Boring but important. Investors may see tax as source of hidden shareholder value or a giant black box of unknown risk. Either way, they are taking note. July/August 2007 issue

Tax is widely regarded as one of the most complex areas of a business and not one that is well understood by investors.

As Albert Einstein once said (on filing tax returns): “This is too difficult for a mathematician. It takes a philosopher.”

Until recently, tax has not been one of the plethora of subjects which senior board members are expected to know about.

However with increasing regulation and scrutiny from a whole host of external stakeholders, boards and investors have turned their attention to the impact that tax and the way it is managed can have on their business.

In a recent global survey conducted by KPMG, nearly half (45% percent) said that shareholders now expect to receive more information on their company’s tax policy than they have in the past.

Given the competitive environment investors operate in to deliver high performance returns, every company within a portfolio must perform and surprises around tax are not welcome, given their already challenging task of stock selection.

Nor do they have time to understand complex tax issues.

Therein lies the challenge for boards and IR professionals; how to enable investors and analysts to make sense of the opportunities and risks that tax presents.

In our view, this is a challenge worth taking up. Companies that choose to embrace this, by being confident about communicating their tax policies can ensure value is not unwittingly destroyed by a tax surprise.

As understanding grows about differentiation between companies and how they manage tax, so can the potential to recognise the embedded value of superior management of tax.

As ever management need to know stakeholders’ expectations and manage communications accordingly.

Companies need to be able to communicate and demonstrate to all stakeholders, not just shareholders; a competitive, consistent and compliant approach to tax – i.e. tax is managed with a range of stakeholders in mind.

Compliance for example means compliance with the company’s goals and values and not simply agreeing with the views of tax authorities on how much tax they would like to collect.

Arguably it can be seen as another indicator of good corporate governance; with a worldwide trend of a move from taxes on corporate profits to taxes on corporate transactions (e.g. VAT, transfer pricing) which needs to be embedded in financial systems, a well run tax function can signal a well run company.

The starting point for any communications plan is to know your inquisitor; investors, and analysts needs and concerns are becoming clearer.

Typically these days, they want to know how much tax you expect to pay in future; why actual taxes are different from expected taxes; what your strategy is; and whether or not the company is subject to any tax authority enquiries and if so, the current status of those enquiries.

In September 2005, Kenneth Lee of Citigroup said: “Despite being one of the most commonplace and material costs any business incurs, taxation is often viewed by the market as beyond meaningful analysis.

"However, recent changes in both the attitude of governments to and regulation of, tax planning suggest that significant changes are afoot. Therefore we view tax as a key risk facing companies that is worthy of significant analysis.”

And in May this year, David Zion of Credit Suisse commented: “Corporate taxes are a giant black box for investors … if investors learn that a company bears more risk than was known before, that could have an impact on their estimates of future cash flows and the return that investors would demand (i.e. increased tax risk should increase cost of capital), which could affect valuations”.

Each company needs to decide what transparency means for them. Its meaning can vary depending on the board’s attitudes to disclosure, communications in general and relevant regulatory requirements.

It may be helpful to think about what reputation the company wishes to uphold, as all organisations must have consideration for the different needs of multiple stakeholders: tax authorities, government, non governmental organisations, customers, suppliers, and investors.

Good tax governance is about the choices management makes and the balance it strikes between the perspectives of its various stakeholders.

Communicating the tax policy in the Annual Report is one way of dealing with increasing scrutiny.

Although it’s a historical report, it contains vital information for external stakeholders seeking information on the company. However, for it to have value, it must have substance and meet the needs of all stakeholders. Unsupported blanket statements can come back to bite you later.

In reviewing their tax policies and processes companies have found this external perspective helps to affirm the purpose and benefit of their investments in tax.

The expectations of external stakeholders and determining what you can communicate will help identify any gap between stakeholder expectations and internal assumptions.

With external stakeholders becoming ever more vocal in their demands for greater transparency and a more ethical approach to tax governance, your company’s reputation has never been under more scrutiny.

Clear credible communication is at the heart of good tax governance and time thinking about how information is communicated externally will be time well spent.

Loughlin Hickey, global head of tax, KPMG, and Patrice Day of KPMG’s tax governance team can be contacted at +44 (0)20 7694 4004 or patrice.day@kpmg.co.uk.