Piyush Baid, FCCA MCSI

In recent years, there has been an increasing acknowledgment of the interconnectedness between economic activity, environmental sustainability, and social responsibility. This understanding has resulted in the rise of environmental, social, and governance (ESG) principles, a framework that directs businesses towards sustainable practices, social equity, and responsible corporate governance.

Within the realm of taxation, policy frameworks are now integrating ESG principles to foster positive societal outcomes and sustainable economic growth. The goal of ESG taxation is to utilize the tax system as a means to incentivize businesses to embrace ESG practices, incorporate the costs associated with the environment and society, and contribute to a fair and balanced society.

The Importance of ESG Taxation

Historically, tax policies have primarily prioritized revenue generation, often overlooking the wider environmental and social consequences of business operations. Given the mounting evidence of climate change, social inequities, and corporate misconduct, there is a clear need for a comprehensive approach to taxation.

ESG taxation has been developed to address this need, acknowledging the significant impact that the tax system can have on shaping business conduct and fostering a more sustainable and fair future. Through the incorporation of ESG principles into tax policy, governments have the ability to encourage favorable conduct, discourage detrimental practices, and establish fair competition for businesses that place importance on ESG performance.

Exploring ESG Taxation Strategies

1. Implementation of ESG strategies into taxation requires integration of the same within the tax policy framework, by usage of tools which streamline the process. There are different approaches to implementing ESG principles into tax policy, each with their own strengths and limitations:

1.1. Taxation Incentives : Offering tax incentives to businesses that exhibit strong ESG performance can serve as a powerful motivator for embracing sustainable practices and social responsibility. These incentives, which may include deductions, credits, or lower tax rates, can effectively encourage businesses to prioritize environmental, social, and governance factors. This approach has the potential to promote widespread adoption of ESG principles, but it needs to be carefully designed to prevent unintended consequences and ensure that incentives are effectively targeted. For example, The Indian government has introduced several tax incentives to promote the adoption of environmentally friendly practices. These incentives include:

  1. Reduced Goods and Services Tax (GST) for Electric Vehicles (EVs): EVs attract a significantly lower GST rate of 5% compared to 28% for conventional vehicles. This tax differential aims to encourage the adoption of EVs and reduce emissions from the transportation sector.
  2. Exemption of Excise Duty on Compressed Biogas (CBG): To promote the use of CBG as a sustainable transportation fuel, the government has exempted CBG from excise duty. This incentive is intended to make CBG a more cost-competitive alternative to fossil fuels.
  3. Tax Deductions for Research and Development in Clean Technologies: Companies can claim tax deductions for expenses incurred in developing and deploying clean technologies, such as renewable energy solutions and pollution control measures. This incentive encourages innovation and adoption of environmentally friendly technologies.

1.2. Taxation Disincentives : The implementation of higher taxes or penalties on businesses that partake in environmentally harmful practices, fail to maintain labor standards, or exhibit poor corporate governance can serve as a deterrent for such behavior and encourage the adoption of responsible business practices. This approach can be effective in addressing specific ESG concerns, but it should be complemented by other policy measures to ensure a healthy balance between environmental and economic considerations. Three examples of the same in India are

  1. Environmental Compensation Charge, introduced in Delhi in 2015 by the NGT,
  2. The COAL cess @INR 400 per tonne which is intended to raise money for the National Clean Environment Fund,
  3. In 2019, the Ministry of Environment, Forest and Climate Change (MoEFCC) introduced the Plastic Waste Management Fee at INR 1 per kilogram of plastic, which is levied on manufacturers and importers of plastic products. The tax is intended to raise funds for the collection, segregation, and processing of plastic waste.

1.3. Understanding Tax Transparency Requirements: Requiring businesses to publicly disclose their ESG performance and tax-related information can significantly improve transparency and accountability. This, in turn, empowers stakeholders to make well-informed decisions and ensures that businesses are held responsible for their ESG impact. This approach encourages increased transparency and enables more effective monitoring of ESG performance. However, it may necessitate allocating extra resources and implementing regulatory oversight. Although not much in practice in India, the EU has taken some measures for transparency under ESG.

  1. The CSRD (Corporate Sustainability Reporting Directive), adopted in 2022, to replace the existing Non- Financial Reporting Directive (NFRD) and introduce mandatory ESG reporting requirements for a wider range of companies, including large EU-listed companies, non-EU companies operating in the EU, and smaller EU- listed companies that meet certain criteria. The CSRD will require companies to report on their environmental, social, and governance (ESG) performance, including their tax practices.
  2. The Transparency Directive, adopted in 2013, requires extractive companies (oil, gas, and mining companies) to disclose payments made to governments in the countries where they operate. The directive aims to increase transparency and accountability in the extractive industries and promote better governance of natural resources.

1.4. ESG-Linked Taxes: Implementing taxes or fees that specifically address environmental or social concerns, such as carbon taxes, pollution levies, or taxes on unhealthy products, can effectively tackle ESG challenges and generate funds for environmental or social initiatives. This approach can be highly effective in tackling specific ESG challenges, but it necessitates meticulous planning to ensure that it does not unfairly burden particular industries or consumers.

2. As with any strategy there are invariably some difficulties in Enforcing ESG Taxation, and while this is not intended as a comprehensive analysis, some of the key pointers as for challenges and complexities are :

  1. Establishing clear, objective, and measurable criteria for assessing ESG performance is essential to ensure consistency and fairness in applying tax incentives or disincentives, much like a lawyer building a strong case. Developing standardized ESG metrics and frameworks can be a complex and evolving process.
  2. Preventing Double Taxation: It is crucial to prevent businesses from being taxed twice for the same ESG activities. This will help avoid placing unnecessary burdens on businesses and maintain a fair and efficient tax system. This necessitates precise coordination among various tax policies and regulatory bodies.
  3. International Harmonization: It is of utmost importance to coordinate ESG taxation policies across jurisdictions in order to avoid tax arbitrage and ensure fair competition for multinational corporations. International cooperation and agreements are necessary to ensure consistency in ESG tax treatment and prevent businesses from exploiting low-tax jurisdictions to evade ESG-related taxes.
  4. Striking a Balance: Achieving the desired outcomes of ESG taxation requires carefully weighing the benefits of incentivizing positive practices against the need to discourage harmful ones. This necessitates meticulous fine-tuning of tax policies and continual assessment of their efficacy.
  5. Collecting and analyzing ESG data is of utmost importance in order to make informed policy decisions and accurately monitor the effects of ESG taxation measures. This necessitates a collaborative effort among tax authorities, businesses, and data providers to establish strong data collection mechanisms and analytical tools.

3. Governments are the more emphasised key stakeholders within this entire paradigm in order for Establishing the Framework for ESG-Aligned Taxation. The key considerations can be discussed under the following heads:

  1. It is crucial for governments to establish clear ESG tax policy objectives that are in line with their national development strategies and international commitments. This requires a careful examination of the scope of ESG taxation, a thorough analysis of priority areas for intervention, and the establishment of suitable tax incentives and disincentives.
  2. When it comes to establishing clear ESG tax objectives, it is crucial for governments to clearly articulate the specific goals they aim to achieve. These goals may include reducing carbon emissions, promoting social equity, or enhancing corporate governance practices.
  3. Advocating for Comprehensive ESG Tax Frameworks: It is crucial for governments to establish comprehensive ESG tax frameworks that incorporate various policy tools such as tax incentives, disincentives, transparency requirements, and ESG-linked taxes.
  4. Advocating for International Collaboration: It is crucial for governments to actively participate in international cooperation efforts to align ESG taxation policies and discourage tax arbitrage. This entails engaging in negotiations for multilateral agreements, exchanging best practices, and providing assistance to developing nations in the implementation of ESG taxation measures.

4. Businesses: Embracing ESG Principles for Long-Term Success

  1. Businesses play a vital role in ensuring the successful implementation of ESG taxation. Through the adoption of ESG principles and the integration of sustainable practices into their operations, businesses can reap the advantages of tax incentives, bolster their reputation, and make a meaningful impact on creating a fair and equitable society.
  2. It is crucial for businesses to incorporate ESG principles into their corporate strategies. This involves establishing well- defined ESG objectives and taking practical steps to accomplish them.
  3. To ensure greater transparency and accountability, it is imperative for businesses to implement strong ESG reporting practices. This includes the public disclosure of their ESG performance as well as relevant tax-related information. This level of transparency allows stakeholders to evaluate the ESG commitments of businesses and ensure they are held responsible.
  4. Advocating for Collaborative Partnerships: It is crucial for businesses to actively seek out collaborative partnerships with governments, NGOs, and other stakeholders. By doing so, they can foster the development of innovative solutions and effectively tackle shared ESG challenges.

In summary: Promoting a fair and sustainable tax system

ESG taxation signifies a fundamental change in tax policy, expanding its scope beyond mere revenue generation to encompass a wider emphasis on sustainability, social responsibility, and ethical business practices. Through the incorporation of ESG principles into tax policy, governments have the opportunity to shape a future that is both sustainable and fair. This approach also encourages responsible corporate conduct and contributes to the development of a more equitable and inclusive society. Given the growing momentum of the ESG agenda, it is clear that ESG taxation will have a significant impact on the future of taxation.

(Source: This article is published in souvenir of National Convention 2023 which was held on 23rd & 24th December 2023 at Kolkata)