Sustainability and ESG – the now-familiar parlance for Environmental, Social, and Governance – are increasingly becoming metrics most asset managers think about day-to-day. Investors are also increasingly applying these considerations as part of their investment decision-making process.
Riding on this momentum, more and more market players are developing sustainable investment products offered to investors. Among them, investments in natural capital present an up-and-coming, and yet untapped, market opportunity rooted in truly sustainable returns.
Asset managers venturing into such waters should anticipate tax considerations that surround these types of investments.
What is natural capital and why it is important?
The term natural capital typically refers to the world’s stock of natural assets, which consists of the stock of renewable and non-renewable natural resources such as the soil, minerals, rivers and oceans, the air, plants and animals. Such environmental elements may offer valuable goods and services to the public.
According to the World Economic Forum, more than half of the world’s total Gross Domestic Product (GDP) is moderately or highly reliant on nature and its services, with the three largest sectors being construction, agriculture, and food and beverages production1. Deterioration of biodiversity and nature has a negative impact on the economy. Therefore, climate inaction could result in substantial losses for the planet, with a projected impact of between 4% and 18% of global GDP with different impacts across regions2.
The United Nations have put forth a global goal to be nature-positive by 20303, ensuring the development, adoption and implementation of an effective biodiversity framework and aiming to reverse the current catastrophic nature loss. According to Forbes, there is a US$100 trillion investment opportunity in climate transformation4.
New nature-based investment markets and legal frameworks recognize investment into natural capital, allowing alternative asset managers to directly invest in nature and accredited projects which target the conservation, sustainable management and restoration of natural capital. These could be, for example, forestry management projects, regenerative and sustainable farming practices, water supply management, biofuel, restoration of land and livelihoods (e.g., sustainable grazing practices), or other natural capital assets. The underlying streams of revenue would vary based on the underlying investment derived from certified sustainable commodities (such as timber logs, coffee beans and cotton), conservation fees, fishing and hunting rights, carbon sequestration, and carbon corporate offset arrangements, among others.
What is it about natural capital investment that catches the eyes of fund managers and investors?
Today, external pressures from the public, regulatory bodies and stakeholders to reduce detrimental impacts on nature and the threats of climate change and biodiversity loss which are degrading the ecosystem are increasing. This propels investors to seek – and alternative asset managers to offer – investment products into natural capital.
Investors are looking into nature-positive investments that could sustain their return expectations. They are thus increasingly employing screening tools and standards to identify ESG risks in order to make an informed decision, turning away from negative ESG impacts and protecting their public image.
Alternative asset managers are setting up more natural capital funds. By investing into natural capital, the asset managers are putting an economic lens on environmental assets and may seek market opportunities with substantial returns. The pivot towards sustainable investing is accelerating, surrounded by schemes to balance the risks associated with nature, expected returns and sustainable goals.
Thematic funds create opportunities for engaging with natural capital (attracting capital from institutional investors including sovereign wealth funds, pension funds and insurance companies) by valuing environmental and social returns and mitigating long-term climate risks.
Why is tax a relevant consideration for natural capital?
Based on our experience, an increasing number of alternative investment funds are being set-up, especially in Luxembourg, focusing on natural capital strategies.
When considering investment into natural capital, there are a few things to keep in mind from a commercial and tax perspective, as they could have an impact on a fund’s internal rate of return:
- Tailor the structure to the underlying investment: From the outset, alternative asset managers would need to consider an appropriate type of fund and holding structure tailored to the type of investors and the specific nature of investment. Certainly, investments into green bonds, concession rights and investments into tangible assets each require different structuring considerations and arrangements, and may result in unintended outcomes if left unchecked (e.g., investors may become subject to tax filing obligation outside their country of jurisdiction, or additional tax reporting).
- Local tax considerations: Some types of investment may need to factor in the relevant direct tax and indirect tax considerations that naturally feed into the viability of the project from a financial point of view. For example, local investment jurisdictions may provide for specific value-added tax regimes for carbon credits, targeted levies (e.g., royalty on timber production), or may introduce specific incentives (e.g., grants and incentive schemes to promote specific activities and/or employment, accelerated tax depreciation rates or more tailored depreciation methods). In addition, the features of commercial agreements and differentiated nature-based streams of revenue should be considered from a tax and transfer pricing angle.
- Non-resident capital gains taxation upon exit: As noted, it is key to understand the local tax rules where the natural capital asset is located to anticipate relevant exit strategies. For example, from a tax perspective, the land in agricultural projects and forestry projects may qualify as a real estate investment or be considered as forming part of a commercial business, depending on the jurisdiction where the project takes place. Many jurisdictions may retain taxation rights on the sale of the project companies holding these assets, claiming that it is in substance and actually a sale of the underlying real estate instead of a business. Therefore, potential capital gains taxes and real estate transfer tax may need to be particularly considered.
- Cash repatriation: The regular cash yield for institutional investors – especially, pension investors – may be of essence. Therefore, appropriate funding strategy is key, and the related withholding tax impacts would need to be considered.
Sustainable investments are both a growing trend and global need in achieving a nature-positive outcome, and natural capital is the asset class that can boost climate transformation with a beneficial impact on the world’s biodiversity, while achieving attractive returns.
The creation of nature-based streams of revenues comes with attached risks and rewards, but also new challenges for asset managers, from selecting nature-positive investments, understating the relevant income streams and all the related tax implications.