Engagement step one: identifying red flags

Step one: engagement candidates: identifying red flags in portfolio companies

Large tax gap

A good indicator of potential earnings risk is the difference between the effective tax rate on a company’s income statement and the weighted average of statutory rates based on the firm’s geographic sales mix8. Although the mismatch may be explained by factors unrelated to tax minimisation, such as tax credits, large and persistent tax gaps are generally the result of profit-shifting and aggressive tax planning.

Foreign effective tax rate

The foreign effective tax rate can be calculated using foreign profit data and current and deferred foreign tax data, which are both found in the tax footnote. Applicable primarily for companies based in a jurisdiction with a worldwide taxation system (e.g. the US), this rate can be then compared to the average statutory rate of the countries where the company does business, and a significant gap may call for further dialogue.

MNEs can choose to deem some deferred foreign profit as likely to be repatriated in an effort to cause their global tax rate to more closely resemble peers’ or typical statutory rates, even though the company may not intend to actually repatriate the foreign cash. This decision will make the tax gap red flag outlined above appear acceptable, when the company may actually be highly aggressive in its tax planning.

Large or growing unrecognised tax benefits (UTB) balance

Also known as uncertain tax positions, UTBs display the tax positions being taken by a company that management believes are less than 50% likely to be upheld by a tax authority. A large balance compared to peers (which can be calculated by dividing each company’s UTBs by its enterprise value), or a growing balance, suggests a company that has recently adopted higher risk tax strategies has faced a change of position from relevant revenue authorities.

New disclosures or changes in language used in tax footnotes

Although disclosure in tax footnotes is generally minimal, some companies provide information regarding recent changes to their tax strategies that may not have been reviewed by tax authorities and hence may increase earnings risk in future.

Opaque disclosure of geographic revenue mix

Particularly when combined with any of the above red flags, poor disclosure of geographic revenues may hinder the ability of an analyst to assess the tax gap.

Media stories or government inquiries

Although these do not necessarily signify any wrongdoing, they are valuable in determining specific tax strategies used by a company – especially if there are repeated mentions – and are highly indicative of reputational risk. The company’s response to any allegations may also be a good proxy for the board’s risk tolerance related to tax practices.

Lack of a tax policy

Disclosure of how the company perceives and addresses tax-related risks, including information on overarching policies and governance of the issue, is critical. While many companies still do not provide any meaningful narrative or disclosure beyond numbers in their annual reporting, examples of good practices in this regard have emerged. Leading MNEs should be expected to follow this model.

A company having multiple subsidiaries in tax havens may also constitute a red flag, although there is no globally accepted definition or list of tax havens, inclusion in some lists has been heavily contested by some countries and full disclosure of subsidiaries is often lacking (many US companies have dramatically reduced the number of disclosed subsidiaries over the past few years). Investors, however, can make use of information provided by regional and national regulators, or organisations such as The Tax Justice Network (Financial Secrecy Index).

When prioritising which companies to engage with and preparing to engage them, investors should also take into account sector-specific, region-specific and companyspecific factors:

Sector-specific risk	Certain sectors have developed a reputation for aggressive tax planning, as they are more exposed to scrutiny (e.g. consumer goods), or are well placed to employ different strategies (e.g. IP rights at pharmaceuticals). Aspects of recent or upcoming legislation may be more pertinent to some sectors (e.g. focus on technology though BEPS, obstacles to M&A activity by Pharmaceuticals).
Regional tax systems	Depending on a company’s domicile, location of headquarters and business operations, tax-related risks may change significantly, especially in the absence of a global tax system. Political agendas, national government’s approach, media and consumer pressure may play a significant role.
Company profile and operations	The company’s structure, history and nature of activities should be taken into account. For example, presence in a tax haven as a result of past M&A activity may be acceptable.

We select companies in three stages:

• Stage one is using company reports and other data to find out the weighted effective tax rate and how much this deviates from the actual rates.

• Stage two is broadly looking at what sort of tax policies these companies have.

• Stage three is looking at publicly reported cases of inappropriate tax practices within our portfolio companies.

Steven Bryce, Arisaig Partners (Asia) Pte Ltd

 

 

 

 

 

Download the full report

• 

  Why and how to engage on corporate tax responsibility

  March 2016