The business case for responsible investors to explore the long-term implications of tax-related risks is multifaceted.
Investors could assess the financial materiality of tax risks and may choose to make tax a priority engagement topic In the event there is a lack of appropriate company disclosure. Investors could also examine tax responsibility issues that may become material in future, including the impact on society and human rights, and other issues that norms-based investors may feel they should be engaging on already.
Companies that are aligned with the needs of society will be less exposed to negative impacts from consumer pressure and increased costs associated with fines for poor practice. We also think that increased political will to regulate will favour more progressive, resilient companies.
Harriet Parker, Alliance Trust Investments
For large, “universal owners”, tax becomes even more pertinent; rather than just a cost to be minimised, it is a key systemic risk that could have a serious effect on the profitability and the sustainability of a company, as well as broader impacts n overall portfolio and macroeconomic returns.
We believe that corporate decisions around taxation are financially material and therefore relevant for creating long-term value.
Matthias Muller, RobecoSAM
Aggressive corporate tax planning should be a concern to investors as it can:
- create earnings risk and lead to governance problems;
- damage reputation and brand value;
- cause macroeconomic and societal distortions.
The impact of tax-related risks can be severe and cover a large number of portfolio companies.
Governance issues and earnings risk
Earnings that are reliant on tax planning rather than genuine economic activity are vulnerable to changes in tax regulation and enforcement. An overemphasis on minimising tax may encourage poor decision-making by company boards, such as non-strategic acquisitions that are more likely to be impacted by the closure of regulatory loopholes or the cancellation of sweetheart deals.
Even if specific tax regulations are not changed, more proactive enforcement by regulators suggests the earnings risk resulting from these strategies is increasing. As countries and their tax authorities become increasingly concerned with the exploitation of loopholes in international tax frameworks and are under fiscal pressure to fund additional government programmes, the incidence of tax disputes and litigation will increase.
Some boards appear unaware of the effect that incentives can have on tax planning: setting management targets or Chief Financial Officer remuneration based on earnings after tax could intentionally or unintentionally encourage them to focus on minimising the tax bill as opposed to growing earnings. Indicators for company-wide performance scorecards that are tax sensitive could impact the pay of all senior executives.
Where performance assessment is based on taxsensitive indicators, our concern is that companies will be driven to employ riskier strategies in an effort to minimise tax.
Michelle de Cordova, NEI Investments
Aggressive tax planning strategies can impact the timing and even ability of firms to spin off or sell business units or assets, suggesting that aggressive strategies may be encouraging companies to avoid making necessary capital decisions.
Tax-related risks extend beyond short-term earnings risks, so companies and their boards should be prepared to deal with potential changes in their business environments. The board should be aware of risks due to possible changes in tax rules, including to any incentives the company may be taking advantage of, and be ready to challenge unduly complex strategies where it is clear that these have been employed solely to reduce the tax bill. When evaluating long-term risks, the board should seek to understand any potential impact on key stakeholders.
Sources of scrutiny on aggressive tax planning strategies
Multinational enterprises (MNEs) have become much more vulnerable to unexpected tax assessments and increases in tax liability as strengthened enforcement has spread around the world. In particular, all but a handful of countries have introduced regulations on transfer pricing, the majority in the past five to ten years. Most have established specialist units to enforce these and other international tax rules, and many have received training from international organisations. In July 2014, the OECD (Organisation for Economic Co-operation and Development) reported to the G20 Development Working Group that such assistance was being provided to twenty low income countries since 2011, and gave examples of significant increases in tax collection from transfer price enforcement in Colombia, Kenya and Vietnam. Concerns about MNE tax avoidance have also led to stronger actions in developed countries.
In 2015 the UK enacted a diverted profits tax (DPT)2 aimed at specific tax avoidance structures (also known as the “Google Tax”), and Australia has proposed similar measures. In the United States, congressional committees have produced research on “international tax avoidance” techniques used by companies, or required tax directors of large corporations to testify regarding their tax strategies (hearings by the Senate’s Permanent Subcommittee on Investigations chaired by Carl Levin). Scrutiny from US lawmakers has also arisen in response to the increase in inversions3, or corporate re-domicile transactions, that have taken place over the last decade. This scrutiny led to new inversion rules in September 2014.
These concerns and political pressures led to a more concerted response from an international regulatory perspective through the OECD Base Erosion and Profit Shifting (BEPS) project4. This project attempted the first comprehensive reform of international tax rules for over 80 years, on the basis of a consensus among nearly 50 states.
The central aim of changes to international tax rules through the BEPS project is to ensure that companies are taxed according to “where their economic activities take place and value is created”. Tax authorities will be given strengthened powers to assess corporate tax activity, most notably through two new and very powerful tools: country-by-country reports (CbCRs) and transfer pricing documentation. This will apply for the first tax year after 2016 for all MNEs with a turnover greater than 750m euros, but the limit will be reviewed in 2020.
Download the full report
Why and how to engage on corporate tax responsibility
The need for transparency and better disclosure has been a focus area for global bodies such as The World Federation of Exchanges, which has included tax transparency as a “material ESG metric” for reporting by listed companies; the International Federation of Accountants (IFAC), which has called for jurisdictions to share information to promote accountability and long-term global sustainability; and the International Accounting Standards Board (IASB), the independent standard-setting body of the International Financial Reporting Standards (IFRS) Foundation, which has worked on changes to tax disclosure rules.
Investors have also started to be more vocal with their own concerns regarding aggressive tax planning (e.g. the Domini Social Investments and NEI Investments tax shareholder proposal submitted at Google in 2014. Brokers and research providers have also recently provided commentary and detailed reports (e.g. Kepler Cheuvreux, Sustainalytics report commissioned by Arisaig, VBDO).
In summary, earnings and governance related tax risks can arise from several angles, as outlined in the graphic below.
Reputational and brand risk
The media and NGOs have brought company practices to light through investigative projects and heightened public awareness of the topic, building public understanding of complex tax issues and in turn pushing governments (e.g. hearings by the U.S. Senate Permanent Subcommittee on Investigations and by the UK Public Accounts Committee) and other stakeholders, including investors, into addressing the issue.
While the historic focus of NGO groups, including the Tax Justice Network, Christian Aid, ActionAid, Citizens for Tax Justice, the FACT coalition and Oxfam, has been on the social justice and macroeconomic element of taxation, campaigners are increasingly framing arguments around financial and investment risks.
Although media article do not necessarily indicate any wrong or illegal practice, the impact on a company’s reputation can be significant.
For sectors reliant on government licences to operate (e.g. mining), reputational damage may harm the relationship with the host and/or home country, hitting existing projects and affecting the ability to win future licences. A company may also be deemed as high risk by tax authorities, leading to more scrutiny for its structures and higher hurdles of justifying legitimate business activities.
For companies in consumer-facing sectors, negative media coverage can result in boycotts and consumer backlash. It can also undermine the efforts invested by the company into their corporate responsibility positioning and affect their brand value. Given this scrutiny, it is essential for corporate sustainability officers to understand their business’s tax decisions and how those decisions impact the company’s financial results and stakeholders, and for senior executives and boards to be able to explain to investors how their company’s global tax strategies align with their sustainability commitments.
It is critical for companies to ensure that their sustainability officers are involved in tax strategy and relevant communications.
Adam Kanzer, Domini Social Investments LLC
Although the OECD BEPS project proposes that CbCRs would be available only to tax authorities and should be kept confidential, many consider that their publication is inevitable. In fact, publication of similar country-by-country information is already required for companies in some sectors, such as the extractive industry. In Europe, it has already also been mandated for banks, and the Commission is considering whether the requirement might be extended to all sectors. Therefore, companies should be able to defend how they allocate profit to each country both to tax authorities and the general public to avoid reputational risk and investor backlash.
We have voted against the financial statements or discharge of duties of financial sector companies that have not reported on their tax practices country-by-country.
Pauline Lejay, ERAFP
|Brand value impact||Total brand value (US$ million)||Extract from Best Global Brands report (2013)|
|Apple||Negative||98.316||Apple’s reputation has taken a few hits this past year… a US Senate hearing examining the company’s “highly questionable” tax minimisation strategies.|
|Amazon||Negative||23,620||The issue of tax avoidance in the UK demonstrates that Amazon’s expansion plans must be checked with responsibility and prudence, or it faces risks to its brand reputation|
|Goldman||Negative||8,536||Continuing to wrestle with negative public sentiment, the brand has been criticised for leveraging tax policy loopholes in The Volker Rule|
|Citi||Positive||7,973||The brand has its “Citi for Cities” initiative : A prime example is its “e-payment gateway” in Mumbai to improve the tax collection and receipt process|
|Starbucks||Negative||4,399||In the hot seat over corporate taxes in the UK, it remains to be seen whether this will have a long-term impact on the brand|
Macroeconomic and societal risk
At a macroeconomic level, aggressive tax strategies implemented by corporations may result in lower levels of public investments or less support for important social programs, impairing economic growth and undermining long-term investment returns.
Tax payments should not be considered a zero sum game: higher tax revenue to governments can positively impact business’ ability to produce sustainable returns through increased infrastructure investment and projects that grow the population of eligible consumers; it can also provide a pool of healthy, well-educated potential employees. Taxpayer-funded scientific research has produced critical innovations that benefit companies.
Aggressive tax planning can distort competition and result in companies with cross-border operations gaining an advantage over domestic rivals. This distortion can also discourage new business formation — a key driver of job creation, innovation and socioeconomic advancement — due to the lack of a level playing field for new entrants.
Tax responsibility is viewed by many in civil society as an issue of fairness, especially given that if corporate receipts fail, tax burdens will be placed on lower- and middle-income individuals, who are already burdened with increasing income inequality – highlighted as the most likely global risk in the World Economic Forum report for a number of years.
While the amount of tax revenue lost to aggressive tax planning is not clear, several organisations have highlighted huge estimates: a report from the International Bar Association’s Human Rights Institute Task Force on Illicit Financial Flows, Poverty and Human Rights cited research estimating that developing countries lost US$5.86tln to illicit financial flows from 2001 to 2010, and that corporate tax abuses accounted for 80% of those outflows; the Independent Commission for the Reform of International Corporate Taxation (ICRICT) highlighted a report by the UN Conference on Trade and Development estimating corporate income tax losses for developing countries, due to profit-shifting by multinational corporations, at one-third of total corporate income taxes due — US$100 billion per year.
Proxy advisory firms, and many large investors, consider these issues company by company, without considering the larger systemic impact of company activities
Adam Kanzer, Domini Social Investments LLC
Prevalance and impacts
While media coverage highlights practices of the largest companies, the breadth of exposure across an investment portfolio is unknown. In spite of the increased scrutiny on tax practices, investors are largely unable to assess a MNE’s tax risks due to a lack of transparency around the strategies a company might be using and the policy and governance practices that guide those strategies.
The 2015 MSCI Tax Gap Analysis shows (despite lack of transparency making it difficult to identify cases) the potentially high exposure across an investment portfolio:
- 243 out of 1,093 companies in the MSCI World Index had a large tax gap6;
- 20% of those companies f profit after taxes could result from tax strategies rather than core business activity;
- 26% of those companies use tax havens (compared to 16% in the wider index).
Download the full report
Why and how to engage on corporate tax responsibility