Case study by MFS Investment Management

In mid-2013, our ESG research analyst observed several signs suggesting that both regulations and societal expectations regarding multinational tax minimisation strategies were changing, including that debt-laden developed countries are losing hundreds of billions of dollars annually due to the use of aggressive tax minimisation strategies. According to the Organisation for Economic Cooperation and Development (OECD), developing countries lose more to tax avoidance than they receive in foreign aid. These data points, along with others, contributed to our conviction that corporate tax avoidance would become a focus for regulators globally.

After researching common tax avoidance strategies used by multinationals, we identified an initial group of the potentially higher risk companies by analysing each firm’s tax gap: the difference between the weighted average statutory tax rate for a company based on its geographic sales mix and the effective tax rate shown on the company’s income statement.

For the companies with the larger tax gaps, we reviewed several other factors, placing particular emphasis on companies exhibiting or benefiting from:

  • large or growing unrecognised tax benefits balances;
  • very low foreign effective tax rates;
  • new disclosures or changes in language used in the company’s tax footnote;
  • recent media or governmental scrutiny regarding their tax practices.

We identified a number of companies, and engaged with their management teams to fine-tune our risk assessments.

Impact on analysis

To analyse the financial materiality of the issue, our ESG research analyst gave a detailed thematic presentation, which was followed by security-level, tax-related research that was conducted in close collaboration with our industry analysts and portfolio managers.

As a result of this work, the weightings of multiple portfolio holdings have been reduced, and several analysts have normalised (increased) the tax rates used in their financial models. In some instances, analysts have also incorporated sizable tax increases into their downside scenario analyses to understand how the security might be impacted if significantly higher tax rates were imposed.

One simple example of our work in this area relates to an IT services company. After researching the firm’s tax strategies and engaging with its chief financial officer, our ESG analyst determined that the firm’s tax rate was likely to remain relatively stable over the next several years; however the analyst covering the stock chose to develop a bear case scenario that incorporated the risk of faster regulatory action, to ensure that the broader team understood the potential downside in the stock (below).

  Base case analysisBear case analysis 
Effective tax rate  14%  20% 
P/E multiple  14.5x  12.5x 
Pre-tax EPS impact  -2 
Tax rate EPS impact  -7 
Total EPS impact of bear case adjustments  -9% 
Downside vs base case  -21% 

This firm has a high proportion of recurring revenues, which otherwise would have led to minimal downside scenario adjustments. However, the addition of a higher tax rate and the associated impact on valuation and investor sentiment that would likely result from the tax risk being realised led to a bear case scenario in which EPS was estimated to fall 9% below the analyst’s base case assumption, resulting in more than 20% downside potential in the stock’s fair value.

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