THE COST OF TAX AVOIDANCE
As the Starbucks example shows, the impact of tax risk can be very meaningful. Companies that are forced to pay more tax could end up paying a considerably higher amount of pre-tax profits away. That money will no longer be shared directly with shareholders or reinvested in the company and their future earning may be lower than previously thought, which could spark a fall in the company’s share price, for example.
“If tax takes a bigger proportion of earnings, a company could see a situation where there are earnings downgrades or dividend cuts,” says Richard Marwood, equities fund manager at Royal London Asset Management (RLAM).
Although shareholders’ interests are arguably aligned to those of a company in terms of trying to minimise tax and maximise profit, tax risk clearly raises questions about performance sustainability.
“Paying unsustainably low levels of tax and taking advantage of loop holes will likely weigh on valuations,” says Leon Kamhi, head of responsibility at Hermes Investment Management.
RLAM’s Marwood says: “As shareholders we want companies to pay as little tax as possible, but we don’t want those companies to be too aggressive with their tax policy as that creates unsustainability. We want them to be pragmatic, but not over-aggressive.”
Tax risk also has the potential to create significant shocks for individual companies.
In August, Brussels slapped Apple with a bill for €13bn plus interest in unpaid tax after it emerged the company had paid only 0.005% tax on its European profits for more than 10 years despite a corporation tax rate of 12.5% in Ireland. The Irish authorities, who are contesting the EU’s decision, allowed Apple to transfer profits to a subsidiary with no staff or location that paid no taxes.
Aside from the direct financial implications, there are also reputational issues associated with companies that avoid tax. Marwood says Apple, like Starbucks, has been “tarnished” by revelations of its tax practises.
According to Alan MacDougall, managing director at Pensions & Investment Research Consultants (PIRC): “There is a reputational damage risk that could spill over to shareholders.”
With the mood music changing towards tax avoidance, it is easy see how investors could face a similar backlash against their investment practices if they are found to invest in tax avoiders as many have with their fossil fuel holdings.
EXPECT MORE NAMES
The collection of brands that have so far been named and shamed as tax avoiders is also likely to be the tip of the iceberg. The list will undoubtedly grow as governments close loop holes in their efforts to address inequality, but also to raise much needed revenue to address the burgeoning debt mountain that continues to develop in the post-crisis era. The threat of a potential normalisation of tax rates is increasingly real. Theresa May in her Conservative Party speech in October put business tax dodgers ‘on warning’ saying: “an economy that works for everyone is one where everyone plays by the same rules.”
Most notable, however, is the Organisation for Economic Cooperation and Development’s (OECD) efforts on behalf of the G7 and G20 to address tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to tax havens where there is little or no economic activity.
Their inclusive framework brings together over 100 countries and jurisdictions to collaborate on the implementation of the Base Erosion and Profits Shifting (BEPS) Package. Recommendations such as these, which should work to prevent companies like Apple transferring profits in the manner they have (interestingly, Ireland is a BEPS collaborator), may take a long time to be translated into local law, but they set a clear direction of travel.
And that direction increases the risks of companies coming up against the tax authorities in the future. Corporate tax risk is therefore on an increasing trajectory and presents a growing challenge to investors in their efforts to reduce investment risk – especially where it is not rewarded.
