A comprehensive Environment, Social and Governance (ESG) program extends beyond the enterprise; the more mature ESG programs cover the entire ESG ecosystem seeking to assure that business partners, service providers, counterparties and borrowers, among others, are acting consistently with an entity’s stated ESG policies and goals. An organization’s stakeholders also expect that these principles are integrated into the investment strategies, both public and private, which necessitates the inclusion of ESG in the investment evaluation and approval process. This often requires that historical investment policies, processes and due diligence efforts be adapted to incorporate ESG principles. 

As previously addressed, tax is a critical part of ESG. Accordingly, for investors that aim to maintain robust ESG policies, ESG tax issues should be included in the investment review and approval efforts. KPMG firms’ clients are incorporating ESG principles into due diligence efforts, including tax diligence, with increasing frequency. This development is consistent with the overall growth of ESG-centric thinking and the acknowledgement that ESG strategies require adopting a holistic approach that extends beyond the entity level.

Below are some key considerations for investors as they evaluate how to incorporate these principles into both private and public investments.

Investors should incorporate ESG tax issues in their due diligence efforts to assure that their due diligence process encompasses key ESG tax issues contemporaneously and throughout the investment cycle. Investors in private entities may want to identify problematic tax positions in the diligence process to ensure that such issues can be addressed as part of commercial negotiations. 

Due diligence findings should identify, risk rate, and where possible, quantify, tax positions that deviate from the investor’s ESG tax policies. This will allow the investor to prepare an action plan outlining how these deviations will be addressed prior to closing or, within a certain timeframe, post-closing where feasible. The due diligence process should also generate a gap analysis whereby the target’s ESG tax framework is compared to those of the investor. This gap analysis should identify deviations and result in an action plan to close significant gaps and mitigate the risk that deviations might affect the current or future valuation of the investment or the overall business enterprise. 

The tax gaps may vary widely, particularly when comparing tax policies. For example, an investor/acquiror may have a policy requiring that certain transactions be supported by a “should” level tax opinion from a reputable tax advisor. If the target has historically operated at a lesser level of comfort, the acquiror will want to flag and address the gaps as part of the post-deal integration plan. Another example might be the identification of special tax incentives negotiated by a target with a government. If the acquiror maintains a policy of not engaging in such negotiations, it will want to determine how to manage the target’s historical tax position in light of adverse publicity or reputational risks.

Where the investor is rated by an external ESG rating agency, the investor should evaluate the extent to which the investor’s ESG rating may be impacted by the target’s ESG activities (or lack thereof). The investor should also determine whether it will have the necessary information for a timely and accurate submission to the ESG rating agency. The investor should then develop an action plan to identify how tax data will be sourced to feed into the overall ESG rating process.

As tax is relevant to all three pillars of ESG, the range of tax issues to be considered in a due diligence effort may be extensive and may vary by industry and geography. As a starting point, an ESG tax due diligence effort might include the following questions:

  • Does the target company have a board-approved tax risk policy?
  • How has the target company monitored the governance of its tax risk policy in practice?
  • How does the board consider tax risk as part of its risk oversight function?
  • How is the tax function of the target company staffed and mapped to the organization?
  • How has the target company documented support for the tax policy in connection with its legal structure?
  • How are material tax risks identified and mitigated?
  • Does the target company comply with mandatory disclosure requirements?
  • Are there current country-specific tax developments applicable to the target?
  • Does the target company publish an effective tax rate (“ETR”)? Is the ETR further detailed by jurisdiction or other criteria?

Other tax issues may be relevant to particular industries, jurisdictions, targets or managers, such as tax benefits of investments in renewable energy investments, carbon taxes, relations with tax authorities and employee-related tax benefits. Ultimately, the scope of the ESG tax due diligence will likely depend on a variety of factors, including the investing entity’s ESG tax policies, the level of investment and the industry and jurisdictions in which the target operates.

Conclusion

ESG tax due diligence is an important part of M&A tax review and may require the development of specific approaches to address differences based on industry and jurisdiction. Incorporating ESG tax concepts into the diligence process is increasingly associated with good tax governance and responsible investment. As investors develop their ESG policies and programs, they are integrating tax into their investment process because stakeholders believe that a sustainable investment strategy will ultimately be value accretive to the enterprise.

Contributors

David Dietz, Managing Director, KPMG in the US 

Eric Janowak, Managing Director, Deputy Global Lead, Sovereign Wealth and Pension Funds Tax, KPMG Lower Gulf