Tax reporting under the ESG spotlight: Standing up to intensifying scrutiny

New sustainability reporting standards and public disclosure of Country-by-Country Reports (CbCRs) mean that the tax elements of environmental, social and governance (ESG) are under the spotlight as never before. How can you make sure your business stands up to the associated scrutiny, and stands out for the right reasons?

Tax teams are used to being in the spotlight, but the ESG agenda has given tax a whole new dimension, urgency and set of complications. Analysts, Non-Governmental Organisations (NGOs) and other key stakeholders want to know where your business stands on these Tax ESG considerations.

Strategic change and its tax implications

If we start by looking at the interplay between corporate strategy and tax, it’s clear that tax permeates through ESG in a number of critical ways – some positive, others negative. The most obvious is the social impact of your Total Tax Contribution (TTC). But as supply chains are restructured and green transition gathers pace, the close interaction between tax and ESG now stretches much further into your business, its strategy and how this is changing.

Tax as a lever
Governments are using a mix of tax incentives (e.g. relief for capital expenditure) and penalties (e.g. carbon emissions and plastic packaging taxes) to encourage businesses to adopt sustainable practices and accelerate the shift to net zero.
As your supply chain changes, so does tax
Supply chains are being transformed. This might be as a direct result of ESG – e.g. onshoring or nearshoring to reduce your carbon footprint. It might also be a result of other factors such as new trade barriers.

Either way, your tax contribution and transfer pricing arrangements could look very different in the future. This requires suitable messaging to the markets. But tax issues make this more complex – how to explain the loss of tax contributions in countries you are exiting, for example.
Technology is turning business models on their heads
Technology – both green innovations and the impact of digitisation and automation – is changing how you operate. The result is likely to be a shift in your tax profile. For example, automated modern assembly lines could reduce carbon taxes on the one side, but cut payroll taxes on the other.
It’s complex
Tax and ESG is a complex arena. Some businesses might welcome the incentives and seek to maximise the benefits, for example. They might also see the levels of tax they pay as a sign of their corporate responsibility. But what if a significant part of this tax contribution is a result of negative environmental impacts such as high carbon emissions or plastic usage?

Reporting is critical

Clear and credible reporting on these tax impacts and developments is critical. Effective disclosure is an opportunity to set out a fair and transparent approach to tax. But it comes with the same potential allegations of ‘greenwashing’ that have been known to accompany other aspects of ESG.

It’s also important to consider the impact on your ratings and market valuation. Our 2021 Global Investor Survey found that nearly 80% of investors worldwide believe that how a company manages ESG risks is an important factor in investment decision-making. Both environmental taxes and the social impact of your tax contribution are likely to be prominent features in any such ESG risk evaluation. We assess these factors as part of our total impact management and measurement (TIMM) framework. TIMM allows businesses to evaluate the impacts of the strategic choices on society (positive and negative) and judge the trade-offs between them.

With reputations and investment at stake, Tax ESG therefore raises three fundamental questions for your business:

Have the tax implications been built into your ESG objectives and wider strategic plans?
How are your Tax ESG disclosures going to be judged by investors, analysts, NGOs and other key stakeholders?
How do you make sure that your Tax ESG disclosures are sufficiently transparent, credible and consistent?

Taking the lead

Are businesses meeting these disclosure demands? Up until now, reporting on Tax ESG has been largely voluntary. Our latest Trends in voluntary tax reporting report reveals that half of FTSE 100 groups now make TTC disclosures. And 38 companies discuss tax within their Task Force for Climate-Related Financial Disclosures (TCFD).

Some businesses have gone further by reporting on their tax affairs within their Global Reporting Initiative (GRI) disclosures (GRI Standard 207) and/or the World Economic Forum (WEF) Global Tax Metric for Sustainability Reporting. These disclosures and the explanatory narratives that accompany them go beyond TTC to set out the business’ approach to managing tax and the risks and controls surrounding this. GRI 207 is especially notable in recommending disclosure of what are otherwise private CbCRs.

A further window on tax comes from the ratings models being applied by a number of investment managers. The criteria may be as basic as whether the company discloses its Effective Tax Rates (ETRs) or CbCRs. But experience shows that this kind of information-gathering can quickly take on a life of its own as the scope and demands keep ratcheting up. What’s good enough today, may fall short in the future.

Raising the bar

The businesses leading the way on tax transparency want to show their approach to tax is sustainable and builds trust with their stakeholders . Just as importantly, many are using the voluntary disclosures as a test-bed for the step-up in mandatory reporting ahead.

The game-changer is the move to make CbCRs publicly available. Analysts and NGOs will be poring over these disclosures, not just to see what’s in them, but also how they compare to other reports including your annual accounts. One of the resulting problems is the lack of consistency between the two very different measurement bases in CbC and GAAP reporting. At the very least, the dry numbers in your CBCRs would need to be supported by narrative explanation.

Public CbCRs are just the beginning. Moves to bring financial and sustainability reporting into line are reflected in the setting up of the International Sustainability Standards Board (ISSB) by the IFRS foundation in the wake of COP 26. The ISSB aims to establish a global baseline of sustainability disclosure standards. This includes tax disclosures that build on the recommendations from the TCFD.

Even more demanding will be the data on your tax footprint required under the EU’s Corporate Sustainability Reporting Directive (CSRD). While this is an EU directive, many UK businesses with a parent or significant presence in the EU will need to comply.

The way forward

How do you get up to speed on these reporting demands? Four priorities stand out:

Work out where you stand
Determine where your business stands on tax and how this relates to your wider ESG commitments. The starting point is to align your tax, ESG and commercial strategies. This would include understanding your stakeholder requirements and peer benchmarking to allow informed decisions regarding your external messaging.
Develop your narrative
Determining where you stand will help to form the basis for a clear and compelling tax narrative. For many, this is likely to go beyond compliance to focus on how your tax policies create value for society.

In communicating your narrative, it’s important to assess what different stakeholders want to know. Raw numbers aren’t enough. You’ll need to explain your strategy and performance against it on the one hand, and make sure this ties up with financial and sustainability reporting on the other. It is also important that both CFOs and Heads of Tax are ready to tackle what could be ‘awkward’ questions from analysts and NGOs. Explaining the potential anomalies in the CbCRs would be a clear case in point.
Apply a financial reporting mindset
With financial and non-financial reporting coming together, tax reporting will need to be governed by a financial reporting mindset and investor-grade set of controls.
Establishing a set of clear policies on how to monitor, validate and document the accuracy of data you’re using both internally and disclosing that governance structure externally is helpful to stakeholders. It’s also important to carry out ongoing testing of processes and controls to satisfy the requirements of legislation and guidance. Further priorities include continuous improvement to find out what data stakeholders need to understand, the Tax ESG risks and opportunities and help them evaluate the ramifications of the data they’re receiving.

Bringing Tax ESG up to a financial reporting standard is also likely to require independent external assurance (We have produced a guide which helps organisations looking to do this).

Some businesses have already opened up their voluntary disclosures to such assurance. CSRD will make assurance mandatory for many UK businesses. Failure to obtain assurance could be reputationally damaging. But your assurance provider won’t be able to sign off on your disclosures unless the data you’re submitting are complete, accurate and reliable, and the governance and controls associated with the disclosures are robust.
Get your systems up to speed
The weight of new data needed to prepare your reporting is likely to require a review and possible overhaul of systems and processes. Automation will help take much of the burden off your tax team and allow them to focus on articulating your story and managing the risks.

No going back

The genie is out of the bottle on Tax ESG reporting. The more information stakeholders demand and the more your competitors disclose, the more you’ll be expected to report. Getting on the front foot is a chance to set the narrative on Tax ESG, while developing the robust processes and credible disclosures needed to build stakeholder confidence and trust.

To discuss Tax ESG and other reporting requirements, please get in touch.