One of the lesser-discussed principles of responsible investing in a growing mass of information about ESG principles and practices, is that investors should adhere to ‘good tax citizenship’. What does this mean for practitioners?
Researchers at Parametric, the implementation specialist manager, have grappled with the philosophical and practical elements of practicing after-tax optimisation of returns alongside good tax citizenship. They published a paper last week (November 14) entitled ‘Tax-Managing a Responsible Investing Portfolio’.
The authors, Raewyn Williams, Parametric Australia managing director and head of research, and analyst Josh McKenzie, say: “Overlooking the tax implications of day-to-day investment decisions risks [a super] fund breaching its legislative duty to manage taxes; but, of course, aggressive tax planning could ‘out’ a responsible-investing fund as inauthentic and hypocritical if they are criticising companies for such acts.”
That’s the problem. The solution, they suggest, is to adopt a sensible framework akin to the way ‘responsible’ companies think about tax, which will easily reconcile the two principles, while adding 25-60bps to net returns with relatively little impact on risks.
They use an exemplar portfolio from Calvert, a sister company within the Eaton Vance group which specialises in sustainable investments, to show how a super fund could implement this portfolio in an after-tax focused way. Unlike most of their international peers, Australia’s super funds pay tax, so the problem is peculiar to Australia.
A part of Calvert’s stated beliefs is that “most corporations deliver benefits to society, through their products and services, creation of jobs, payment of taxes, and the sum of their behaviours”.
“The principle, part of the ‘G’ in ESG , motivates Calvert to exclude from its modified index portfolio companies in the MSCI universe fined for breaches of tax law or are subject to public tax controversies which allege that the companies have engaged in aggressive tax planning,” the paper says. “For example, ‘FAANG’ tech stocks have flexibility over the sources of their profits (the ability to ‘profit-shift’) and, some argue, pay relatively little tax in high-corporate tax jurisdictions given the size of revenues attributable to that country. When the UK in December 2014 passed a ‘diverted profits tax’ to address this problem (with Australia following suit in 2017 and France last year), it was quickly dubbed the ‘Google tax’.”
Under an APRA guidance note, SPG 530, super funds must ensure that ESG considerations don’t impinge on portfolio characteristics such as risk, return, diversification and liquidity. Parametric’s test translates the Calvert ESG-orientated fund characteristics over the most recent five-year period to those received by a super fund client, adding 50bps to the risk budget to cater for implementation of tax management to the original portfolio.
In their conclusion, the authors say that the increase in risk budget is rewarded by better returns, but the year-on-year journey can be bumpy. “We can further encourage a superannuation fund uneasy about if and when its responsible investing convictions might pay off financially for fund members: our hypothetical tax-managed responsible investing portfolio added a quarter of a per cent in after-tax returns each year over a non-tax-managed version.
“If one is prepared to treat the pre-tax performance impact of tax management as random (centring on zero through time), the benefits of tax-managed responsible investing may be closer to 60bps each year. For a super fund prepared to take on active risk to implement responsible investing, it seems an easy and useful extension to add a much smaller risk budget to pursue responsible investing in a tax-managed way, with results that are smoother, measurable and more immediately harvestable.”