Why we believe tax is under-analyzed, and how it informs our broader view of governance.
- We believe a global minimum corporate tax rate of 15% would be immaterial for the stock market overall.
- But it could be material for some companies, particularly in the technology and health-care sectors.
- Tax analysis adds value to our holistic-assessment approach both directly, via forecasting likely future tax rates, and indirectly, by informing our assessment of operational risks and overall governance.
Finance ministers from the Group of Seven (G7) nations have reached a landmark accord backing the creation of a global minimum corporate tax rate of at least 15%. The political motivation is based on the widespread view that large companies don’t pay their fair share of tax, because they are able to shift profits to tax havens, as well as the need to finance public-spending commitments.
The Impact of a Global Minimum Tax Rate of 15%
Let’s consider the companies in the S&P 500. Only one in seven companies has an expected tax rate below 15%. If we exclude real-estate companies, which have special tax rules which are not expected to change, only one in 11 companies, the majority of which are in the information technology and health-care sectors, has an expected tax rate below 15%. The average expected tax rate is 11% for these companies, so if this rate were to rise to 15%, their post-tax profits would fall from 89% of pre-tax profits to 85% of pre-tax profits, a 4% reduction. For the S&P overall, the impact on earnings would be less than 1%.
This analysis is overly simplistic, because the proposed 15% minimum tax is on a country-by-country basis, rather than on an overall basis. For example, a company with half of its profits in a developed economy with a 30% tax rate, and half of its profits in a tax haven with a 0% tax rate, has an overall tax rate of 15%. Under the proposed rules this would increase to 22.5%: half remains taxed at 30% and half at the new 15% minimum rate. It is worth noting that the average expected tax rate for the S&P 500 is 21%. This is very close to the corporate tax rates in the major economies: current tax rates in the UK, US and Japan are 19%, 21% and 23% respectively, suggesting that, on average, companies are paying their fair share of tax. The OECD (Organization for Economic Co-operation and Development) has estimated that a global minimum tax rate could increase global corporate tax revenues by 2 to 3%. This also equates to a reduction in earnings of less than 1%.
Changes to Where Companies Pay Tax
The 15% minimum tax rate is referred to as Pillar 2 of the agreement and aims to change how much tax is paid. Pillar 1 of the agreement aims to change where tax is paid, based on where the company operates rather than where profits are recognized. This is to address online business models which sell products or services in higher-tax-rate countries but hardly pay any tax in those countries because they are able to move profits into lower-tax jurisdictions.
“It’s complicated and this is a first step,” said Rishi Sunak, UK Chancellor of the Exchequer. Perhaps this is an understatement: tax is notoriously complex, even at a national level, and coordinating change internationally is even more of a challenge. How do you define and allocate taxable profits between different nation states for a company which develops, manufactures, sells, services and finances in different countries? There are a lot of difficult, detailed questions to be addressed, such as how to define a ‘large’ company, should the minimum tax be applied at a group or entity level, and how do the new rules interrelate to the existing rules?
History shows that bold proposals are often watered down as key sectors in each county lobby for exclusions. In addition, tax havens and companies will not stand still. The countries with the most to lose, such as Ireland and Singapore, are likely to respond by attracting international companies in other ways. Companies will continue to be advised by their tax advisors to restructure advantageously.
Tax Analysis Can Lead to Operational Insights and Informs Our Broader View on Governance
While the overall impact of a global minimum tax may be immaterial in aggregate, there will be individual cases where the impact is material. We need to consider the tax angle on a company-by-company basis.
Tax is often one of the biggest expenses for a company, yet in our opinion the market does not pay it sufficient attention. This is partly because some analysts consider tax boring and would rather discuss the products and services of the business, and partly because tax is so difficult to understand. Albert Einstein once said that “the hardest thing in the world to understand is the income tax”.
For each company we review, we look at publicly available information and start by asking some fundamental questions: Does the effective tax rate (tax expense divided by profit before tax) make sense given what we know about the geographic mix of the business? How does the cash paid on taxes compare to the tax expense? If there is a big difference, what are the reasons? Are there material tax losses and, if so, what is their economic value?
The information disclosed in company accounts is very limited. For example, taxable profits, which in many cases are very different from accounting profits, are not disclosed, and even accounting profits are not analyzed on a country-by-country basis. The disclosure problem is well recognized by the IASB (International Accounting Standards Board). In its recent Third Agenda Consultation (March 2021), it included a potential project on income taxes, including a suggestion that companies disclose more about their tax structures so that investors can improve their understanding of the tax risks.
Our tax review often leads to insights into a business’s operations. For example, one company we reviewed had a very low tax rate for many years and it transpired that this was owing to a large facility in Puerto Rico. The company benefited not only from a low tax rate but also from low labor costs.
Our tax review also helps inform views on governance more generally. If we get the sense that management is aggressive in its tax structures, it is more likely that it is also aggressive in other areas of its business, such as financing structures and accounting judgements.
In conclusion, the impact of a global minimum tax at 15% is likely to be immaterial in aggregate, but there will be specific cases where the impact is material. We need to consider the prospect of a global minimum tax alongside other proposed increases to tax rates, in particular in the UK and US, when we assess the risk and reward of each investment.
Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice.
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