THE ROLE OF TAXATION IN ESG

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For years, financial reporting and decision making based on accounting numbers of a Company has been the way to go. However, the entire process of decision making and reporting has evolved over the years, especially as the world has started to realize the impending threat of global warming. Environmental, Social and Governance (ESG) Reporting and its role alongside financial reporting has now been the talk of the town for the past several years.

As global temperatures have started rising and resources are being depleted, more companies, investors and regulators have started to realize the importance of ESG reporting. Investors and stakeholders are placing reliance of their decision making on Environmental, Social and Governance Factors more than ever. In Pakistan, the concept of ESG is still relatively new, however, globally it has been the center of discussion for quite some time now.

For those readers unaware, ESG is a set of standards used to analyze the business practices of an organization along with screening investment decisions against three components. It encompasses an extensive range of considerations but broadly speaking involves the following elements:

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Traditional financial reporting involves providing information related to a company’s annual performance against accounting measures. However, ESG reporting takes this a step further and measures a company’s performance in terms of the Environment, the Social element and its Governance. Business risks for a Company are identified against these factors and measures being taken to reduce or eliminate these business risks are highlighted in the company’s ESG report.

However, when ESG is talked about, one’s mind instantly jumps to the focal points of this reporting methodology i.e. a Company’s carbon footprint and initiatives taken to reduce it, its impact on society and its corporate governance practices. There is one important element which is often neglected i.e. the implication of taxes.

There is often a misconception that tax implications on ESG reporting only revolve within the “Social” element i.e. the tax expense being incurred by an entity and its contribution to the society through these taxes being paid to the Government.

However, that is certainly not the case. Tax has been a crucial element of every business decision or when analyzing and investment. Similarly, taxation plays an important role when it comes to analyzing an organization’s performance with respect to the ESG Standards as a whole rather than being limited to one particular factor.

Regarding the Environment component of ESG, countries such as China, Japan, the European Union and so on have already taken the initiative to impose a tax on the carbon emissions being made by a particular entity. These taxes are imposed through various mechanisms depending on the per tonne carbon emission being made. Therefore, stakeholders demand that these tax implications are disclosed in an organization's ESG Report and what impact does it has on its after-tax profitability.

The Social aspect of ESG is no different when it comes to the implications of taxation. Some might even consider the Social aspect as being the most relevant when it comes to taxability. In a broader picture, taxation is a social phenomenon. Every person whether juridical or natural is in some way engaged in contributing to our society through taxation. Hence, every organization is engaged in contributing to society through the taxes it pays whether direct taxes such as income tax, indirect taxes such as VAT or environmental taxes which are linked to an entity’s carbon footprint.

Therefore, there has been a growing trend amongst organizations to report their contributions to society in the form of taxation. These numbers also hold a government accountable as regards to how these taxes were spent for the well-being of society in general.

The Governance element in ESG does not fall shy as well when it comes to the role of taxation. Stakeholders of an organization expect that the taxation strategy being adopted by those entrusted with Governance is disclosed. Moreover, it is also demanded that an organization’s ESG report provides a brief on how these tax strategies would ensure that their capital is being utilized efficiently when it comes to taxation.

Every business decision involves an element of taxation and those charged with Governance as well as those involved in ESG reporting have started to realize its importance. Taxation is now becoming one of the core points of discussion when it comes to ESG reporting and organizations are involving experts to assist them developing a more efficient and effective tax strategy with respect to their ESG initiatives.

Meghna

By,

Mohammed Kamil Gohar - ACA

Partner (Riaz Ahmad, Saqib, Gohar & Co.)

February 15, 2024.