Global awareness of environmental, social and governance (ESG) issues is growing. This article explores the interplay between ESG and transfer pricing. The integration of ESG considerations into transfer pricing strategies has become increasingly crucial for multinational corporations (MNCs). The following highlights key principles, impacts, challenges and best practices for aligning these critical aspects of modern business strategy.
Understanding transfer pricing
As we explore the intersection of ESG and transfer pricing, it’s crucial to first understand the fundamentals of transfer pricing itself. This knowledge will serve as a foundation for exploring how ESG considerations are reshaping traditional transfer pricing practices.
Definition and purpose
Transfer pricing refers to the rules and methods for pricing transactions between enterprises under common ownership or control. It ensures that enterprises conduct transactions at arm’s length, treating them as if they were between unrelated parties. This practice is vital for maintaining fair competition and compliance with international tax laws.
Key principles and regulations
The Organization for Economic Co-operation and Development (OECD) guidelines are the cornerstone for global transfer pricing regulations. Although aligned with OECD guidelines, many countries, like the U.S., have specific transfer pricing rules.
The arm’s length principle is fundamental. It requires that parties price related transactions as they would between independent entities in comparable circumstances. For MNCs, adhering to these guidelines is essential. It helps with tax planning, risk management, avoiding double taxation and disputes with tax authorities.
The relationship between ESG and transfer pricing
In simple terms, ESG and transfer pricing intersect when a company’s internal intercompany dealings reflect or need to reflect its commitment to sustainability, social responsibility and good governance.
For example, a company might set different prices for goods and services exchanged between its subsidiaries. The company could base these prices on the subsidiaries’ environmental practices or labor standards. Or how an MNC’s transfer pricing analysis should consider where and what value is created by key decision-makers around ESG strategies. This alignment ensures the company’s global finance and tax strategies are consistent with its broader ESG goals.
This approach makes sustainability an integral part of business operations.
Who should think about this
The integration of ESG and transfer pricing affects various roles within an organization. To successfully align ESG goals with transfer pricing strategies, it is important to understand who needs to be involved.
Roles and functions
- Chief financial officers (CFOs) and finance teams: They need to integrate ESG factors into financial planning and reporting.
- Head of tax and transfer pricing: They must ensure compliance with transfer pricing regulations while incorporating ESG considerations. Note that this can also be an effective tax planning tool. Determine whether any ESG-related activities result in the creation of intangible assets.
- Sustainability officers and ESG committees: They help align transfer pricing strategies with the company’s sustainability goals.
- Supply chain managers: They need to factor in sustainable supply chain practices. These could subsequently affect tax and transfer pricing.
- Legal and compliance teams: They ensure that the company adheres to both tax laws and ESG-related regulations.
Relevant decision-making areas
- Pricing strategies: Deciding how to price goods, intangibles and services within the MNC. They should do so in a way that reflects ESG commitments and relative contributions.
- Investment decisions: Allocating resources to projects and initiatives that support ESG goals. Note that this is potentially an effective tax planning tool because value drivers matter.
- Regulatory compliance: Ensuring the company meets international transfer pricing regulations and ESG reporting standards.
- Stakeholder engagement: Communicating ESG strategies and effective transfer pricing policies to investors, regulators, and other stakeholders.
The impact of ESG on transfer pricing
ESG considerations are significantly influencing transfer pricing decisions across multiple dimensions. Let’s explore how environmental, social and governance factors are reshaping the panorama of ESG and transfer pricing.
Environmental considerations
Environmental factors are increasingly influencing transfer pricing decisions. Companies must account for carbon pricing, emissions trading, and sustainable supply chain management. For instance, a subsidiary’s involvement in significant carbon reduction projects. This could affect the pricing of goods, intangibles and services exchanged between related entities.
Let’s consider a real-world example from Apple of how environmental factors can influence transfer pricing decisions:
- ESG initiative
- Mitigate climate impact through five pillars, including low-carbon design.
- Implementation
- Transitioning to materials from recycled sources and those made using low-carbon energy.
- Design updates to cut product energy use through energy efficiency improvements.
- Impact on business
- Costs incurred to source and use 100% recycled aluminum in their products. Additionally, costs to design energy-efficient products are offset by the reduced energy needed to manufacture these products.
- Partner with IMEC to improve integrated circuit production data. Use improved data and shared expertise to reduce the carbon footprint of the entire semiconductor value chain.
- Invest in R&D projects to innovate product manufacturing processes for improved energy efficiencies.
- Intercompany agreements for ESG collaborations
- If intercompany collaboration on an ESG initiative is likely to result in the creation of intangible assets, companies should implement proper intercompany agreements. This could potentially even be a cost-sharing arrangement. This ensures proper revenue and expense allocation. Planning can help to manage future financial outcomes and minimize the risk of transfer pricing disputes.
- Creation of intangibles through third-party ESG collaborations
- Apple’s collaboration with IMEC aims to achieve carbon reduction targets and has the potential to create intangible assets. This includes the licensing of patented or trademarked processes to related companies. It can create potential transfer pricing opportunities.
- Such collaborations enhance Apple’s reputation as a leader in sustainability innovation, resulting in new business opportunities in the low-carbon economy.
This example raises important questions for multinational corporations when it comes to ESG and transfer pricing:
- How do ESG initiatives impact our cost structures across different entities?
- What type of intercompany arrangement should we implement for ESG-related R&D?
- How do we value and price ESG-related intangibles created through collaborations?
Social Factors
Social aspects, such as fair labor practices and community impact, also play a crucial role in transfer pricing strategies. Ensuring compliance with labor standards across jurisdictions can affect cost structures. It might necessitate adjustments in transfer pricing to reflect these commitments.
Moreover, maintaining a social license to operate by positively impacting local communities is becoming a priority. It may also positively impact revenue growth, which subsequently impacts on your transfer pricing strategies.
To illustrate how social factors can impact transfer pricing, let’s look at an example from HP Inc.:
- ESG initiative
- Combating modern slavery within the supply chain.
- Implementation of ESG initiative
- Require suppliers to implement the HP Supplier Code of Conduct, which incorporates international labor and human rights principles.
- Monitor risks of modern slavery through human rights assessments and due diligence programs
- Non-conformance identified through a self-assessment questionnaire and subsequent audits.
- Impact on business
- Resulted in more than $3.5 billion USD in new sales for FY21.
- Costs incurred to implement risk detection and perform audits.
- $0.4 million USD in repayments during FY21 to address findings associated with modern slavery.
This case prompts several considerations for multinational corporations in thinking about ESG and transfer pricing:
- How do social responsibility initiatives affect our pricing and profit allocation?
- Should we compensate entities implementing ESG programs differently?
- How do we account for ESG-related costs and benefits in our transfer pricing policies?
In HP’s case, the implementation of robust social responsibility measures led to significant new sales. This demonstrates a clear business benefit.
However, it also incurred costs related to risk detection, audits and addressing issues found. From a transfer pricing perspective, this raises questions. How should HP allocate costs and benefits across the company’s global entities? Consider the following questions.
Should there be compensation for this service to the entity responsible for implementing the Supplier Code of Conduct? How to attribute the $3.5 billion in new sales – solely to the selling entities?
Or should there be partial allocation to the entities responsible for the ESG initiatives leading to these sales? Similarly, how should HP distribute the costs of audits and repayments across the organization?
Moreover, as these measures of social responsibility become more integral to HP’s brand and reputation, they will gain importance. HP may start to view them as valuable intangibles. This could potentially justify adjustments to existing transfer pricing arrangements. This includes increased charges for the use of the brand by subsidiaries benefiting from HP’s enhanced reputation.
Governance issues
Governance considerations, including tax transparency and anti-corruption measures, significantly influence transfer pricing policies and compliance costs. From startups to multi-billion-dollar corporations, MNCs must ensure their transfer pricing arrangements are free from manipulative practices. Strong governance practices not only mitigate risks but also enhance the company’s reputation and stakeholder trust.
Transfer pricing challenges and risks
As organizations strive to integrate ESG into their transfer pricing strategies, they face both traditional and new challenges. Understanding these obstacles is necessary for effectively maneuvering through the terrain of ESG and transfer pricing.
Traditional challenges
Transfer pricing has always faced challenges such as disagreements over pricing methods, complexity in transactions involving intangibles or key value drivers, and regulatory inconsistencies. The integration of ESG factors compounds these traditional issues.
New challenges posed by ESG integration
The intersection of ESG and transfer pricing introduces new challenges beyond traditional transfer pricing issues. These challenges include data collection and measurement complexities specific to ESG factors. Balancing profit allocation with ESG performance metrics can be particularly complex, especially when regulations vary across jurisdictions. Companies must navigate these ESG and transfer pricing challenges to align their financial, tax and ESG goals effectively.
Reconsidering the supply chain function
Recent challenges, including those caused by COVID-19 and material shortages, have affected global supply chains. This situation presents an opportunity to elevate the significance of the supply chain function. By assuming more risk, the supply chain function can play a greater role in ensuring operational resilience. Adjusting profits earned by entities providing key supply chain functions seems justified.
Updating and refining intercompany arrangements
By implementing supply chain transparency and ethical practices, HQ and other affiliates within the MNC may incur additional costs. These costs are for ensuring compliance with these standards. At the same time, the entities responsible for these programs might drive incremental revenues. They can uphold the brand name and reputation.
This presents an opportunity to update and/or refine intercompany arrangements. Re-evaluating the functions of the entities involved is necessary. Adjusting the transfer pricing arrangements may reflect the value created by these entities in maintaining the brand.
Disclosure leading to stakeholder awareness
Disclosures could alleviate criticism that MNCs do not pay their fair share of taxes. This includes claiming tax incentives (that reduce tax liability) for ESG initiatives, such as low-carbon infrastructure projects.
This approach incentivizes companies to invest in this area and helps to achieve more progress toward addressing climate change. Expanded disclosure would also inform stakeholders of the company’s economic contributions. This includes investments, employment creation and payments to local suppliers and governments.
Revisiting tax compliance requirements
A reset may be beneficial as companies expand operations and enter new jurisdictions. By building a comprehensive tax report, companies can re-examine their tax policies.
They can align these policies with their current business model. This process can be part of an ESG initiative. It could include legal entity rationalization for MNCs with recent M&A or divestitures. Transparency may improve the company’s overall reputation.
Best practices for integrating ESG into transfer pricing
Certain best practices have emerged as companies navigate the complexities of ESG and transfer pricing. These strategies can help organizations effectively align their ESG goals with transfer pricing policies. This helps ensure compliance while maximizing the benefits of sustainable business practices.
Developing a holistic approach
A holistic approach to transfer pricing and ESG involves aligning these strategies with the company’s overall mission and values. This requires robust documentation and reporting systems to track ESG metrics alongside financial data.
Engaging with stakeholders and tax authorities
Proactive engagement with stakeholders, including tax authorities, is essential. Transparent communication about ESG initiatives and their impact on transfer pricing can foster trust and cooperation, reducing the risk of disputes.
Leveraging technology
Technology plays a crucial role in managing data for both transfer pricing and ESG reporting. Advanced data management and analysis tools can streamline the process. This helps ensure accuracy and compliance.
How BPM can support you
Integrating ESG considerations into transfer pricing is a strategic imperative for MNCs. By developing holistic approaches, engaging with stakeholders and leveraging technology, you can effectively navigate the complexities of ESG and transfer pricing. At BPM, we offer comprehensive services to help your business address these challenges. We can help align your transfer pricing strategies with your ESG commitments.
Businesses must proactively address the challenges of integrating ESG into transfer pricing. Contact BPM today to navigate the complexities and balance financial performance and sustainable practices harmoniously. We can help answer critical questions such as:
- How can we quantify the value of our ESG initiatives for transfer pricing purposes?
- What transfer pricing adjustments do we need to reflect our ESG commitments?
- How can we balance ESG goals with tax efficiency in our global operations?
- How can we align our transfer pricing policies with our carbon reduction targets?
- What’s the best way to implement appropriate intercompany arrangements for ESG-related R&D (e.g., cost-sharing arrangements)?
- How can we develop transfer pricing strategies that incentivize ESG performance across our organization?
Our team of specialists can assist you with:
- ESG impact assessment: Evaluate how your ESG initiatives affect your current transfer pricing policies and identify areas for adjustment.
- Intercompany agreement review: Analyze and update your intercompany agreements to reflect new ESG-related services and value creation.
- ESG value chain analysis: Map your ESG initiatives across your global value chain. This will help ensure the proper allocation of costs and benefits.
- ESG-related intangibles valuation: Assess and value intangible assets created through ESG initiatives for transfer pricing purposes.
- Documentation and compliance: Develop robust documentation to support your ESG-influenced transfer pricing positions.
- Risk management: Identify and mitigate potential transfer pricing risks associated with ESG initiatives.
- Stakeholder communication: Develop strategies for effectively communicating your ESG and transfer pricing approach to tax authorities and other stakeholders.
Reach out to our team today to ensure your transfer pricing strategy is both tax-efficient and ESG-compliant.
