With much written about the relationship between strong environmental, social, and governance (ESG) practices and corporate performance, Institutional Investors are integrating ESG factors into investment decisions. Investment managers and portfolio companies are also adopting sophisticated ESG practices as a critical part of risk management and as a means to differentiate their business. Tax is playing a critical role in the developments.
Institutional investors are starting to use this information to make informed investment decisions. One large Institutional Investor vocally supports ESG issues, excludes companies it has determined as not ESG-compliant from their investment universe and has even publicly divested from companies with weak or no reporting related to tax and transparency. Other Institutional Investors are also taking public positions on ESG. A group of Danish pension funds have developed and signed a Tax Code of Conduct to help support goals of responsible tax behavior in their investments and through their investment partners. Actions like these underscore the public approach investors are taking in supporting tax as a critical component of ESG.
Components of an ESG tax program
The tax considerations of establishing an ESG program often begin with the evaluation of the investor’s tax framework as well as that of investee companies and their third party investment managers. In connection with this, the creation of a tax risk appetite statement is a starting point.
The potential benefits of a tax risk appetite statement are:
- increasing transparency and accountability of the investor’s current and future risk profile
- improving decision-making on risk mitigation (i.e. accepting, reducing, avoiding or transferring risk) and performance management (i.e. risk versus return)
- strengthening risk awareness as part of an enterprise wide risk culture.
The tax risk appetite statement can often be part of a broader, enterprise-wide, risk governance framework.
In terms of evaluating ESG and Tax, investors should consider how tax risk is managed by its investment partners. Investors may want to assess the impact of tax risk through their relationships with its investments in investee companies and third party investment managers. For example, as part of tax due diligence, investors should consider the following:
- Does the investee company have a tax risk statement?
- Does the manager have a tax risk policy?
- Is tax risk included as part of the board’s risk oversight function?
- Is the tax function of the investee company or manager adequately staffed?
- Does the investee company or manager make use of complex structures?
- What level of tax risk is the investee company or manager willing to accept?
- Are tax risks adequately disclosed?
- Does the investee company’s ETR seem reasonable, both in the aggregate and by jurisdiction?
- Does the manager report an ETR? Are returns identified on a pre and post-tax basis?
The ability of an investor to conduct diligence of the tax position of its investment partners will depend on numerous factors, including the level of investment. This relationship may generally correlate with the level of control, since an investor seeking a majority position will generally have a greater ability to influence the tax risk policy of an entity through board seats or other interactions. However, given the high profile of many Institutional Investors, they could be criticized for investments that do not follow ESG principles as they apply to tax regardless of the investor’s level of investment or control. Therefore, it will likely be important for Institutional Investors to carefully consider the consequences of investments with parties that are less than fully transparent about their tax risk profile.
Institutional Investors are integrating ESG factors into their stakeholder discussions and institutional policies. Governments, NGOs, investment managers and portfolio companies are rapidly developing sophisticated ESG policies, measurements and practices. Tax is a critical component in the developments.
The direction of travel seems clear. Integration of ESG factors has become a core part of the investment process and Institutional Investors must stay ahead of the curve to avoid tax, reputational and other risks that might arise.
The journey will vary by institution. Each Institutional Investor will need to determine the aspects of ESG that are relevant to its investment strategy and material to potential investment companies and managers.