Tax risk presents a material threat to financial outcomes that investors are largely ignoring.
Stick with me here… I know I’m prone to droning on about the importance of corporate tax in solving the world’s ills, but there is also a very strong risk management angle to this story.
It boils down to this: corporate tax risk is a growing threat to financial returns and, by extension, sustainable investment. But it is not being taken seriously enough.
New research from MSCI has found that a quarter of companies in their ACWI Index have a large tax gap (531 out of 2,160) and are paying an average rate of 14.3% versus the 31.8% that would be expected based on the jurisdictions where they generated revenue. Furthermore, 71% of those with large tax gaps were multi-nationals.
Were the entire gap to be plugged by regulatory reform, the report says, MSCI ACWI Index constituents would have faced additional annual tax liabilities of up to $220 billion in aggregate. $150 billion of that would fall on multi-nationals.
This is no small sum. And should serve as a wake-up call to investors who, to date, aren’t paying enough attention to the risks associated with corporate tax. To put this into some kind of context, $2.7 trillion in assets was benchmarked to the MSCI ACWI index family alone in June 2016.
Regulatory reform on corporate tax has admittedly been very slow and still has a long way to go to catch up, but there is a strong and building movement focussed particularly on cross-border tax avoidance.
Regulators are increasingly focussing on country-by-country financial disclosures, for example. Yet, according to MSCI’s research, less than half (45%) of multi-nationals in the MSCI ACWI Index produced this kind of report for at least 75% of their total revenues as of 1 Nov 2016.
The OECD is among those trying to stop multi-nationals exploiting tax gaps or engaging in tax-regime arbitrage to artificially shift profits to tax havens even though they have little economic activity in those havens. The OECD is already collaborating with over 100 countries on its Base Erosion and Profits Shifting (BEPS) Package, for example. So while the path may be slow, the direction is set.
Even President Trump – hailed for his plans to cut headline corporate tax rates to as little as 15% - may present tax risk rather than relief for many companies. As part of his plan, he will do away with some deductions, including for interest on future loans, which currently makes it attractive for companies to technically move their domicile out of the US. According to Morgan Stanley, interest deductibility is the third largest corporate deduction at $455 billion. If Trump’s plan eliminates or severely limits those deductions, a lot of companies will feel a lot of pain. And that pain will be shared with equity and credit holders alike.
Investors’ lack of recognition on tax risk sits in contrast to other areas, where the political mood is also forcing change. They have increasingly recognised the risks associated with climate change, for example, and, as more and more countries ratify COP21, are beginning to take things much more seriously. More broadly, the financial world is beginning to take clear action on climate risk: HSBC has tightened lending to palm oil producers, one of the key contributors to deforestation. Similarly, Moodys have downgraded the credit ratings on palm oil producers.
Yet, just like climate change, corporate tax risk will also have a genuine impact on financial outcomes. If, as the OECD is recommending, interest deductions are capped at 10% of EBITDA, 40 of the 381 multi-nationals with a high tax gap in MSCI’s research “could see upwards of a 10% increase in their taxable income (and hence tax payout), with some potentially looking at 100% or more’.
And how long can it be before the credit ratings agencies start to build tax risk into their ratings in a more systematic manner?
It goes without saying that more tax payable means lower profits after tax and, in turn, lower share prices and/or lower dividends, but also lower credit-worthiness on bonds. It also means corporate sponsors may be inclined to cut contributions designed to plug pension deficits. Thus, tax risk can manifest itself in investors’ outcomes in a huge variety of ways (not to mention the wider impact of rising inequality).
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A quick cuppa with Faith Ward, Chief Responsible Investment and Risk Officer, Environment Agency Pension Fund