Malawi lost USD 4,691 million between 2001 and 2010 due to illicit financial flows and if policy recommendations are not taken on board, the country could lose even more in the next decade. Currently, Malawi ranks 75th out of 143 countries for largest average illicit financial flow estimates for 2001 to 2010.
The term, “illicit financial flows” refers “to the cross-border movement of money that is illegally earned, transferred, or utilized”, and on average 80% of illicity flows are a result of trade mispricing.
According to Global Financial Integrity’s December 2012 report on illicit flows, USD 5.86 trillion left developing countries in the previous decade. In practice, this means that for every USD 1 developing countries receive in official development assistance, usually from nations that are home to the head quarters of companies engaged in nerfarious financial practices, they lose USD 10 through illicit outflows. Sadly, Sub-Saharan African has witnessed a 23.8% increase in outflows, driven primarily by trade mispricing.
Companies and individuals are able to avoid paying taxes by shifting large sums of money from one jurisdiction to another. Transfer pricing is used by multinationals; goods are sold between two subsidiaries of the same parent company. This is a legitimate practice as long as the transfer price, or an “arms-length price”, used between the subsidiaries is a fair market price, i.e. the same as if the two companies involved in the transaction were two independents and not part of the same corporate structure.
However, some companies may wish to artificially distort the prices to minimise overall taxes paid and record as much profit in an area with low or no taxes. This phenomenon – trade mispricing – explains a significant proportion of illicit financial flows.
For example, take a company called World Inc., which produces a type of food in Africa, then processes it and sells the finished product in the United States. World Inc. does this via three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a tax haven, with zero taxes) and America Inc. (in the United States).
Now Africa Inc. sells the produce to Haven Inc. at an artificially low price, resulting in Africa Inc. having artificially low profits – and consequently an artificially low tax bill in Africa. Then Haven Inc. sells the product to America Inc. at a very high price – almost as high as the final retail price at which America Inc. sells the processed product. As a result, America Inc. also has artificially low profitability, and an artificially low tax bill in America. By contrast, however, Haven Inc. has bought at a very low price, and sold at a very high price, artificially creating very high profits. However, it is located in a tax haven – so it pays no taxes on those profits.
What has happened here? This has not resulted in more efficient or cost-effective production, transport, distribution or retail processes in the real world. The end result is, instead, that World Inc. has shifted its profits artificially out of both Africa and the United States, and into a tax haven. As a result, tax dollars have been shifted artificially away from both African and U.S. tax authorities, and have been converted into higher profits for the multinational.
This is a core issue of tax justice – and unlike many issues which are considered to be either “developing country” issues or “developed country” issues – in this case the citizens of both rich and poor nations alike share a common set of concerns. Even so, developing countries are the most vulnerable to transfer mispricing by multinational corporations.
Given that 60% of world trade now takes place within multinationals, the potential for countries to lose important tax revenue is increasing and it is becoming evermore difficult to track. In fact, a Christian Aid study, “False Profits: Robbing the Poor to Keep the Rich Tax-Free“, (March 2009) suggests that USD1.1 trillion in bilateral trade mispricing flowed into the European Union (EU) and the United States of America alone from non-EU countries between 2005 and 2007.
South Africa hosted the Alternative Mining Indaba this week, held to coincide with the Investing in African Mining Indaba. At the Alternative Mining Indaba, Alvin Mosioma of the Tax Justice Network Africa told the participants that the top 10 global mining companies have an estimated 6 000 subsidiaries. As a result, he explained that
It is impossible for any government to know how much profit is generated from its mineral wealth.
How is it possible that you have 3 000 employees in Malawi and three in the Cayman Islands and you can attribute 70 percent of your profit to the operation in the Cayman Islands?
[There is] very limited capacity within governments to negotiate good mining contracts especially with multinational companies. In most cases, the multinational companies have skilled personnel and negotiators while governments do not. Mining companies may bring consultants, bankers, economists and lawyers to the negotiating table and often outnumber government […] teams.
Access to this many resources, knowledge and expertise too often means that contracts ultimately benefit the mining companies and the government will always get the short end of the stick.
Malawi faces a challenge in ensuring illicit financial flows do not grow in the next few years with the increasing number of mining companies granted rights to explore and extract resources within the nation’s borders.
Global Financial Integrity, through the Task Force on Financial Integrity and Economic Development, has made recommendations on how to reduce illicit financial flows.
- Tackle trade mispricing: Require that the parties conducting a sale of goods or services in a cross-border transaction sign a statement in the commercial invoice certifying that no trade mispricing in an attempt to avoid duties or taxes has taken place and that the transaction is priced using the Organization for Economic Co-Operation and Development (OECD) arms-length principle.
- Start country-by-country reporting: Require that all multi-national corporations report sales, profits, and taxes paid in all jurisdictions in their audited annual reports and tax returns.
- Publish beneficial ownership: Require that the beneficial ownership, control and accounts of companies, trusts and foundations be readily available on public record to facilitate effective due diligence; and explicitly require, and enforce, that financial institutions identify the ultimate beneficial owners or controllers of any company, trust or foundation seeking to open an account.
- Introduce automatic tax information exchange: Require governments to collect from financial institutions data on income, gains, and property paid to non-resident individuals, corporations, and trusts. Mandate that data collected automatically be provided to the governments where the non-resident entity is located.
- Enforce strict penalties for money laundering: Require that predicate offenses for a money laundering charge are harmonized at the most restrictive level and codified.
An international consensus at the highest business and political levels is necessary if these are to be enacted and enforced.
For further information on illicit financial flows and their impact on development, watch the video embedded below of a talk given by Raymond Baker, Director of Global Financial Integrity and the author of Capitalism’s Achilles Heel: Dirty Money and How to Renew the Free-Market System. He discusses the problems of illicit financial flows and the linkages between corruption, money laundering, and poverty and ways to curtail the problem for the benefit of enhanced global development and security.
(October 1 2010, Bergen Resource Centre for International Development, Norway.)