In the context of ESG, green intangibles can refer to inventions, know-how, recycling processes, energy conservation techniques, packaging, waste disposal methods, brands, etc., that aim to tackle environmental challenges.
Transfer pricing issues that may arise include identification of green intangibles and related DEMPE[1] owners, revisiting of existing royalty arrangements in the light of green intangibles, use of alternative remuneration methods such as profit splits and cost contribution arrangements, valuation of green intangible assets, etc. A periodic assessment of an organization’s intangibles strategy and DEMPE framework will be key to ensuring that contributing entities are adequately captured in the intangibles’ TP policy and appropriate methods are chosen to reward such entities.
Organizations must continuously monitor how green intangibles change the DEMPE framework and accordingly refresh transfer pricing policies.
Chapter 3
Sustainable procurement
Integrating ESG goals into procurement strategies such as creating a central procurement company, impacts TP policies.
Sustainable procurement seeks to provide the lowest environmental impact on the buy-side by employing the highest standards of transparency of suppliers starting from ethical sourcing of raw materials, reducing energy consumption, streamlining logistics and maximizing reuse of products.
One of the ways organizations could achieve their green procurement ambition is to evaluate setting up a centralized procurement company that houses experts and key decision-makers who ensure key ESG drivers on the buy-side are recognized and implemented group-wide. From a TP perspective, a procurement company should earn an appropriate remuneration considering the functions it performs, the risks it assumes and the assets (intangible and tangible) used to deliver the procurement service. As such, procurement companies have traditionally been remunerated by a cost-plus method.
By embedding ESG targets and initiatives, remuneration could potentially move toward value-driven models (e.g., procurement commissions on purchase value) depending on relative contributions and how procurement synergies should be shared within the group.
Chapter 4
Carbon credits and carbon trading
Product pricing is likely to be impacted by carbon credits and offsets, triggering a revisit of TP policies.
Between 1 October 2023 and 31 December 2025, transitional provisions of the CBAM will apply wherein quarterly emissions reporting will be required by the impacted companies. Related financial measures will come into force in 2026.
Carbon credits and offsets can potentially affect product costing and prices to customers which could have an impact from a transfer pricing perspective. Furthermore, a specialized carbon trader (CT) group entity could perform end-to-end functions in relation to carbon credits (advisory to actual trading), and potentially assume and control risks associated with these activities. Such activities could be remunerated based on market prices of carbon certificates plus an arm’s length price for its services.
A CT entity could also perform simplistic administrative, analytical and support functions and be compensated using, for example, a cost-plus method. Importers within the group could also buy and sell carbon credits or certificates from or to other group entities at market prices. While arriving at intercompany prices for carbon trading activities, careful consideration should be given to potential adjustments that may be required for market prices to facilitate equitable comparison.
Chapter 5
Push down of ESG costs
Centrally incurred ESG costs should be passed on to benefiting entities on an arm’s length basis.
Generally, head office (HO) or principal entities incur costs related to ESG initiatives in the form of strategy and communication, performance evaluation, training and education, data gathering and reporting, software and licenses, ESG due diligence, etc. However, costs incurred for such initiatives may be passed on to group members only if the members are set to receive tangible benefits.
As such, organizations must be aware of Chapter VII of the OECD TPG when identifying costs that should be charged under the arm’s length principle, including the applicability of the Low Value Adding Services framework (as per paragraph 7.44 of the OECD TPG). This framework clarifies which costs are relevant for allocation.
Identifying allocable ESG costs, benefiting entities, appropriate cost drivers and an arm’s length mark-up is key.
Chapter 6
Intercompany financing
In the pursuit of climate-conscious lending, the concept of “greenium” and its TP implications assume a pivotal role.
The banking industry is working to address climate change by focusing on lending to more green projects of organizations. Furthermore, credit rating agencies have started to embed elements of ESG into their credit tools to differentiate environmentally-friendly companies from the rest. Both factors have led to a concept of “greenium” or green-premium, which refers to the cost savings from a green bond's eco-friendly status, leading to reduced interest payments.
This arises because of the difference in interest rate between sustainable instruments and ‘traditional’ instruments, demonstrating a bank’s willingness to lend at a lower rate to those companies with higher ESG credentials. From a transfer pricing perspective, questions often arise as to how the greenium should be shared among the relevant group entities while engaging in intragroup financing activities. Organizations should consider this in addition to other comparability factors given in Chapter X of the OECD TPG, which provides comprehensive guidance on the TP aspects of financial transactions.
The way forward
ESG initiatives and their related changes are likely to drive significant changes in businesses, necessitating a need to re-evaluate intercompany TP policies. Transfer pricing managers and tax leaders should understand the company’s ESG goals and ensure that they are fully aware of intended objectives and how they can lean in to support the transition.
It is also essential, from an organization point of view, that tax and TP be considered integral parts of the ESG journey so that the transformation is well managed. Furthermore, considering the increased focus on tax transparency matters — such as the introduction of Public Country by Country Reporting (PCbCR) next year — it is quite likely that TP policies and their governance and alignment with value creation will grow in significant importance for relevant stakeholders.
Five actions organizations can consider from a transfer pricing perspective:
- Perform a thorough TP risk assessment to understand where ESG initiatives will have the most impact
- Build necessary tax audit support files to ensure that transition risk (if any) on account of ESG is managed
- Ensure master files, local files and benchmarking studies reflect the ESG journey and related changes
- Consider measures such as voluntary disclosures in tax returns about new ESG TP policies to increase transparency and potential reduce penalties
- Consider Advance Pricing Agreements (APA) procedures to proactively resolve disputes that may arise on account of ESG transformation
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Summary
Transfer pricing managers should assess the impact of ESG on their policies, build tax audit support files, update documentation, consider voluntary disclosures and explore Advance Pricing Agreements (APAs) to navigate potential disputes arising from ESG-related transformations. Furthermore, with increased focus on tax transparency, the alignment of TP policies with value creation gains significance for all stakeholders.
