Paying a fair corporate tax rate matters

Paying a fair rate of corporate tax is an important contribution that companies make to society. If companies are proactively seeking to minimize their tax payments, this should be seen as a red flag.

Economists at the International Monetary Fund estimate that global corporate tax avoidance costs governments between US$500 and US$600bn every year.1 This includes $200bn in revenues being channelled away  from low-income economies, which is more than these countries receive in foreign aid each year.2 These vital resources could be spent on improving education, health and social services, as well as supporting sustainable development and contributing to a fairer and more equal society.

As governments around the world continue to ratchet up higher levels of debt following the Covid-19 crisis, this loss of tax revenue becomes even more critical. Since the 2008 global financial crisis, large companies have been paying lower rates of tax on average.3 Big tech firms in the US have come under the spotlight for their tax avoidance antics. A study by the UK transparency campaign Fair Tax Mark, found that six of the largest tech firms, including Amazon, Facebook and Google, have been ‘aggressively avoiding’ the payment of taxes, totalling US$100bn over the past decade.4 Regulators are starting to pay attention, especially in Europe and the UK. Governments are beginning to roll out digital taxes.

Legal loopholes

Corporations today can legally avoid or minimise their tax bill in various ways. For example, they can set up foreign subsidiaries in tax havens, such as the Cayman Islands, or use transfer-pricing to shift profits from one division to another. These tactics may be seen by some as ‘sensible business’. Some investors even celebrate when companies pay minimal tax. On the contrary, we believe that deliberate and systematic tax avoidance strategies can contribute to inequality, weaken our social fabric and reduce the ability of governments to make societies fairer and safer for all citizens.

As long-term investors, we seek to invest in high-quality companies that are well placed to benefit from and contribute to sustainable development. We look for companies led by exceptional people, who have strong ethics and long-term time horizons.

Paying a minimal amount of tax today may benefit companies in the short-term, but does not help build economic strength in the long-term. Studies have shown that higher taxation is associated with higher spending in health care and education, particularly in low-income countries, as well as helping to build a more responsive, accountable and capable state.5 The Austrian economist Joseph Schumpeter famously explored the link between tax and more responsible spending by governments over  a century ago.6 

A low tax rate is a risk

Paying low levels of tax can also be a source of significant risk to future cash flows within companies. In India, for instance, the government has been charging an additional 18% interest rate on disputed balances over years – this can quickly compound into a serious liability.7 It can also lead to reputational damage for companies. Ultimately, a dollar or rand or rupee of earnings at the legitimate company tax rate is worth more to us than the same earnings at a tax rate half the level or less.

When we come across a company proactively trying to minimise their tax payments, it is a red flag for us.

If the management team is comfortable to cut corners in tax, they may be more likely to cut corners elsewhere.

As such, tax is a key topic that we raise with companies as part of our engagement activities.

We actively engage on tax

One of our most prominent tax engagements in the past decade involved a large pharmaceutical company. This company used complex structures to reduce tax rates to mid-single digits that lasted for nearly a decade. We felt these structures violated the spirit of the law and increased the risk to future cash flows. Lengthy engagement did not lead to much progress and we were left with no choice but to sell our holdings. Today, many years later, governments are demanding half a billion dollars in back taxes from the company. The company is also fighting several antitrust cases and had failed to report a material related party transaction – a stark reminder that governance lapses do not happen in isolation. 

Assessing tax rates on their own is obviously not enough to make a full assessment of the quality of the management or the financials of a business. However, it is a very useful piece in the “quality assessment jigsaw puzzle” that investors should consider during their appraisal of a company.

Lorna Logan, Senior Investment Analyst
May 2021

For illustrative purposes only. Reference to the names of each company mentioned in this communication is merely for explaining investment insight and Stewart Investors does not necessarily maintain positions in such companies. Any fund or stock mentioned in this presentation does not constitute any offer or inducement to enter into any investment activity nor is it a recommendation to purchase or sell any security.

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