Navigating the ESG Landscape: Transfer Pricing in a Sustainable World

| Image credits: Image by Pascal Beckmann 

• Is environmental, social, and governance (ESG) sustainability a common topic during your company's board meetings?
• Does your company prepare an Annual Sustainability Report?
• Does your company have operations in multiple countries, and does your business model require addressing the challenges of integrating ESG policies and principles across multiple countries?

If you have answered yes to at least one of these questions, then this article is for you.

I. ESG and TP - Potential Impacts on TP Policies

The integration of Environmental, Social, and Governance (ESG) principles into corporate strategy has emerged as a critical priority for businesses worldwide. As organizations strive to align their operations with sustainable and socially responsible practices, the impact of ESG initiatives extends to various financial and operational functions. One area where this interplay is increasingly relevant is transfer pricing. 

This article explores how ESG factors are reshaping the landscape of transfer pricing, from the valuation of intangible assets linked to sustainability efforts to the complexities of intercompany financial arrangements that promote environmental and social goals. Understanding this evolving dynamic is crucial for companies seeking to balance regulatory compliance with their commitment to responsible business practices.

As with any transfer pricing analysis, understanding the impact of ESG on transfer pricing goes back to the analysis of functions performed, assets employed, and risks assumed so we can identify:

• New transactions arising from ESG considerations;
• Potential changes to the MNE’s business model;
• The potential impact on the brand value or intangible property of the MNE; and
• Changes to the overall value chain.

The scope of the functional analysis should include:

1. FUNCTIONS: Typical ESG-related functions often include:

• Tasks related to environmental conservation;
• Social impact activities, such as impact investing;
• Corporate governance compliance with environmental regulations;
• Sustainability reporting; or
• Employee welfare programs.

From this analysis, it can be determined whether the costs incurred by one or more entities in the MNE provide a benefit to other companies in the group. If that is the case, appropriate remuneration should be evaluated.

2. ASSETS: It is important to identify tangible and intangible assets employed when generating value within the ESG area, such as:

• Patented sustainable technologies;
• Trademarks associated with environmentally friendly products; or
• The company’s reputation for ethical business conduct.

When analyzing assets employed that impact ESG, a detailed DEMPE analysis should be performed.

3. RISKS: These are related not only to value generation, but also to financial performance. Examples include: 

• Physical impact that the group has on the environment, and any future regulatory limitations imposed by governments;
• Damage in case of non-ESG best practice behavior and/or “greenwashing”, when a company tries to convey a false impression or misleading information about how its products/services are environmentally sound;
• Regulatory penalties; and
• Operational and market risks.

A functional analysis is crucial to determine who bears the costs of the ESG initiatives and whether they can be passed on to group members. Generally, it is the MNE HQ or the principal entities that incur costs related to these initiatives, in the form of strategy and communication, performance evaluation, training and education, data gathering and reporting, software and licenses, due diligence, etc. However, the costs may be passed on to group members only if they meet the benefit test. 

II. Examples of transfer pricing - ESG Interactions

Creating an exhaustive list of transfer pricing implications is nearly impossible since every change in the value chain or business model needs to be examined individually. However, below are a few examples of how ESG and TP may interact:

1. Intellectual Property (IP): innovative technologies and new concepts emerge from adopting ESG strategies. These ESG efforts can also impact brand value, either positively (like being associated with environmentally friendly practices) or negatively (“greenwashing” or adverse ESG events).

• Example: A company develops an innovative renewable energy technology in response to ESG goals. This technology becomes a valuable intangible asset when manufacturing the company’s products, leading to intercompany licensing agreements between affiliates. The question arises on how to fairly allocate the value derived from this ESG-driven innovation, and whether the associated IP is recognized in the transfer pricing model.
• Potential High-Risk Scenario: A company falsely markets itself as environmentally friendly (greenwashing), inflating its brand value. Transfer pricing implications might arise if the brand value is transferred between group entities at inflated rates, potentially causing tax authorities to question the valuation.

2. Intercompany Services: ESG related costs, resources and knowledge might provide incidental benefits to the group entities and might not be seen as a service from a local entity perspective. However, these can bring significant advantages over the competition, so a thorough evaluation should be made.

• Example: A multinational enterprise (MNE) establishes an internal sustainability team, whose efforts to promote ESG compliance result in cost savings across multiple group entities. These savings, stemming from ESG-related initiatives (such as energy efficiency projects), could be considered intercompany services, but not all entities benefit equally. A transfer pricing assessment must determine whether, and how, these incidental benefits should be charged.
• Potential High-Risk Scenario: A MNE allocates significant ESG-related costs (e.g., sustainability initiatives, energy-efficiency upgrades) to various group entities under the guise of shared services. However, some entities receive no direct benefit from these initiatives, which could lead to tax authorities challenging the allocation of ESG-related costs, arguing that they do not provide value to all group entities and should not be charged as intercompany services.

3. Intercompany Pricing of Carbon Credits: companies have been allotted emission rights, which will decrease over time. Some MNE companies might need more rights, and others where for example investments have been made to reduce emissions, might need less. What is an arm’s length price for the intercompany sale of emission rights?

• Example: A group entity in a country with strict emission regulations invests in carbon-reducing technologies, leading to surplus carbon credits. Another group entity in a country with less stringent requirements needs additional carbon credits to comply with local regulations. A transfer pricing analysis is needed to determine the arm’s length price for transferring these carbon credits between the two group entities, ensuring the transaction complies with local regulations and tax policies.

4. Restructuring: changes in the key functions performed within the MNE’s supply chain can result in a transfer of profit potential within the group. Can it be seen as a business restructuring from a transfer pricing perspective? Such changes could be considered as business restructurings under Chapter IX of the OECD transfer pricing Guidelines, potentially leading to exit taxes in the transferor country.

• Example: A multinational company restructures its operations by shifting part of its production from a high-emission, coal-powered facility to a new, solar-powered plant in another country to meet its ESG sustainability goals. While this move reduces the company's carbon footprint, it also involves transferring key manufacturing functions and valuable assets (such as specialized machinery) to the new location. This shift could change the profit allocation within the group, with the new plant taking on more value-added activities and the potential for increased profits in the new country. A transfer pricing analysis is needed to assess whether the restructuring leads to a shift in profit potential that might trigger exit charges or other tax implications in the country where the production was originally located.
• Potential High-Risk Scenario: A MNE restructures its supply chain to align with ESG goals, claiming the move was driven by environmental sustainability (e.g., reducing emissions by moving production closer to raw materials). However, the new location is in a jurisdiction with less stringent environmental regulations, leading to suspicion that the move was driven by cost-cutting rather than genuine ESG concerns. Tax authorities might challenge this restructuring, arguing that the MNE’s environmental benefits are minimal, while the shift has significantly altered profit allocations, potentially leading to disputes over whether the restructuring qualifies as ESG-driven or is merely a profit-shifting strategy. This could result in adjustments, including exit taxes for the original location.

5. Intercompany Loans: the banking industry is changing its lending practices. For instance, credit agencies are incorporating the impact of climate change in their credit rating models. Investor willingness to lend at a lower rate to those companies with higher ESG credentials is backed by the concept of “greenium” or green premium, which explains the difference in interest rate spread between sustainable bonds and the “traditional” ones. Transfer pricing questions here include how to take account of lower borrowing costs and who should benefit from such savings in intercompany financing arrangements.

• Example: A MNE with high ESG credentials secures a loan at favorable interest rates, thanks to its sustainability efforts. This low-cost capital is then lent to a subsidiary in a different jurisdiction. The transfer pricing challenge here is how to allocate the benefit of the lower borrowing cost between the parent and the subsidiary, considering the “greenium” effect. Should the borrowing advantage remain with the parent, or should it be passed on to the subsidiary?

6. Grants and Incentives: who is entitled to the benefit of these initiatives? Is it the MNE headquarters that decided on the location of the investment? Or the entity that supported the claim process? Or maybe the entity that actually received the benefit, together with its intercompany contracting partners? Maybe it is all of the above.

• Example: A company establishes a wind farm that qualifies for government grants aimed at promoting renewable energy. The grant application is prepared by a subsidiary, while the parent company makes the strategic decision to invest. The transfer pricing question is how to allocate the financial benefit of the grant across the group—whether the subsidiary, parent, or both entities should benefit from the incentive.

In conclusion, the integration of ESG principles into transfer pricing strategies is a necessary consideration for MNEs navigating today's business landscape. The growing emphasis on sustainability and responsible business practices demands a reevaluation of traditional transfer pricing policies. By establishing robust ESG strategies, MNEs align themselves with global sustainability goals and unlock opportunities for operational efficiency, stakeholder trust, and competitive advantage. The dynamic interplay between ESG and transfer pricing requires proactive assessment, adaptation, and strategic alignment to ensure compliance, value creation, and long-term resilience in an evolving market shaped by ESG priorities.