Institutional investors are making it increasingly clear that they expect a strong commitment to ESG-factors when assessing real estate fund investments. As the importance of tax within the ESG-imperative grows, investors find themselves in a position where they have to actively review the approach to tax applied by real estate fund managers in light of their own tax policy. This publication highlights certain ESG-related operational tax due diligence considerations for institutional real estate investors, with a specific focus on the governance aspect of ESG.

State of play

The larger institutional investors in Europe have focused on responsible tax in their investment decision-making well before ESG gained the momentum that it has today. This focus on responsible tax is directly correlated to the role these investors – generally pension funds and insurance companies – play within their communities as organizations that people need to trust. Reputational risks and (tax) contributions to society need to be carefully managed. This usually translates into institutional investors developing their own tax policies and testing their investments against certain tax principles that align with their approach to tax and tax risk appetite. In this regard, publication of tax policies by institutional investors is on the rise to support their goals of responsible tax behavior in their investments and through their investment partners.

When assessing real estate fund investments from an ESG-tax perspective, institutional investors predominantly focus on the material application of their tax principles. Simplistically put, this comes down to testing whether certain tax principles are met by the fund and fund manager, which in a majority of the cases boils down to reviewing whether:

• a fund (manager) is compliant from a tax filing and ‘spirit of the law’ perspective (‘compliance’-principle), 
• there are (sufficient) non-tax reasons for the existence of entities and instruments within a fund structure (‘business rationale’-principle), 
• relationships with tax authorities are properly managed including disclosure of (uncertain) tax positions (‘relationships with tax authorities’-principle), 
• tax incentives are claimed in a responsible manner (‘seeking and accepting tax incentives’-principle) and 
• how the fund manager deals with tax transparency towards stakeholders (‘transparency’-principle). 

The way tax principles are tested in practice differs per investor. It can range from high-level to detailed and is often supplemented by checklists covering specific tax items that need to be confirmed by the fund manager (or tax adviser performing the fund tax due diligence). Such checklists are usually part of internal procedures necessary to sign-off on the investment from an ESG-tax and general tax perspective. Testing tax principles in this manner focuses predominantly on the social aspect of tax within ESG. It namely tests how a real estate fund manager views its role and contribution to society from a tax perspective, with tax being a critical factor for the execution of governmental policy and spending.

Operational tax due diligence

As the importance of tax within the ESG-imperative grows, this inherently leads to an increased focus on the governance aspect. 

The above manner of assessing tax principles when reviewing a real estate fund investment is in essence a comparison of tax principles between those of the investor and those of the fund manager. If there is sufficient overlap and the necessary confirmations can be provided (e.g., compliance and tax payments are in order), then there is no reason for the investment not to go through from the social perspective of ESG. However, the social aspect says very little about the quality of the actual application of tax principles by the fund manager. To give a tax policy – generally consisting of a tax strategy and tax principles – substance in practice, the governance aspect becomes essential. Assessing tax governance can be challenging, but there is a lot of insight and value to be gained by also understanding how tax (risk) is managed from an operational perspective:

1. Good corporate governance: When tax is considered a core part of corporate responsibility, it is important to understand how a fund manager’s tax policy is de facto governed within its organization. To ensure a tax policy has authority and recognition, it is a best practice that tax governance in general is overseen by the board of directors and that the board is accountable for the execution of the tax policy. To assess the quality of tax governance, examples of items to review are whether the fund manager’s tax policy has been approved by the board, what the scope of the tax policy is (e.g., taxes, business units and jurisdictions covered), whether the responsibility for execution of the tax policy has been clearly delegated to key individuals, whether and how the board reviews the effectiveness of the tax policy, whether the board has approved the tax risk management and control frameworks to support the execution of the tax policy, and what key mechanisms are in place to ensure adherence to and awareness of the tax policy within the fund manager’s organization.
2. Tax function and being in control: Looking at the execution of a tax policy, it is evident that a fund manager’s tax function plays a critical role. Even though the board may be accountable, the tax function will in practice be responsible for being in control of tax. To assess the quality of a tax function, examples of items to review are whether there are clear roles and responsibilities assigned to the tax function, what the scope of these responsibilities looks like (e.g., discretion to delegate certain responsibilities to other departments, business units or external parties), whether the tax function has sufficient and appropriately qualified and trained tax professionals (e.g., compliance versus transaction specialists), and whether the measures to support and guide the tax function with being in control of tax are available and documented (e.g., tax risk management policies and control frameworks).
3. Tax risk and control measures: Tax risk and control measures can range from limited to detailed. This usually depends on the complexity and size of the fund(s) and fund manager. A full review of such measures can easily become a lengthy exercise, which leads to the question where the due diligence responsibility of an investor ends for ESG-tax purposes. When wanting to conduct such review efficiently, the most important items to focus on are the key tax risks identified by the fund manager, the key control objectives and control measures implemented to manage these risks, and understanding the mechanics utilized within the control measures (e.g., mandatory sign-offs, ‘four eyes’-principle, frequent internal meetings or trainings, integration of tax risk management into the broader internal risk reporting and business processes, reviews by external advisers and so on).

Performing an operational tax due diligence on real estate fund investments that covers these items is ultimately a decision that needs to fit an investor’s approach to tax and tax risk appetite. The size of the institutional investor, the size of the contemplated investment and size of the fund, the level and depth of operational tax due diligence, the reputation of a fund manager, complexity of a fund structure and number of (property) jurisdictions are all examples of items that can be considered when making such decision.

When considering tax essential to ESG, adding operational tax due diligence to your tax fund reviews can help you better assess the quality of a fund manager’s tax policy and tax affairs.

How can A&M help?

A&M has extensive experience in performing tax fund due diligence on behalf of institutional real estate investors. If you want more information on the various approaches A&M has to tax fund reviews, please feel free to get in touch with your usual A&M adviser, Roel de Vries or Nick Crama.