Why tax is creeping up the ESG agenda

A small group of experts and investors are sounding the alarm about how avoiding taxes creates portfolio risks.

In December, the Principles for Responsible Investment described tax avoidance as a “financially material” threat with potential to “undermine market performance”. Earnings, penalties and fines, reputational damage and governance liabilities are related risks, according to the PRI report.

“Underpaying taxes in a country struggling to fund its social systems can affect the performance of that market’s economy,” says Peter Dunbar, the PRI’s head of private equity. But solving the issue is tricky, he tells New Private Markets in an interview.

For one thing, it’s a grey space. One person’s efficient tax structure is another person’s example of egregious or abusive structuring.

There is no consensus “right or wrong for how taxes are structured”, Dunbar says. “There’s an element of subjectiveness.” What makes addressing avoidance even harder, he continues, is that investors must accept “lower short-term gains to benefit from a long-term approach which benefits society as well”.

Bill Burkart, founder of The Investment Integration Project, a group advocating for sustainable investing practices, says investors should be considering “not just your portfolio’s impact, but the context of your portfolio’s impact”.

“An operating environment composed of various societal, environmental and financial systems is, ultimately, what influences long-term performance,” Burkart tells New Private Markets.

For most investors, it seems tax avoidance is “not something [we] have taken a position on,” as a spokesperson for the Washington State Investment Board said in an email to New Private Markets. We reached out to every LP in the top 10 of the Global Investor 100 ranking, published by affiliate publication Private Equity International. None agreed to an interview for this story.

Only one has publicly made tax avoidance a priority for responsible investing: Canadian pension fund manager Caisse de dépôt et placement du Québec. CDPQ highlighted “abusive tax planning” and the “negative impact their use has on public finances in countries around the world” in a report the LP published last April.

Another early-mover asset owner on tax avoidance is Danish pension manager PKA.

In November, PKA said it would begin screening portfolio companies – both listed and unlisted – for indicators of tax avoidance schemes to help maintain “economic sustainability”, in a statement. Jon Johnsen, PKA’s chief executive, said the approach to this issue was “no different” to climate change and pressuring companies to reduce carbon emissions.

“We use our investments to influence companies’ behaviour… this is what we call active ownership, and it is a way to help make a difference,” Johnsen said in the statement.

For GPs, tax avoidance as an ESG issue is something “very few people think about”, a partner at one private markets firm told New Private Markets. That might change soon, as new sustainability reporting initiatives continue to be developed, including the nascent Task Force on Inequality-related Financial Disclosures.

A group of organisations is preparing to launch a new reporting framework to provide investors, policymakers and other stakeholders with guidelines for collecting data about how the investment structures and business practices of asset owners impact economic growth.

Predistribution Initiative, a US-based non-profit organisation supporting financial industry reform, is helping to launch the framework to help reduce “systemic risks to the health of the overall economy”, Delilah Rothenberg, the group’s executive director, told New Private Markets in an interview in January.

TIFD is not expected to launch for a few years. In the meantime, Rothenberg said more work is needed to better understand which practices are fair or foul.

“The industry needs to think about how the funds of private equity managers are structured and whether those funds are structured to avoid paying taxes,” she said. “Where do you draw the line between tax efficiency and irresponsible tax practices?”