3 Key ESG Regulatory Developments Transforming Tax Strategy

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In today’s connected world, businesses face increased scrutiny from regulators, shareholders, and consumers. As new regulations regarding environmental, social, and governance (ESG) standards come into effect, corporate responsibility has gone from a nice-to-have to an imperative.

The 2023 BDO Tax Strategist Survey found that 89% of Strategists — defined as tax leaders who have more involvement in strategic business decisions compared to Tacticians — have a formal mandate to advance ESG goals and are executing it effectively, while just 58% of Tacticians said the same. Tax Strategists provide value by highlighting the tax implications of strategic business decisions, and ESG initiatives have a direct impact on tax and regulatory compliance.

It is important for tax professionals to monitor evolving ESG regulations so they can anticipate their business impact and prepare for the tax implications. However, regulations can vary significantly from one jurisdiction to another, so it is important to align compliance practices with the business’s geographic footprint.

Let's examine three key and forthcoming regulatory developments every tax practitioner needs to know about.

OECD Pillar Two

The OECD’s Pillar Two model rules represent a new era in global tax policy. The Pillar Two model rules introduce a 15% global minimum corporate tax, designed to ensure that multinational enterprises (MNEs) with more than EUR 750 million in revenue pay a minimum level of tax on income in each jurisdiction where they operate. Although the OECD two-pillar framework is a tax initiative, its emphasis on tax transparency is aligned with ESG principles.

More than 140 countries have agreed, in principle, to adopt the OECD model rules into their domestic legislation. Some countries have already begun the process of enacting legislation that will enter into effect on January 1, 2024, while other jurisdictions, including the U.S., may not enact legislation until 2025 or later, or not at all. Even though some jurisdictions are implementing the model rules later than others, some companies may still be subject to a “top-up tax” (up to 15%) due to provisions in the model rules that allow other jurisdictions to collect that top-up tax.

Pillar Two may have major implications for corporate tax strategy:

1. It introduces another tax companies must consider in ESG disclosure reporting, which could result in increased scrutiny of MNEs’ total tax take.
2. It may affect a company’s effective tax rate by impacting tax incentives that promote sustainability.?MNEs will need to evaluate tax incentives carefully to assess whether the full benefit of the incentives may be realized, or if the benefit will be diluted by the Pillar Two top-up tax. The answer will depend on the company’s specific facts, as well as the sector, jurisdiction, and incentives involved.?

To prepare for the introduction of Pillar Two, Tax Strategists should verify that they have the proper systems and processes in place to support more complex reporting and compliance requirements. Strong data governance, advanced data analytics capabilities, a modern financial reporting platform, and potentially even automated tax compliance software can all be essential to complying with forthcoming tax rules in multiple jurisdictions.

Uyghur Forced Labor Prevention Act?

The Uyghur Forced Labor Prevention Act (UFLPA), a law designed to prevent the importation into the U.S. of products made in the People’s Republic of China with forced labor, went into effect in June 2022. Since then, Congress has made it clear it is serious about enforcement. Lawmakers from both parties have been outspoken about compliance, further underscored by the Senate Finance Committee announcing a probe earlier this year into the U.S. automotive industry’s supply chain.

To comply, companies must be able to document and report on their supply chains, including full details of their suppliers’ sourcing and operations. Companies that do not comply risk fines, bans, or detention of goods, which may significantly disrupt business.

Tax departments play a significant role in ensuring compliance with customs and trade regulations. To meet regulatory requirements and prove that forced labor was not used in any part of the supply chain, tax departments must embrace both digital and on-the-ground solutions.

Tax leaders should establish internal reporting controls like on-the-ground supply chain assessments to verify company and third-party reporting. They should also collaborate with digital and supply chain leaders to embrace modern technologies like DNA tracking, artificial intelligence, and blockchain technology to gain end-to-end visibility and monitor and respond to risks in real-time.

As a first step towards compliance, businesses should review their operations using a checklist of UFLPA requirements. Then, they can engage with their tax team, and potentially with external advisors, to evaluate remapping supply chains and realigning their tax and supply chain strategies.

EU Carbon Tax

The EU Carbon Border Adjustment Mechanism (CBAM) will impose a tax on carbon-intensive products imported into the EU. The tax is intended to prevent “carbon leakage,” a practice whereby companies move their production to countries with less stringent climate regulations to avoid paying for carbon emissions, an issue that became prevalent after the EU introduced its emissions trading system (ETS).

The tariff applies to imports of in-scope commodities — including iron, steel, aluminum, cement, and fertilizers — from non-EU countries that do not impose a domestic carbon levy on emissions equal to what EU producers would pay. Implementation begins on October 1, and the first annual report from importers is due in January 2024. During a transitional period, there will be no taxes on imported goods; however, inaccurate reporting will result in fines. The tax enters full effect beginning in 2026, and the EU will gradually expand the scope of carbon-intensive imports subject to the tax in the coming years.

This measure will have far-reaching operational and cost implications for companies that fall under its purview. Companies that operate in the EU and produce or purchase any of these high-carbon products outside the EU should take proactive steps to prepare for the CBAM, including:

• Determining which products are in scope and subject to the CBAM. Reevaluating and potentially replacing suppliers that do not align with new EU carbon tax requirements.
• Updating financial reporting processes and internal controls to meet new standards.
• Embracing new supply chain technologies that allow for greater visibility.
• Adjusting to new workforce demands and training staff.

Non-EU companies will also be affected, given that they will have to implement tracking systems for the embedded carbon emissions associated with in-scope products. This data -- which must be independently verified -- must be provided upon importation.

All these changes have complex tax implications, so tax leaders should be involved in decision-making and be prepared to advise on how operational changes will impact tax strategy.

Looking to the Future of Tax and ESG Strategies

ESG regulations can have significant tax consequences, so businesses should include tax leaders in conversations about risk mitigation, compliance, and supply chain strategy. This process starts with fostering a strategic approach to tax that is integrated across every function of the business.

The key to achieving ESG risk mitigation is to instill a high level of transparency across the business, from the supply chain to the tax function. By embracing transparency, business leaders can realize a range of benefits beyond compliance. They can improve visibility across the organization, which can strengthen their total tax approach, and enhance efficiency, innovation, and corporate reputation.

For more on how to navigate the intersection between ESG and tax strategies, join us for this Intersection of Tax & ESG Webcast: Sustainable Value Creation for Multinational Companies.