“It’s the uncertainty that’s the challenge. It makes it really difficult to make these long-term decisions on big projects in infrastructure,” a senior exec at IFM Investors, a global investment management firm, told me recently. Uncertainty is certainly everywhere in today’s market. But this wasn’t the Head of Investments or Operations; this was Rose Li, IFM’s Head of Commercial Tax.
Given all of the uncertainty in the world, the tax environment is a place that one might expect a certain level of stability. Far from it. In fact, the events surrounding the pandemic have added impetus to underlying global trends that were forcing tax authorities and policy makers to radically rethink the role tax plays in the economy. Particularly when it comes to infrastructure.
Around the world, we are seeing governments and competent authorities debate the potential for catalyzing increased investment into infrastructure, including through tax reform. But are these initiatives actually driving real change in institutional capital flows?
Off the mark
According to Martin Boily-Côté, Managing Director of Taxation at PSP Investments, many of the current tax incentive programs are a poor fit for some institutional investors. “Increased depreciation [allowances] and exemptions tend to benefit those investing into greenfield developments; rate reductions are great but we have concessions related to our ownership that put us in a great tax position already,” notes Boily-Côté.
Indeed, the general consensus is that specific tax incentives are rarely amongst the leading considerations when deciding on investment flows. “Tax is never a driving force in terms of the investments we make,” says Li. “Rather, we see tax as one of the risks and potential areas of opportunity that we need to understand when we’re making decisions as an infrastructure investor.”
In this respect, certainty is the key factor that institutional investors are looking for. “We’re long-term investors so we don’t really like to see significant tax changes during the holding period. It’s almost never a good surprise,” says Boily-Côté with a sigh.
“I think that uncertainty piece and how different investors view that uncertainty is something that is becoming a differentiator when it comes to investment decisions,” adds Li.
Eyes watching the horizon
There is certainly growing uncertainty in the global tax environment. Institutional infrastructure investors are keenly watching proposed changes to tax legislation and rates in the US and the UK, for example. They are also assessing the potential impact of multilateral activity on the tax agenda. The OECD’s BEPS Pillar Two initiative is near the top of the dashboard.
The need to consider various types of investors as well as entities under a fund platform adds uncertainty for asset managers in considering Pillar Two, notwithstanding a proposed investment fund exception. “At this point in time, exactly how this minimum tax concept that is being proposed will apply to a managed fund is a bit of an unknown. It’s going to be something to watch,” notes Li. Sovereign wealth and pension funds, on the other hand, seem more confident. “I think it’s now clear that we’re exempt from Pillar Two, but the devil is always in the details,” adds Boily-Côté.
Many investment decision-makers are also spending a lot more time thinking about what tax authorities might do in the future and how public sentiment towards tax is changing. “It’s not just understanding the uncertainty of upcoming legislative change,” suggests Li. “It’s also understanding factors that are very market driven, understanding the market sentiment, the sentiment of the local tax authority, and being able to anticipate the next change.”
Keep it simple
The challenge is being able to balance that risk calculation against the impact on the value of the current portfolio and the ability to compete for investments. “We do all sorts of sensitivity analysis when we look at potential investments, but we generally base our decisions on what we know,” explains Boily-Côté. “Otherwise, we’d be way too conservative in our models and this is a very competitive world we are operating in.”
However, both Li and Boily-Côté agree that uncertainty and unnecessary complexity in tax regimes can impact the economics of a deal and the effectiveness of any planned incentives or stimulus. “When you simplify the tax regimes and tax outcomes for foreign investors, it does make it easier for people to invest,” notes Li. “For example, when the US introduced the qualified pension fund exemption, that made it much easier for investors to get comfortable with an investment from a tax perspective.”
Other reforms, particularly those that take years to materialize or those that are overly complicated or uncertain, are likely to fail. “Ongoing tax reform creates uncertainty – not just in the way the legislation will change but also in the way that the laws are administered,” argues Li. “It’s the latter that can be particularly difficult.”
“Returns are already so tight, any change in the tax environment can turn a good investment into a bad one very quickly,” adds Boily-Côté. “What we need is for tax reforms to be predictable so we can have some certainty about our current investments.”
For policy-makers and tax authorities the takeaway is this: certainty in the tax environment can do more to attract institutional capital than tinkering with incentives and legislation.
For institutional investors, the takeaway is that the uncertainty is not going away any time soon. Understanding and managing the changing tax environment will continue to be a key capability for institutional investors and asset managers going forward.