What is the SFDR and what does it have to do with tax?

A long-standing challenge for funds marketing themselves as promoting or exhibiting ESG criteria is that there is little common consensus on what ESG actually means. The SFDR aims to alleviate some of these concerns and establish clearer parameters around what sustainable investment looks like in practice. However, while the SFDR provides some welcome commonality in the form of comparable disclosure requirements, it is far from comprehensive on other aspects – including tax. This leaves fund managers in the unenviable position of knowing that tax is something they need to get right when it comes to positioning a fund as Article 8 or Article 9 for SFDR purposes but with no clear path as to how to do so.

The SFDR requires that Article 8 fund investments must follow good governance practices, while Article 9 funds are required to make “sustainable investments”, which by definition must follow good governance practices. The SFDR concept of “good governance” is derived from the SFDR definition of “sustainable investment”, and includes, among other things, reference to “tax compliance”. What does that mean in the context of “good governance”?

What “good tax governance” means is not elaborated on. However, while there is no concrete guidance or set of rules as to how to approach this question in the specific context of SFDR, there is an increasing volume of guidance and precedent to draw on to show that a responsible review of tax governance has been taken seriously. This may not provide a panacea for fund managers in this context, but it is at least a starting point.

So, what is “good” tax governance?

As so often in tax, the answer is to some extent “it depends”. We have been seeing the emergence of various sources of guidance and standards for good tax governance, from voluntary standards like the Global Reporting Initiative, to an enhanced focus on “systems and delivery” in HMRC’s large business risk reviews. While there are common themes between these, there is a clear sense that the metric shifts depending on who it is measuring.

This is not tax relativism, but a pragmatic acknowledgement that not all businesses face the same tax risks, and an organisation’s size and business model may render certain tax governance KPIs defunct. Proportionality remains an important consideration in what “good” looks like. For instance, there is not much point asking nuanced questions about an organisation’s tax department if it is too small to justify having one, or if that function is outsourced. The crux is understanding what is appropriate for the taxpayer in question. 

That is not very helpful for those tasked with diligencing whether a given standard is met. In the absence of clearer EU guidance for SFDR purposes, a pragmatic response seems to be to focus on the emerging common strands of good tax governance, which include:

• commitment to acting in accordance with applicable tax laws and maintaining a constructive dialogue with the tax authorities;
• documenting and regularly reviewing tax policy and strategy;
• top-down commitment to including tax as a board and strategic matter;
• the ability to identify and communicate the main tax risks facing the business;
• a tax control framework, including a tax risk register and good data management; and
• identified responsibilities and clear escalation procedures.

Next: how to diligence this?

Understanding the tax practices and governance arrangements of any organisation is rarely a checkbox exercise and – as consensus increases on what good tax governance means in practice – may require more of a dialogue (perhaps with a wider range of people) than typical due diligence processes have previously involved.

It is sensible to start by approaching the task with a structured list of tax governance questions as prompts for discussion and to communicate clearly to a potential investee company what you need to understand. Fund managers may wish to review their existing diligence and engagement practices and work out where tax governance would most naturally fit (to the extent it is not already an explicit diligence focus). Managers often take an initially standardised approach and require portfolio entities to complete due diligence questionnaires in respect of their tax compliance and risk management arrangements.

There is value to this diligence beyond ESG compliance and supporting a particular SFDR fund categorisation: the process can unearth unattractive tax “skeletons in the closet” that may not be picked up by traditional tax diligence, and may also therefore provide an opportunity to price chip. 

To facilitate this process, we have been developing a range of solutions for our clients to navigate the nebulous and complex world of diligencing tax as an ESG matter in the investment space, and we have a range of tools and products available to fast-track what can be a daunting and time-consuming task into a manageable exercise. This includes a self-assessment tool for investee companies to apply to their tax governance arrangements.

Conclusion

The lack of granularity on what good tax governance means in the SFDR is perhaps not surprising. It is fair to say that taxpayer behaviour is not a central focus of the SFDR, with the word “tax” appearing only once in the entire regulation. However, the fact that it appears at all – and as a necessary part of the central concept of “good governance”, itself a core requirement of “sustainable investment” – underscores the fact that tax is an embedded part of the ESG landscape and fund managers must therefore get to grips with how to demonstrate that their investee companies practise good tax governance.