Tax Primer on ESG Initiatives

Tax Primer on ESG Initiatives

June 12, 2023

Companies focus on making a profit and advancing stakeholder returns above all else. After all, that is what attracts investors. However, over the past couple of decades, many investors not only seek out companies with an attractive bottom line but also those that improve society at large. Companies are being encouraged to align the business goals of making a profit with the achievement of certain environmental, social, and governance (ESG) goals.

Companies have a vested interest in forming and achieving actionable ESG strategies to maintain or enhance their appeal to prospective investors, to attract customers who display a loyalty to companies that share their ESG vision, and to develop a corporate culture that can be a difference-maker in hiring and retaining top talent. In addition to attracting investors and thus lowering their cost of capital,1 companies are being further incentivized to meet ESG goals through an array of federal and state tax credits.

Tradition claims that in business you can’t have your cake and eat it too. Investors and society, however, are demanding just that: to achieve both profit and ESG goals. Every company is different, but ESG goals are generally viewed as follows:

  • Environmental – The environmental prong of ESG revolves around what and how a company improves the environment in which they conduct business. This may include goals to conserve the natural world, such as achieving zero emissions (e.g., releasing zero greenhouse gases into the atmosphere or striking a balance between greenhouse gas emissions produced and greenhouse gas emissions taken out of the atmosphere) as well as overall climate sustainability efforts.
  • Social – The social aspect of ESG centers on actions taken to show the company values all people through respect and inclusion efforts. This includes consideration of diversity, equity, working conditions, and overall social justice.
  • Governance – The governance piece of ESG focuses on how ethically and responsibly a company conducts and oversees its day-to-day operations. This includes establishing ethical corporate policies, maintaining independently audited financial statements, creating fairness through information disclosures, and being transparent and accountable to the public.

Where Tax and ESG Intersect

In addition to making a company attractive to investors, customers, and employees, an effective ESG strategy could directly benefit a company’s bottom line via tax benefits. The federal government historically has passed laws that incentivize companies to embrace the environmental prong of ESG through a variety of tax credits, such as the Production Tax and Investment Tax Credits. The Inflation Reduction Act of 2022 extended and expanded the aforementioned tax credits and created new federal tax credits (a Zero-Emission Nuclear Power Production Credit and Production of Clean Hydrogen Credit). Further, the Inflation Reduction Act opened up an opportunity for nonprofit organizations and other tax-exempt entities to receive certain tax credits as direct payments from the IRS.2 The following credits are eligible as direct payments:

  • Alternative Fuel Refueling Property Credit
  • Production Tax Credit
  • Credit for Carbon Oxide Sequestration
  • Zero-Emission Nuclear Power Production Credit
  • Credit for Production of Clean Hydrogen
  • Credit for Qualified Commercial Clean Vehicles
  • Advanced Manufacturing Production Credit
  • Clean Fuel Production Credit
  • Investment Tax Credit
  • Advanced Energy Project Credit

The Renewable Electricity Production Tax Credit is a per kilowatt-hour (kWh) federal tax credit for electricity generated by qualified renewable energy resources, including, but not limited to, energy created from wind, water, geothermal, or solid waste. The tax credit ranges from 1.3 cents per kWh to 2.5 cents per kWh, dependent upon which natural resource is used to produce the energy. For example, electricity produced from wind can receive as much as 2.5 cents per kWh produced. Electricity produced from municipal solid waste would generally receive 1.3 cents per kWh produced.3

The Investment Tax Credit (ITC) is a federal tax benefit granted to companies that install qualified renewable energy production equipment. Businesses that invest in these types of qualified assets either directly or indirectly (i.e., investing in another business with qualified investments) receive a tax credit, which is generally a set percentage of the amount that was invested in the asset. Eligible expenses not only include the asset itself but also installation, indirect costs, and required preinstallation.4 As an example, for businesses that install solar-electricity- producing equipment, the base ITC is generally 6%; however, under the Inflation Reduction Act the credit could increase to 30% if the project meets certain wage and apprenticeship requirements.5

Tax-Related ESG Reporting

There are several items to consider when accounting for and disclosing ESG initiatives:

  • Deferred tax assets – The generation of nonrefundable tax credits results in tax assets for a company, which can be used to offset current or future tax liabilities.6 If the company doesn’t currently have the ability to use the credit in its entirety in the year generated, it will recognize a deferred tax asset, which means the company will likely use the credit in the future to offset tax liabilities. If the company is in start-up mode and doesn’t anticipate turning a profit for the foreseeable future, the company would likely apply a valuation allowance against the value of the deferred tax assets generated as a result of these tax credits. Additionally, a company may be able to monetize unused tax credits by selling them.
  • Tax disclosures – Under the governance aspect of ESG, it is important that a corporation’s financial statements are transparent and accurate in relaying current and deferred tax impact. This includes ensuring that the corporation’s financial statements properly illustrate effective tax rates, deferred tax assets/liabilities, tax policies, compliance with transfer pricing tax laws, as well as disclosure of any tax relief received from governments.

ESG Value in the Future

Much of what constitutes ESG is not new; rather, it seems to be getting increased attention. ESG appears to have staying power in how businesses allocate their capital expenditures. Global ESG assets surpassed $35 trillion in 2020, and generally appear to grow about $5 trillion per year. Per a Bloomberg article published in 2022, global ESG assets were expected to have surpassed $41 trillion by the end of 2022 and to grow to $50 trillion by 2025.7 The PICPA has an Insights white paper available on its website that looks at the growing influence of ESG reporting in the accounting profession.

Companies are diligently trying to identify and allocate financial value to their ESG initiatives. Since there is no regulated set of rules published by an authoritative body, any value assigned to a company’s ESG initiatives may be subjective.

Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of Certified Public Accountants

  1. Ashley Ross and Anthony Sommer, “Environmental, Social, and Governance Reporting: What ESG Is, Why It’s Important, and Where It Might Be Going,” Bloomberg Tax (May 19, 2022).
  2. “Fact Sheet: Four Ways the Inflation Reduction Act’s Tax Incentives Will Support Building an Equitable Clear Energy Economy,” U.S. Treasury.
  3. “Renewable Electricity Production Tax Credit Information,” U.S. Environmental Protection Agency (July 8, 2022).
  4. “Guide to the Federal Investment Tax Credit for Commercial Solar Photovoltaics,” U.S. Department of Energy, Office of Energy Efficiency & Renewable Energy (January 2020).
  5. “Federal Solar Tax Credits for Businesses,” U.S. Department of Energy, Office of Energy Efficiency & Renewable Energy (March 2023).
  6. It is important to note that tax credits flow through pass-through entities, such as partnerships and S corporations, to the ultimate owner and are, themselves, not able to claim the tax credits as an asset.
  7. ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence,” Bloomberg press release (Jan. 24, 2022).