As stakeholders increasingly demand sustainable practices, companies are compelled to integrate Environmental, Social, and Governance (ESG) factors into their operations. Thus, integrating ESG considerations into transfer pricing is no longer optional – it's essential. In this article, we specifically discuss the interplay between ESG and intercompany financing.

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

In recent years, the financial landscape has experienced a significant transformation, marked by the integration of ESG factors into mainstream practices. This evolution is evident in the banking sector, where institutions now factor ESG metrics into their lending and investment decisions. In order to align with third-party behavior, it becomes inevitable to consider ESG factors in intercompany financing which impact the risk and sustainability profile of borrowing entities and therefore interest rates. 

Credit rating agencies have started to introduce ESG criteria into their assessments, aiming to recognize environmentally friendly companies, thereby demonstrating how ESG factors (e.g., reliance on fossil fuels, environmental compliance, lack of diversity, etc.) can influence a company's credit rating and subsequently affect their borrowing costs. In general, what it means is that the entities engaging in non-sustainable activities and/or lack robust governance structure to demonstrate an engagement with ESG risks, could be subject to higher interest rates to account for an increased risk.

However, companies that can demonstrate the use of sustainable practices and governance structure could benefit from lower interest rates. In this respect, we refer to the green-premium (so called “greenium”) that refers to cost savings from a green bond's eco-friendly status, leading to reduced interest payments. The question is which entities in the group contributed to ESG factors resulting in green premium and if and how this group benefit should be (re-) allocated between the contributing entities. Essentially, a re-allocation would align financial rewards with each entity's role in ESG efforts and value creation. When setting interest rates on intercompany financing transactions the following scenarios may need to be considered: 

  • For intercompany financing originating from external funds, the question is how the terms of such external financing affects the on-lending within the group. If the group is committed to meet certain requirements of an external party related to ESG (e.g., purpose of the loan is ESG-related; some ESG metrics were considered when the loan terms were determined etc.), similar characteristics may need to be considered  for the related intercompany loan. On top of that, if there any group benefits achieved from negotiating external group financing (e.g., green premium), such benefit may need to be (re-)distributed within the group accordingly, in line with the arm’s length principle. From an economical perspective, if intercompany financing omits some of the ESG specific conditions imposed by a third-party, it may result in non-compliance with the transfer pricing regulations. 
  • For intercompany financing originating from group funds (rather than from an external debt), ESG considerations may also need to be considered by looking at how third parties would act in similar circumstances. As there is no direct internal comparison in this case, there might be difficult to find such external comparison and publicly available data; however, there are different synthetic approaches which could be used in this case, e.g. by looking at credit and ESG ratings and financial structures of big multinational companies. 

 Regardless of where the funds originate, we believe that when setting interest rates on intercompany financing, it is crucial to consider the impact of ESG requirements on terms and conditions, as well as on the financial benefits from such loans.

Forward Thinking

Integrating ESG considerations into transfer pricing involves assessing the environmental and social impact of intercompany transactions, alongside traditional financial metrics. This will help to align with third party behavior and ensure equitable allocation of taxation rights related to intercompany interest payments. Moreover, having a proper ESG policy and governance will demonstrate a company’s engagement with ESG risks, and might help secure better interest rates externally which would benefit the group as a whole, including intercompany arrangements.
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