This article first appeared in Forum, The Edge Malaysia Weekly on September 20, 2021 - September 26, 2021

Environmental, social and governance (ESG) practices are gaining ground with campaigns like Plastic Free July attracting the attention of businesses and citizens alike to contribute to the global movement on ESG. The call for sustainability has, in turn, whetted the appetite for investments that support the environment.

Governments are also taking up the mantle to address climate change. With global temperatures rising and erratic weather patterns, more countries are pledging their commitment to net zero emissions by a certain timeline. The momentum generated by these initiatives has resulted in increased scrutiny on businesses to meet sustainability goals on top of generating profits and securing returns on investment for investors.

In 2019, the European Commission introduced sustainability disclosure regulations that require the integration of sustainability risks in all investment processes and financial products as well as the consideration of any adverse impacts on sustainability at the product level. In the US, the House of Representatives recently passed the ESG Disclosure Simplification Act of 2021, which would require publicly traded companies to disclose their commitments on ESG standards that are reflected in their operations, activities and supply chains.

In Malaysia, it is currently mandatory for public-listed companies to disclose their management of material economic, environmental and social risks and opportunities via a Sustainability Statement in their annual reports. This is further amplified by the Malaysian Code on Corporate Governance 2021, which advocates board leadership integrating sustainability considerations in their corporate strategy, governance and decision-making.

One may ask: how does taxation come into the ESG equation and what is taxation’s vital role in ESG? While not normally transparent, companies’ tax strategies and payment of taxes would be one of the largest contributions made to governments and social causes around the world. Taxation intersects with ESG initiatives, especially around tax policies, tax strategies, tax incentives and tax reporting. By including tax metrics in their ESG initiatives, businesses would improve their ability to communicate their contributions to their stakeholders and derive greater value from investments made.

Tax policies and tax strategies should be key considerations as companies chart their ESG journey. The push for better transparency, which is a key element of ESG, has been gaining momentum in recent years. One of the earliest countries to adopt the publishing of tax strategies is the UK.

In December 2016, the UK government introduced significant new tax governance requirements where large organisations are required to publish their tax strategies as it relates to UK taxation. This includes details of tax legislation compliance, how UK taxes are managed and tax planning. Failure to publish these tax strategies within the time limit will result in penalties being imposed on the businesses.

Global organisations such as the Organisation for Economic Co-operation and Development and the Principles for Responsible Investment have provided various guidance documents to investors to support engagement with investee companies on tax policy and transparency. These measures have also been introduced and adopted in many European countries.

While tax governance builds a solid base in aligning a company’s tax strategies and tax policies with ESG, the other key value driver in ESG strategies is the availability of tax incentives as well as new environment-related taxes.

For decades, tax incentives have been an opportunity for governments to wield the “carrot”, in the carrot and stick analogy, to achieve desired outcomes. Tax incentives can be a key value driver for businesses, and various governments around the world have introduced tax incentives to encourage businesses to pursue ESG-related initiatives.

For example, in the US, the use of investment tax credits is seen as a key component of strategic ESG integration. A tax credit is a type of government-sponsored tax incentive that can reduce a company’s tax liability and incentivises corporate taxpayers to invest in certain types of projects that produce economic, environmental or social benefits. From the investors’ perspective, tax benefits are an addition to the usual return on investment.

Closer to home, most countries in the Asia-Pacific region have made progress in this area by introducing some form of ESG tax incentive. In Japan, companies that acquire carbon-neutral assets or assets that manufacture carbon-neutral products are entitled to special tax depreciation or tax credits. Similarly, in China, Hong Kong, Singapore and even Malaysia, tax incentives in the form of tax credits or tax exemption are granted to companies that invest in certain “green” industries or products.

Under the Malaysian Budget 2020, the existing Green Investment Tax Allowance for the purchase of green technology assets and projects, and Green Income Tax Exemption (GITE) on the income earned from green technology services, have been extended until 2023. The scope of the GITE has also been extended to companies that undertake solar-leasing activities. These incentives provide tax exemptions to companies and encourage investments in the green technology industry and in green assets.

As one of the leading Islamic finance hubs in the world, the Malaysian government has also introduced various tax incentives for sustainable Islamic financing activities. This includes the recently extended Green Sustainable and Responsible Investments (Green SRI) Sukuk and Bond grant scheme, which is provided by the Securities Commission Malaysia (SC) to sukuk issuers to finance the external review costs incurred in issuing a Green SRI sukuk. The extension now covers grants for all types of SRI sukuk and bonds that meet the Asean Green, Social and Sustainability Bond Standards approved by SC up to Dec 31, 2025.

While tax incentives are always welcomed by the business community, there has also been growth in new environmental taxes in recent years. In the European Union (EU), governments have introduced various environmental taxes. Finland was the first to introduce a carbon tax in 1990 and since then, 18 EU countries have followed, implementing carbon taxes that range from less than €1 per metric ton of carbon emissions to more than €100 per metric ton. In 2019, such taxes accounted for approximately 2.4% of the EU’s gross domestic product and 5.9% of total government revenue from taxes.

Recently, in July, the EU presented its proposed Carbon Border Adjustment Mechanism, which intends to tax imports by EU importers based on the greenhouse gases emitted to manufacture the imports. The intention is to stop polluting industries from shifting their production outside of Europe to avoid the EU emissions limits and then importing back into the EU. This could have an economic impact on imports from countries outside the EU.

Countries such as the UK are introducing a tax on plastics that is conceptually similar to the carbon tax. The Plastic Packaging Tax will be introduced by the UK in April 2022 and will affect businesses, including manufacturers and importers, as well as consumers who buy plastic packaging or goods in plastic packaging in the UK. Recently, the EU passed a tax of €0.80 per kg on non-recycled plastic waste effective January 2021. Although this is a start, it may not immediately result in a boost to recycling rates.

The imposition of the above taxes, while welcomed by environmentalists, would result in additional costs of doing business. Businesses need to be aware of these additional costs and investors such as fund managers would need to factor these new environment taxes into their annual operating and revenue projections.

Governments and investors globally are seeking greater transparency and governance by corporations in answering the call for stronger ESG practices. Companies, in particular, have a pivotal role to play as their decisions around tax strategies and policies have implications on their business as well as their stakeholders. This is especially critical at a time when investors such as fund managers, who are key stakeholders for businesses, are looking to achieve a greener portfolio.

The 2021 Global ETF Investor Survey estimated that nearly 82% of surveyed investors plan to increase their allocation to ESG this year, and in Europe, 36% of new exchange-traded funds launched in 2020 were ESG funds. In the bonds market, there was a record number of issuances for green bonds last year to fund environmentally-sustainable projects.

As investors become more ESG-conscious, companies need to be aware of the tax incentives available to align their activities to meet demand, as well as environmental taxes that could significantly impact the bottom line. Fund managers would need to clearly understand the importance of tax as part of their ESG investment strategy. Investors who consider taxation as part of their ESG strategy would not only be better positioned to manage potential risks but also identify opportunities to reap the benefits of their investment.

Jennifer Chang is a partner at PwC Taxation Service Malaysia

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