Stock Markets, Pension funds, PE ratios and tax avoidance

“The pension fund community has been surprisingly quiet about aggressive tax avoidance engaged in by the companies they invest in, but there are signs that their attitude towards corporate tax is changing.” So reports the FT.

The lack of interest in corporate tax by pension funds has long surprised me, given the long term focus of most funds and the risk assessment framework they follow on investments. So the press release by  a group of institutional asset owners and managers  including the £150B UK Local Authority Pension Fund Forum (LAPFF) Quebec pension fund Batirente, Royal London Asset Management (RLAM), Paris based OFI Asset Management & Triodos Investment Management from the Netherlands is significant. They state:

“Modernising the international taxation framework cannot be separated from global financial integrity, rebuilding trust and strengthening resilience in international financial structures and investment markets.” LAPFF Chair, Councillor Kieran Quinn said.

“As international investors, ensuring sound governance practices are embedded in corporate activities, including taxation planning and associated reporting and disclosure mechanisms is a fundamental concern.”

“Financial secrecy, opaque accounts and aggressive tax practices do not best meet our underlying objectives as inter-generational investors aiming for sustainable value creation.”

“We urge G20 Leaders to ensure transparency and disclosure, are directly embedded as core principles in relevant tax treaties and national agreements and to work towards a comprehensive multilateral agreement at G20 2015.”

“In addition, we call on transnational corporations to recognise that many existing financial practices around secrecy and taxation are not sustainable and no longer meet institutional investor governance expectations nor reflect growing civil society views of responsible, transparent corporate behaviour within a licence to operate.”

But what this statement doesn’t address is the value impact of such a stance on pension funds and pension fund beneficiaries. All members of pension funds or schemes benefit from tax avoidance in that this lowers the provision that they need to make for pensions and increases the income from their pension fund while it accumulates and when it pays out. The elephant in the room here is the  price /earnings ratios of companies which pension funds invest in (the same issue applies to all share based investment vehicles). I’ve been surprised by the fact that there has been little coverage of the impact of BEPS changes to PE ratios and hence share/stock prices.

Let’s assume a group has a tax rate of say 15% (which is low by anyone’s  standards but not uncommon amongst the largest companies in the world) and a PE of 20 (which broadly applies to the sector it is in). Under a robust outcome from BEPS one might expect that tax rate to increase as the benefits of hybrid mismatches, etc decrease and let us assume that the tax rate for this particular company increases to 25%. What is the impact? Well if earnings are currently forecast to be 170 (200 with a tax charge of 30) then earnings will decline to 150 (200 with a tax charge of 50). So earnings will decline by 12% and if the PE ratio is not affected by this change then the share price will fall by the same amount. This might not seem a large amount, but for a Group with a market cap of $10bn it’s the not insignificant sum of $1.2bn. In addition, with a lower level of earnings, one would expect that the dividend paid would fall as well.

Now this is a gross oversimplification, of course. However, what surprises me is that investors do not appear to be focussing on this and realising that a proportion of earnings from Groups with low tax rates might be more risky than they were, if BEPS has a significant outcome – which is what we are being told by the politicians at the G20.

So who is going to economically bear the cost of increased tax as a result of BEPS changes? Will it be the investors, the Group’s consumers or the Group’s employees? If share prices were affected by this amount, pension funds and pensioners will be affected by both the fall in the value of investments but also the income from a dividend stream which will also fall.

Is the investment community sleep-walking into this issue?


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