The European Commission has intensified its efforts to integrate Environmental, Social, and Governance (ESG) principles into business regulations. Multinational companies vary widely in their reactivity and willingness to integrate ESG principles into their existing operating and business models; some do the bare minimum, whilst others completely rethink, reshape and redesign their business model around ESG principles. ESG initiatives have the potential to materially impact value creation, a core principle that must be considered when designing a transfer pricing model. This article focuses on ESG initiatives, their impact on value creation and how they should be considered from a transfer pricing perspective. 

This article was written by Michael Kratz and Vera Zhuravleva. Michael ([email protected]) and Vera ([email protected]) are part of RSM in the Netherlands Tax Services with a focus on transfer pricing.

Companies may find it difficult to decide those ESG initiatives which have the potential to impact their transfer pricing policy, and those which do not. Our view is that the impact of ESG initiatives on a multinational group’s transfer pricing policy is proportional to the “disruptiveness” of the ESG initiative. The more disruptive, the larger the impact. This can be illustrated using a simple example. 

Consider the case of a fictional clothing retailer called “FastFashion” who aims to offer the latest fashion trends at low prices. The company is looking at introducing various ESG initiatives into the way it does business. It considers two alternative approaches.

Under a first option, management considers various changes to its supply chain that are designed to address both the environmental and social aspects of ESG. The company decides to take steps to ensure that its supply chain is free from child labour and uses sustainable materials, logistics and transportation partners. To usher in these new initiatives, the company considers employing an in-house supply chain consultant and a new governance office to audit suppliers and partners.

These changes represent a new way of implementing the company’s current (traditional) business model. Whilst the company will focus on ensuring the ESG “profile” of their suppliers and partners meets a new (and ethically higher) standard, it remains focused on its core business model (i.e., to provide fashionable clothes and competitive prices to its customers).

However, this does not mean that multinational company’s engaging in similar ESG initiatives can forget about their impact on transfer pricing. ESG initiatives that impact the “nature” of a product or service could justify a review of benchmarking studies which support the transfer price of that product or service when it is sold between group entities. For example, the garments designed and manufactured by the “new” FastFashion could be considered “sustainable fashion” that justifies a premium (or discount) when sold between group entities, when compared to “ordinary” garments. 

Under a second option, management considers moving towards a more sustainable and circular business model. Garments will be designed with durability and repairability as the focus, recycling and reverse logistics will become an important element of allowing customers to return and exchange old garments for new (and refurbished) garments. New revenue streams (such as garment rental) will also be explored. To usher in this new business model, the Group considers employing a specialist team with proven success in delivering on circular business models. 

These changes represent a fundamental change to the way that the company creates value. The company’s value proposition shifted from “offer the latest fashion trends at low prices” to “provide eco-friendly fashion with minimal environmental impact and ethical practices”. ESG initiatives are at the heart of how the “new” company will do business and convince consumers to part with their hard-earned money.

These ESG initiatives are likely to be considered a source of value creation as they are to develop a new future-proof business model for the company. In our view, the activities of the specialist ESG team in this case could even be considered to create a “management / business model intangible” that may be remunerated with a share of residual profits or royalty income. 

Forward Thinking

A transfer pricing analysis has long required a careful review of a company’s value chain to identify which entities contribute to the creation of value. The same principle applies when it comes to assessing the impact of ESG initiatives. Multinational groups should ask themselves, does a particular ESG initiative contribute towards value creation? An answer in the affirmative is more likely to materially impact a multinational group’s transfer pricing policy. Even if the ESG initiative does not impact the location of value creation, transfer prices could nonetheless be impacted to the extent that the “nature” of the product or service has been changed by the ESG initiative.

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