Case study by Engagement International and the Municipality of Aarhus, Denmark
In the spirit of showcasing leadership and raising standards of responsible investment among all our signatories, we are pleased to publish case studies of all the winning and shortlisted entries for the PRI Awards 2020.
Give a brief overview of the initiative, its objectives, and why you decided to undertake it.
Engagement International partnered with the Danish city of Aarhus in June 2018 to develop a collaborative, multi-phase engagement project to address corporate tax avoidance in investment and procurement. Aarhus, along with 12 other Danish cities, is a signatory to the Charter for Tax-Haven-Free Municipalities developed by the NGO Oxfam IBIS. The Charter calls for municipal asset owners to avoid investing in and procuring from companies that are registered in tax havens.
When it comes to dealing with corporate tax avoidance, city governance face a challenge in that they only have a binary option: divesting or investing in companies, and excluding or including suppliers. There are no alternative tools to drive positive and long-lasting changes in companies and society at large.
The scope of the engagement project was designed to cover both investment and procurement, with two phases:
- Phase 1, from June 2018 to May 2020, was a pilot engagement project and is the subject of this year’s PRI award.
- Phase 2 began in May 2020 and is a period of expanded engagement, which is still in progress.
Phase 1, objectives:
- Support asset owners through active ownership to encourage portfolio companies to treat tax avoidance not just as a compliance issue, but also an ESG issue.
- Develop a milestone-based engagement assessment framework on the management level of responsible tax with reference to international guidelines and best practices, and in consultation with stakeholders.
- Apply the assessment framework to the 10 listed companies from the MSCI World Index that were found in Aarhus’ investment portfolios and top 100 suppliers. These companies have the greatest number and severity of corporate tax controversies according to MSCI ESG Research in the pilot engagement.
- Engage with and recommend the selected companies to adopt responsible tax strategies and to ensure that effective governance and management measures are in place.
- Adjust the assessment framework and engagement model based on insights collected to inform the development of expanded engagement in Phase 2, where additional tools to promote responsible procurement will be developed.
Describe how your project is aligned to Active Ownership 2.0, including:
a. The significance of the systemic, real world outcomes it seeks.
The business case for institutional investors to engage with companies on aggressive tax planning is well documented in PRI’s engagement guidance, published in 2015. Aggressive tax planning can pose earnings risks, governance problems, reputational risks and brand value damage to listed companies. On an international scale, this can also lead to macroeconomic and societal distortions.
Below are two particular aspects of tax avoidance that demonstrate how systemic and widespread the negative impacts can be:
ONE: It can erode governments’ tax revenue and make them less able to finance essential services, crisis response, and the Sustainable Development Goals. For example:
- According to a study quoted by the IMF, annual loss of corporate tax revenue due to the use of tax havens was estimated to be between $500 and $600 billion, of which $200 billion was from low-income economies.
- Further, the impact of tax avoidance can be exacerbated by sudden global crisis such as the COVID-19 outbreak. While governments around the world are in urgent financial need to mitigate the health and economic damages of the pandemic, tax revenue is expected to shrink due to the crisis.
- At the same time, governments can be caught in the dilemma of providing state aid to businesses that have historically adopted aggressive tax planning strategies.
TWO: It can encourage unfair competition between companies and countries. For example:
- Instead of competing against other companies on business model, product quality, operational efficiency etc., companies may focus instead on aggressive tax planning. They may be able to obtain higher earnings without allocating as many resources to manage the business as their competitors.
- Similar unhealthy competition can happen between countries offering ultra-low or even zero corporate income tax rates and those with more average tax rates.
b. The ambition, ingenuity or effort in the responsible investment tools/activities that were deployed.
The Responsible Tax Engagement project is a concrete solution for institutional investors to bridge the gap between knowledge and practice in promoting responsible tax through active ownership.
The challenge for institutional investors is to find a way to evaluate and measure portfolio companies’ progress towards implementing responsible tax strategies.
Building on its expertise and experience in engaging on other systemic ESG issues, Engagement International has come up with a robust methodology grounded in the widely accepted international guidelines and best practices.
The assessment framework includes five milestones, namely:
- Recognition and Commitment
- Risk Management and Governance
This systematic approach means institutional investors can assess companies across the same criteria, and lets them compare the same company’s performance over time, as well as undertake inter-company comparisons within the same sector or portfolio.
c. The challenges associated with this initiative (e.g. free rider issues hindering first movers) how these were overcome, and what was learned.
The main challenges for Phase 1 of the Responsible Tax Engagement project were:
- Designing an appropriate engagement and assessment model on responsible tax while recognising that taxation is in itself a complex, political and sensitive subject.
- Understanding companies’ tax affairs including the amount of tax payment and to what extent it reflects its tax strategies where disclosures may be limited.
- Limited or nil response from selected companies.
To overcome these challenges:
- The City of Aarhus and the Danish Ethical Trading Initiative hosted a series of multi-stakeholder workshops in October 2018 and January 2019. Over 100 municipal asset owners attended, as well as subject matter experts from academic, business and non-profit sectors. They exchanged ideas on corporate tax avoidance, especially the use of tax havens, and how investors could influence portfolio companies to properly address such a systemic issue. After the workshops, the draft assessment framework was fine-tuned and another round of consultation with investors, academics, NGOs and leading companies in responsible tax was conducted to review its usability and robustness.
- The companies’ effective tax rates, calculated by various methods, were reviewed and compared. In particular, the ETR based on actual tax payment was compared with the estimated statutory tax rate, calculated by MSCI ESG Research.
- Engagement International has a stepped approach to escalate engagement with non-responsive companies. Possible actions include direct engagement with top executives and the board, proxy voting, engagement in the public domain etc.
Outline the results, including evaluation of its success against the objectives; were there any adjustments to the forward agenda; were there any insights learned from this project that can be applied more broadly?
The organisation has so far engaged with 10 listed companies: Alphabet (Google), Apple, Amazon, Microsoft, Credit Suisse, Deutsche Bank, Societe Generale, UBS, Procter & Gamble, and Royal Dutch Shell. And seven companies have responded.
Less responsive companies were concentrated in the US, an observation similar to PRI’s experience of collaborative engagement on tax that ran between 2017 and 2019. Additional stewardship tools and/or escalated engagement will be further considered when engaging with non-responsive companies during Phase 2.
A baseline assessment was established for all 10 companies to measure a future engagement progress. Most of the companies do not currently exhibit adequate management efforts across the five milestones. However, some more proactive companies have undertaken notable initiatives to improve preparedness and transparency.
It has been observed that both investors and companies now perceive tax avoidance more as a systemic ESG issue than a mere compliance matter. This presents an excellent opportunity for investors to enter into dialogue with companies to further promote the adoption of responsible tax strategies.
Encouraged by the overall positive outcome of Phase 1, the organisation has identified another 20 companies from the MSCI World Index with which to engage. Phase 2 (May 2020 onwards) will involve more refined criteria that cover tax controversies, presence in tax havens and effective tax rates. The goal is to have more interested investors on board to strengthen the collaborative engagement with more companies.
Municipal investors are sometimes more exposed to corporate tax avoidance than other institutions. This is because their procurement expenditures on controversial listed companies can be much higher than their existing investment in them.
One of the goals of the expanded engagement in Phase 2 is therefore to transfer the knowledge gained in developing the engagement assessment framework to design a questionnaire that municipal, or any institutional investors, can use internally to survey their significant suppliers’ level of responsible tax management.