Assessing the sustainability of companies’ tax strategies

Assessing the sustainability of companies’ tax strategies

13-09-2018 | Article
Companies can lower their tax burden and boost their profits by exploiting tax competition between countries or regions. Investors will appreciate the resulting increase in company value, but also should not overlook the risks arising from all-too aggressive tax optimization. RobecoSAM’s Corporate Sustainability Assessment (CSA) captures these risks through a specific tax strategy criterion.
  • Increasing public scrutiny and criticism of corporate tax practices have amplified related risks for companies
  • Transparent tax reporting has become part of the CSR best-practice catalog
  • RobecoSAM’s tax strategy criterion seeks to identify instances of potentially harmful tax optimization to assess the sustainability of companies’ tax policies and strategies

Multinational companies have attracted significant public scrutiny and criticism in recent years amid concerns that they are not paying their “fair share” of tax in all of the jurisdictions in which they create value. A key initiative in this respect, the OECD’s base erosion and profit shifting (BEPS) project seeks to tackle tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations, with more than 100 countries and jurisdictions collaborating to implement the BEPS actions. Indeed, recent years have seen numerous examples of authorities taking action to recover lost tax revenues, resulting in large settlements that impact companies’ future earnings.

Against this background, taxation issues are becoming increasingly material, with important implications for sustainability arising from key risks such as reputational risks with a potentially negative effect on brand value; threats to companies’ license to operate through a deteriorating relationship with the host country; direct financial risks from potential changes in tax regulation, and economic development risk as a result of strapped public budgets.

The tax strategy criterion in RobecoSAM’s annual CSA captures the materiality of corporate tax strategies for companies’ long-term value and sustainability by assessing their transparency with respect to tax and taxation risks. It comprises three questions on companies’ tax strategy, their tax reporting, and – new this year – their average effective tax rate, which are complemented by a Media and Stakeholder Analysis.

Tax strategy – digging deeper

As tax avoidance strategies are often legally watertight, a general statement in the financial report that the company intends to comply with all applicable tax laws and regulations is not sufficient. As KPMG puts it, “every company should be in a position to give a coherent justification of their approach to key tax issues such as the use of tax minimization techniques, which is consistent with their approach to other CSR issues.”

With its tax strategy question, RobecoSAM seeks to determine whether companies have published a clear and transparent tax policy or strategy that addresses sensitive or high-risk tax issues and covers at least five key elements:

  • a commitment to compliance with the spirit as well as the letter of the tax laws and regulations in the countries in which the company operates
  • a commitment not to transfer value created to low-tax jurisdictions
  • the use of tax structures intended for tax avoidance
  • the company’s approach to transfer pricing
  • the use of so-called “tax havens”
Figure 1 shows that the aspect most frequently included in global companies’ tax strategies is a corporate commitment to compliance with the spirit as well as the letter of the law, followed by a statement regarding the company’s approach to transfer pricing.
Source: RobecoSAM Corporate Sustainability Assessment (CSA) 2018

Effective tax rates – scrutinizing deviations

RobecoSAM’s tax rate question assesses companies’ reported tax rates and average cash tax rates for the last two years to determine any discrepancies between reported and expected tax rates. While often legitimate, large differences may indicate overly aggressive tax optimization, which in turn may represent a potential source of risk for a company.

After determining the average effective tax rates and average cash tax rates across 24 GICS® industry groups, we communicate these averages in advance so that companies can see how their rate compares with that of their industry peers. Companies with a tax rate below the industry group average are scored on their distance from that established average.

In order to avoid penalizing companies with reasonable explanations for their deviation from the average, companies are offered the option to explain exceptionally low tax rates. Argumentation that is either unreasonable or unsupported by public evidence is not accepted. Acceptable reasons for low tax rates include:

  • Group-wide net operating losses that can be used to offset positive taxable income
  • One-time losses in own operations, for example, resulting from write-offs of a major investment, a large settlement or a fine
  • Net operating losses from acquired companies
  • Single jurisdiction tax code in the case of companies domiciled in a country with a low corporate tax rate, such as Ireland, that generate no more than 10% of their sales abroad
  • Timing issues relating to an event that happened outside of the two-year assessment period and was carried forward to the last two fiscal years

We anticipate some small changes to the tax rate question in the 2019 assessment based on feedback from companies. This will include the use of three-year rather than two-year averages of effective tax and cash tax rates; auto-calculation of the rate on the basis of the figures reported, and further clarification and definition of the acceptable reasoning for tax rates below the industry average. Given the fact that tax rates vary considerably even within industry groups, we are also considering applying industry-specific scoring in coming years.

Figure 2: Frequency of Low-Tax Rate Reasons Reported by Region
Source: RobecoSAM Corporate Sustainability Assessment (CSA) 2018

Note: The high occurrence of emerging markets companies subject to a single jurisdiction tax code is arguably due to the smaller size (and thus smaller base of operations) of companies invited for DJSI Emerging Markets and other related indices.

This Insight is based on RobecoSAM’s 2018 Annual Scoring and Methodology Review.