What You Need to Know About ESG Investments - Tax Professionals Member Article By Dennis Jao
Posted by Dennis Jao

What You Need to Know About ESG Investments

What You Need to Know About ESG Investments

With much writing on the relationship between good environmental, social, and governance (ESG) practices and company performance, institutional investors integrate ESG factors into investment decisions. Investment managers and portfolio companies also adopt sophisticated ESG practices as a key element of risk management and as a means of differentiating their activities. Taxes play a major role in the development.

Institutional investors are beginning to use this information to make informed investment decisions. A large institutional investor openly supports ESG issues, excludes companies it has deemed non-ESG compliant from its investment universe, and publicly withdraws from companies with low or no fees and transparent reporting. Other institutional investors also hold public positions in ESG. A Danish pension fund group has developed and signed a Tax Code of Conduct to support the goals of responsible tax behavior in their investments and through their investment partners. Actions like these highlight the public approach investors are taking to support taxes as a key part of ESG.


Components of an ESG tax program

Tax considerations in setting up an ESG program usually begin with an assessment of the investor's tax structure and the companies in which the investor invests, and their external investment managers. In this regard, preparing a tax risk appetite statement is a starting point.

The potential benefits of a return on tax risk appetite are as follows:

  • Improves the decision-making process regarding risk reduction (i.e., accepting, reducing, avoiding, or transferring risk) and performance management (i.e., the risk versus the profitability)

  • Increases the transparency and accountability of the investor's current and future risk profile

  • Strengthens risk awareness as part of the risk culture at the company level.

Declaring tax risk appetite can often be part of a larger corporate risk governance framework.

Regarding ESG and tax assessment, investors should think about how their investment partners manage tax risk. Investors may want to evaluate the effect of tax risk through their relationships with their third-party subsidiaries and investment managers. For instance, as part of tax due diligence, investors should consider the following:

  • Are tax risks properly disclosed?

  • Does the company in which you have invested have a tax risk declaration?

  • Does the ETR of the company in which it is invested seem reasonable, both globally and legally?

  • Does the investee or management company use complex structures?

  • Does the manager have a budgetary risk policy?

  • Does the tax department of the issuing entity or manager have adequate staff?

  • Is tax risk included in the risk control function of the board of directors?

  • Is the manager reporting an ETR? Are the before and after-tax returns identified?

  • What level of tax risk is the investor or manager willing to accept?

The ability of an investor to exercise due diligence on the tax status of its investment partners will depend on many factors, including the level of investment. This relationship can often be related to the level of control, as an investor seeking a majority position will more often than not have a greater ability to influence an entity's fiscal risk policy through board positions or other interactions. However, given the lofty profile of many institutional investors, they can be criticized for investments that do not comply with ESG principles on fees, regardless of the level of investment or investor control. Therefore, it will likely be vital for institutional investors to carefully consider the consequences of investing with parties that are not transparent about their tax risk profile.


The role of the Tax Department in ESG

Corporate tax departments are expected to play an increasingly important role in setting ESG standards. Taxation is increasingly anchored in the context of corporate strategy and corporate sustainability goals. 

As part of this point, tax departments are tasked with creating tax strategies that include governance and other priorities. Fiscal policies are no longer in the treasury but on the boardroom agenda.

Organizations like the OECD working on redesigning the international tax system, which spans more than 135 countries, recognize the need for corporate taxes to be more transparent. Indeed, tax transparency is and will be the new norm, with the support of the OECD, the UN, and other bodies. A tax governance strategy gives companies the necessary transparency to underpin company tax strategy and policies.

Four considerations that corporate tax departments should understand when creating an effective tax governance strategy are:

  • Review and align the tax strategy with the company's sustainable development strategy, which should include elements of the United Nations Sustainable Development Goals.

  • Be transparent: Transparency does not mean revealing anything that encompasses the activities or competitiveness of the company. However, it is worth providing voluntary information, such as a list of risk management initiatives or the amounts of tax contributions. And, of course, it must be in line with the company's overall approach to transparency.

  • Have a practice of fiscal integrity, which can be defined as a "desire to adhere to both the law and the unwritten rules of corporate income tax in the business." The use of technology can also provide accurate tax returns and records.

  • The overall risk management efforts of the business and the corporate tax department should include factors such as environmental and social issues affecting the business.

As tax issues continue to be the focus of attention for governments and international regulators (likely by increasing compliance requirements for multinational companies), stakeholders, including investors, employees, and customers, will continue to demand more transparency in the way businesses operate.

A tax strategy that includes proactive tax risk management and attention to environmental, social, and governance considerations can better position the company as a full member of companies, markets, and countries in which the company operates.


Conclusion

Institutional investors integrate ESG factors into discussions with stakeholders and institutional policies. Governments, NGOs, investment managers, and portfolio companies rapidly develop sophisticated ESG policies, measures, and practices. Taxes are a key part of the developments.

The direction of travel seems clear. The integration of ESG factors has become a key part of the investment process. Institutional investors must stay at the forefront to avoid fiscal, reputational, and other risks.

The journey varies depending on the institution. Each institutional investor must determine the ESG aspects relevant to their investment strategy and relevant to potential managers and investment firms.


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Dennis Jao
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