It is currently undisputable that taxes have become a critical component of ESG: not only because they can be used as a policy tool to encourage environmental and social outcomes, but also because taxes are decisive to the well-functioning of civil society, as they enable governments to pay for public services and perform public investment.

Hence, companies are increasingly expected to conduct their business (and, by extension, tax affairs) in a responsible and sustainable manner, adopting good tax governance standards.

Tax now raises ethical concerns, triggering reputational challenges to businesses. Many business leaders and investors are focused on avoiding negative media publicity and ensuring that their tax status is seen positively by their stakeholders (including investors, policy makers, employees, civil society and the general public).

Consequently, ESG-Tax has become a core part of the investment process in M&A and private equity (PE) transactions: ESG-Tax factors, in particular factors related to tax responsibility, are vital for the pre-deal and post-deal analysis and the investment decision making.

We can state that, currently, the entire investment process – since the investors’ strategy to the due diligence (DD) process and the value creation post-transaction – considers the target’s approach to ESG-Tax, namely in what concerns to (i) tax transparency and reporting, (ii) tax risk management and appetite; and (iii) fair taxation, i.e., to what extent the target pays the right amount of taxes, at the right moment and in the place where value is created.

ESG-Tax risks are typically considered within the buyer’s evaluation of a business, affecting the value of each transaction. If a poor ESG tax policy might be associated with a high-risk profile affecting the business’ reputation and impacting negatively a buyer’s evaluation of the business; conversely, a good tax governance involving a proper identification of relevant tax costs, generally has a positive impact on a buyer’s evaluation of the business.

Moreover, some investors are even excluding from their watchlists companies that are perceived as non-compliant from an ESG-Tax perspective.

Each player should determine the aspects of ESG that are relevant to its investment strategy or material to stakeholders and potential investors.

The ESG-Tax Standards & Strategy

Although we can find certain legal requirements in terms of tax transparency, compliance and fair taxation, there is no commonly agreed standard as to what constitutes a good or adequate ESG-Tax policy.

ESG stakeholders have been calling for wider and quicker implementation of ESG-Tax measures by businesses, which has been giving rise to the development of a set of voluntary adoption of standards by different groups and organisations

In this regard, and among others (namely, the UN Principles for Responsible Investment and the EDFI Responsible Tax Principles, known as PRI), we highlight two instruments that have been widely adopted by several companies and organisations:

(i) the B-Team Responsible Tax Principles, defined by a coalition of business leaders advocating sustainable practices and intended to work as guidance on the tax policy of the organisations adopting them. They cover three main areas: (1) approach to tax, (3) relations with others and (3) reporting to stakeholders; and

(ii) the Global Reporting Initiative issued in 2019 (called GRI 207), which sets standards for reporting, involving four levels of disclosure: (1) approach to tax, (2) tax governance, control and risk management, (3) stakeholder engagement and management of concerns related to tax, and (4) public CbCR, including disclosure of profits, employees, and taxes per county basis.

When implementing an ESG-Tax strategy, the starting point for a company or organisation should be the definition and documentation of such strategy.

As a general rule, the tax strategy is, (i) primarily, documented in a tax policy statement, establishing general commitments, to a reasonable interpretation of tax law, cooperation with the Tax Authorities and a higher level of disclosure, and (ii) subsequently, possibly densified in a Tax Conduct Code.

Once the ESG-Tax strategy is duly defined and documented, then it should be consistently applied for each transaction and tax decision: it is critical that each tax decision is duly disclosed and justified, being the narrative aligned with the company’s tax policy strategy.

In addition, there are always four questions we can ask to validate each tax decision from an ESG-Tax perspective: (i) Is it legal? (ii) Is it ethical? (iii) How will it look like in 10 years? (iv) Is this something that I want to be responsible for?

ESG-Tax Due Diligence

Investors are interested in ascertaining how ESG-Tax factors are incorporated in the targets’ behaviour and, consequently, how in a M&A or a PE transaction the tax DD should also involve an ESG approach.

While a traditional tax DD is focussed on the identification and quantification of potential tax exposures of a target (business, a company or group of companies), an ESG-Tax DD involves the consideration of tax aspects as part of the sustainability performance, including the risk of reputational damages.

The ESG metrics are requiring tax professionals to ask questions with a different focus. The following can be considered as examples of questions that can be raised in an ESG-Tax DD:

i. Does the company have a duly documented tax strategy?
ii. Is the tax function aligned with the ESG strategy?
iii. Is the tax function adequately staffed? What is the level of involvement of the management team?
iv. Does the company’s structure involve complex constructions (e.g., location and corporate structuring)? If so, what is the narrative to justify it?
v. What level of tax risk is the company willing to accept?
vi. Does the Target maintain cooperative relationships with the tax authorities?
vii. Are tax risks adequately disclosed?
viii. Does the company’s effective tax rate seem reasonable, both in the aggregate and by jurisdiction?

In addition to this approach to targets and in order to avoid reputational consequences of investments with parties with high ESG-Tax risk profiles, depending on certain factors (namely the level of investment), a DD to the tax position of investment partners may also be advisable.