Tax as an essential component of the ESG Framework (1)

Part 1: The growing importance of tax transparency for institutional investors

Most governments face unprecedented social and economic costs posed by the recent Pandemic, the current uncertain times of inflation, war, and supply chain crisis. Thus, the recovery of public finances and the economy as a whole is a major challenge for many governments. An important requirement to tackle these challenges is through fair and effective tax revenue collection and distribution. After all, tax revenues are a much-needed financial resource for building a sustainable and prosperous society. However, despite the importance of taxation for a sustainable and resilient society, study estimates that annual revenue losses for countries as a result of aggressive tax planning[1] and tax avoidance[2] structures practiced by multinationals could amount to around 100-240 billion USD.[3] Although these tax planning structures stay within the legal framework, they are often perceived as ethically and morally unacceptable and in conflict with the spirit of the law. During the past several years various multinationals have faced criticism within the (global) media for their tax avoidance efforts and were furthermore a matter of considerable public and political attention.

This article discusses the increased awareness of institutional investors regarding corporate tax transparency, mainly from ESG (Environmental, Social and Governance) perspective.

In this three-part series, regarding the intersection of tax and ESG it will be illustrated that the tax component has seriously paved its way into the three key elements of ESG. By way of illustration, within the E pillar of ESG, there are environmental taxes such as carbon taxes on greenhouse gas emissions and tax incentives for green energy adoption which are vital in driving behavioral change towards a more sustainable world. Furthermore, tax is considered as a critical element in the S (Social) criteria of ESG as it has been given a prominent role in achieving the Sustainable Development Goals, but also due to the growing perception among investors (and other stakeholders) arguing that businesses should pay their "fair share” of taxes as part of their obligation to society. And last but not least, various aspects of taxation play an important role within governance mechanisms (G element of ESG), such as tax transparency, tax risk management, tax strategies, and tax policies reflecting sustainability efforts.

The growing importance of tax transparency for institutional investors

1. Institutional investors prioritize tax transparency to safeguard against risks associated with investees' aggressive tax behavior and protect cash flows and investor returns.
   There is growing evidence that investees' aggressive tax behavior and/or lack of tax transparency may expose institutional investors to unnecessary regulatory, financial, and reputational risks. As such, aggressive tax avoidance and/or a lack of tax transparency can reduce future cash flows and negatively impact investors' risk/reward profile and equity returns because of unexpected tax liabilities. For this reason, institutional investors attach great importance to tax transparency.
   
   
2. Investors realize that (corporate) tax payments are an important precondition for a business environment for generating positive returns.
   Some significant contributions of companies to society and financial markets cannot be denied as evidenced by employment, innovation, and production. However, one of a company's most essential contribution to society lies in its tax payments. Investors recognise the importance of (corporate) taxes to society and strong government institutions as being in their interest. After all, a society characterized by lacking good infrastructure, poor health and social services, unpredictable legal system, or weak security (in most developed countries all funded by tax revenues) is not able to provide a strong framework for its companies and investors to grow, innovate and expand.
   
   
3. The impact corporate income tax can have on a company’s profitability.
   For investors it is important to determine whether a firms' future cash flow is generated from a genuine business performance, as these inflows also could be attributed to other factors such as dodgy tax exploitation scheme or allocated subsidies. Therefore, in assessing a company's earnings and forecasting its future profits, investors must be able to have a clear view on a company’s structure and underlying transactions. Tax avoidance structures which are not known can compromise the above-mentioned assessment mechanism as they may disguise financial flows and transactions.
   
   
4. Investors attach significant importance to sustainable corporate tax policies of companies that are resistant to regulatory change and stakeholder scrutiny.
   The increased interest in the fairness of tax payments by multinationals has spurred various initiatives, by governments, policymakers, NGO’s, and institutional organizations aiming to improve tax transparency and responsibility, with examples such as: The  OECD/G20 BEPS Project, the EU Anti-Tax-Avoidance Directives (ATAD I and ATAD II), the amended EU Parent-Subsidiary Directive, the GRI 207: Tax Standard, the Sustainable Finance Disclosure Regulation (SFDR) of the European Union,  The EU Public Country-by-Country Reporting (CbCR) directive, The UN PRI guideline on how institutional investors can integrate responsible tax issues within their ESG Framework, the latest DAC 6, requiring reporting of potentially aggressive transactions in corporate tax matters, the prominent role of taxation within the UN Sustainable Development Goals (SDG’s) and other guidelines, benchmarks, and scorecards developed by NGO’s on good tax governance and tax transparency.

Conclusion

Due to societal expectations, tightening regulations and weakened public finances, tax avoidance activities of multinationals have come under increasing scrutiny in recent years. Among the many stakeholders within this landscape, institutional investors increasingly assess the tax risks (reputational, governance, and earnings risks) in their portfolio and implement tax issues within their ESG framework. Tax issues are therefore increasingly part of institutional investors’ ESG Framework and investors demand greater transparency from their (potential) investees. In the next edition, the discussion will center on the Intersection between ESG and Tax in practice.

The coverage of this subject will unfold in three separate editions. The first edition will emphasize 'The growing importance of tax transparency for institutional investors,' followed by an exploration of 'The Intersection between ESG and Tax in practice,' and finally, an in-depth look at 'Institutional investors’ expectations on tax transparency.

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[1] Aggressive tax planning refers to, setting up artificial structures without any commercial or economic justification with the aim to pay as little tax as possible. See Calderoآn, C.J.M. (2016). The Concept of 'Aggressive Tax Planning' Launched by the OECD and the EU Commission in the BEPS Era: Redefining the Border Between Legitimate and Illegitimate Tax Planning. Intertax, 44, 3, 206-226  

[2] Tax avoidance refers to intentionally seeking weaknesses, mismatches, and gaps within (international)

tax laws and regulations to reduce tax liability. Although these tax planning schemes stay with the legal framework, they are often morally unacceptable and conflict with the spirit of the law. See Guenther, D. (2014). Measuring Corporate Tax Avoidance: Effective Tax Rates and Book-Tax Differences. SSRN

Electronic Journal.

[3] See https://www.oecd.org/tax/beps/