A regular briefing for the alternative asset management industry.
It has become clear in recent years that tax is an ESG topic. The UN has said that taxes play a vital role in achieving the Sustainable Development Goals and public reporting of tax practices is increasingly expected by sustainability-conscious investors.
But that growing market pressure has now been underpinned by EU regulatory initiatives. According to the Sustainable Finance Disclosure Regulation (SFDR), tax compliance is an essential ingredient of "good governance" – itself a non-negotiable due diligence item for any funds categorised as "Article 8" or "Article 9". Tax and ESG professionals will need to work together to ensure that this European requirement for sound tax management practices can be met.
However, while there is little doubt that the SFDR will increase the focus on tax policies, the EU's requirement is centred on compliance with relevant laws and management of tax risk. Many investors, on the other hand, are also interested in whether investee companies are paying "the right amount of tax, at the right time, and in the right place" – and, as governments continue to bring forward internationally agreed anti-avoidance rules, these two requirements will increasingly overlap. Good governance will require companies to demonstrate that they are compliant with international tax laws, and these laws will require them to demonstrate substance and non-abusive use of tax treaties and tax concessions.
Investors, though, do not speak with one voice, and some LPs pay more attention to tax issues than others. Participants at a Travers Smith-sponsored Sustainability and ESG in Taxation conference earlier this month confirmed that there is still a spectrum of views about the right approach for a company to take.
The chart below, from a PRI report published last year, shows that, while many investors are looking for tax efficiency, the focus on reputation as a driver of long-term value, and a concern about the socio-economic consequences of aggressive tax planning, is leading some investors to ask for more information about a firm's tax strategy. PRI signatories will be influenced by the PRI's guidance for investors.
As with all ESG topics, one big problem is data availability – especially data that allow fair comparisons between companies. In 2017, the Global Reporting Initiative – the respected international impact reporting body and guardian of the GRI Standards – launched a project to address that. The resulting tax standard, GRI 207, has been effective since 1 January 2021 and must be used by any company claiming compliance with GRI Standards for whom tax is "material".
While some of the requirements of GRI 207 are relatively straightforward – for example, a company's approach to tax strategy, governance and the control framework – smaller companies and their investors might find other aspects more onerous, particularly the country-by-country reporting requirement. While many large multinational companies are already collecting and reporting this detailed quantitative information privately to tax authorities, others will have to calculate and collate it. The GRI standard also requires reporting companies to explain any "difference between corporate income tax accrued on profit/loss and the tax due if the statutory tax rate is applied", which investors may find helpful but some companies might not wish to advertise publicly.
Many investors are interested in whether investee companies are paying "the right amount of tax, at the right time, and in the right place"