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Tax-exempt but tax conscious

Even though pension funds and other tax-exempt institutional asset pools don't pay taxes on their investment income, the taxes paid by the companies in their investment portfolios should concern institutional investors.

The taxes companies pay, especially corporate income taxes, affect corporate earnings and ultimately investment returns to investors.

The U.S. has the highest effective tax rate in the industrialized world, according to KPMG International Cooperative and the Tax Foundation, a tax-policy research organization.

KPMG puts the effective U.S. tax rate at 40%, consisting of a 35% federal rate and combined state and local rates estimated as high as 12%.

Corporations don't pay taxes, they collect taxes. They allow Congress to hide the true level of taxes. The income taxes companies pay come from a combination of reductions in net earnings, meaning less money for dividend payments and investment for research and development or business expansion, as well as increases in the prices customers pay, and sometimes lower wages for employees.

Each of these sources of corporate income tax revenue makes companies less competitive than other companies that have lower income tax burdens, largely foreign ones. For example, reduced investment in research harms future earnings.

As a result, companies compete not only on their goods and services but also, increasingly, on tax strategies. Institutional investors ought to consider the impact of corporate income taxes on investment performance.

Goldman Sachs Investment Partners and three hedge funds — JANA Partners LLC, Corvex Management LP and Och-Ziff Capital Management Group LLC — have pressed executives of Walgreen Co. to consider moving the company's incorporation outside the U.S. to cut the income tax burden, suggesting the change as part of the company's acquisition of the rest of Alliance Boots GmbH, based in Switzerland.

Walgreen paid corporate income taxes at a 37.5% rate compared to an Alliance Boots rate of about 20%. Walgreen owns 45% of AB and plans to acquire the other 55% next year.

Other U.S. multinational companies are changing or considering a change to their jurisdiction of incorporation, moving them outside the U.S. Still other companies employ aggressive strategies in accounting for revenue and income earned around the world to lessen their tax liabilities.

As fiduciaries, pension fund executives and trustees should examine the risks to their portfolios from these tax issues. The issues are difficult.

Should they join with other investors, like the group pressuring Walgreen, to call for companies in their portfolios in high-tax domiciles to move to lower tax jurisdictions?

Or should they join a small but growing chorus of shareholder activists and others calling for companies to pay their “fair share” of taxes? What is a fair share?

Domini Social Investments has co-sponsored a proposal at Google Inc. for its May 14 annual meeting, asking the company to adopt ethical principles addressing the impact of its tax strategy on society, said Subodh Mishra, vice president, Institutional Shareholder Services Inc., in an e-mailed response to an inquiry. Domini sought to introduce a similar proposal at Apple Inc. at its Feb. 28 annual meeting but was prevented from doing so for technical reasons, Mr. Mishra said.

Tax fairness, along with tax transparency, is an emerging issue to which fiduciaries need to devote attention. The issue could affect corporations' bottom lines, affecting investors' performance.

Tax issues are complex. But a pension fund fiduciary's responsibility is clear: to invest the fund's assets to achieve the best long-term outcome based on its risk and return profile and funding objectives.

Just as pension funds have allocated assets around the world to improve risk and return profiles as investing has become more global, corporations are moving or considering moving their domiciles, or stepping up alternative tax strategies to steer revenue and income away from higher tax jurisdictions. In this, corporate directors and executives are meeting their fiduciary duty to enhance corporate performance for shareholders.

Horizon Pharma Inc. plans to move its headquarters to Ireland as part of a merger with Vidara Therapeutics International Ltd. Other pharmaceutical companies see high U.S. corporate tax rates as putting them at risk of being at a competitive disadvantage in the global marketplace.

Aon Corp. moved its incorporation to the U.K. to bolster its competitive position. Analysts estimated the move would cut Aon's tax rate. Willis Group Holdings PLC, a top competitor, is incorporated in Ireland, which has a lower tax rate than the U.S.

Some of the largest holdings in investment portfolios — including Apple and Google — have been called to question by activists and policymakers about their strategies to defer or lessen taxation by steering income into jurisdictions with lower tax than the markets where they generate revenue or are domiciled.

Caterpillar Inc. was the most recent U.S. multinational corporation to come under fire by Congress for its tax practices. At an April 1 hearing, the U.S. Senate's Permanent Subcommittee on Investigations slammed the company's strategy of moving profits to Switzerland purportedly to avoid paying $2.4 billion in U.S. taxes.

Microsoft Corp., Hewlett-Packard Co. as well as Apple and other U.S. companies have been targets of the subcommittee's hearings.

Calls for greater tax transparency will put more pressure on companies that use alternative tax approaches, making them more vulnerable to pressure for change and calling into question the sustainability of such strategies and the investment returns arising from them. As the issue emerges, public pension funds might feel vulnerable to reputational risks for their exposure to companies using alternative tax strategies.

Moves by multinational corporations to other jurisdictions, while lowering taxation, could adversely affect institutional investors in other ways. Such moves could weaken corporate governance, providing for fewer shareholder rights. Or they could undermine the ability of shareholders to seek redress through securities litigation, including class-action lawsuits over improper corporate conduct and activities.

A few years ago, some pension fund executives called on Tyco International Ltd. to reincorporate in Delaware from Bermuda, criticizing loss of U.S. taxation and lower corporate governance standards. Was that really in the best interest of the funds and their beneficiaries?

Aside from their general tax-exempt status, pension funds themselves benefit from the use of alternative mangers, including private equity managers, which have a tax-advantage — lower tax rates than other investment management organizations — and presumably pass on part of that savings to clients.

It's hard to see how urging U.S. companies in a portfolio to absorb higher costs (i.e. higher income tax liabilities) than their foreign competitors satisfies the fiduciary obligation.

This article originally appeared in the April 28, 2014 print issue as, "Tax-exempt but tax conscious".