ESG effects on transfer pricing

Transfer pricing is the practice of pricing dealings between related parties with reference to comparable dealings between unrelated parties on the open market. To the extent unrelated parties begin to be affected by Environmental, Social and Governance (“ESG”) considerations in their business activities, such considerations ought to be taken into account in the setting of transfer prices. This is important as ESG issues have a growing relevance for many companies across the globe.

ESG as value creators

Expenses incurred by multi-national enterprises for ESG purposes can be approached as a pure compliance cost. However the emphasis placed on the implementation of ESG initiatives reflects the belief that ESG improvements are of sufficient value to warrant the compliance and other costs incurred in relation to their preparation. With this perspective, it can be fair to say that ESG can drive value creation.

While this may seem far-fetched to some, we can look to the history and treatment of other reporting norms - such as financial reporting - as instructive for our treatment of ESG initiatives today.

Historical context: The evolution of norms

To understand the role of ESG as a value creator, it is instructive to identify allegories in the historical development of business standards. During the initial introduction of financial reporting standards, any reluctance on the part of the early adopters of these standards may have been attributable to fears that the detail of the disclosures involved could reveal competitive secrets, strategic vulnerabilities or attract unwanted regulatory scrutiny. 

These concerns, as we now know, were eventually trumped by the benefits of increased transparency, investor confidence, regulatory checks and balances, and the improved trust in the commercial system overall. The existence of such regulations provides comfort to investors that the data on which they base their decisions is fair, true and accurate, as well as being validated by independent auditors subject to ethics standards.

ESG as a statement and restatement of values

The example of financial reporting outlined above assumes certain values that are held by the users of financial statements: a belief that the objective information provided by the statements and prepared by independent auditors is valuable enough to warrant the considerable costs incurred in their preparation each year. Similarly, there is a belief that sustainability reporting, social practices or a more holistic form of corporate governance creates value for the companies.

This does not mean that all of the stated ESG values themselves are wholly new; rather they can be seen as restatements of values which have previously been captured in other established reporting practices. Environmental concerns were to some extent captured in the disclosure of contingent liabilities under IAS 37, whereby environmental clean-up liabilities would be reflected and disclosed in the financial report. Social issues were outlined in disclosures made in the course of preparing financial statements in compliance with applicable local laws. Governance assurance was provided by the preparation of the financial statements themselves by qualified and independent auditors.

Transfer pricing, ESG and financial reporting

How does transfer pricing treat the practice of financial reporting itself as a value-creating element of a firm’s business activities? In what circumstances would third parties remunerate each other for the management of ESG risks, be they in relation to the brand, compliance, operational or other related risks in the ESG context?

For example, the preparation of sustainability reporting which is required due to thresholds breached by the group as a whole on a consolidated basis - a so-called “shareholder cost” in transfer pricing parlance - is unlikely to be a service for which third parties would be willing to pay at arm’s length. However, if group management deploys resources in order to make decisions on the direction of ESG concerns which are of importance to the group as a whole as a marketing tool or as a requirement of investors, this could be argued to provide a benefit to other group companies which would be remunerated at arm’s length.

In both scenarios, the initial ESG value can be accurately identified by analysing the importance of ESG to the multinational enterprises as a whole without assessing the respective functional profiles of the individual entities concerned. This ESG value as well as other value drivers within the Group then inform the appropriate transfer pricing policy for the MNE concerned.

Conclusion

By understanding the historical evolution of financial reporting, we can draw parallels to the emerging field of ESG reporting. Just as mandatory financial disclosures have become integral to corporate transparency and investor confidence, ESG reporting is likely to follow a similar trajectory, and thus be treated as creating value.

By bringing clarity to our understanding of ESG and its role, we can become better equipped to apply lessons learned from ESG transformation to problems encountered in the transfer pricing space. To the extent that ESG value drivers expressed by MNEs increasingly become the norm between unrelated parties, the pricing of dealings between associated enterprises will be obliged to follow suit.