Bringing the Billions Back
Because of the bank secrecy of tax havens, individuals can hide money in them and evade tax simply by transferring money to a bank account in a tax haven, and not inform their country’s own tax authority about it.
But multinationals, which are large operations with many employees and requirements to report detailed annual accounts on a global level, need to use other methods.
The most common methods are described below:
Multinational groups of companies are often complex structures with hundreds of subsidiaries, a substantial number of which may be located in tax havens where no or very low taxes are paid and secrecy is applied.
Profits are allocated between subsidiaries through internal trading, a complicated process which is hard for tax authorities to police.
It is estimated that 60 percent of international trade is now intra-firm trade between subsidiaries of the same multinational.
Transfer pricing involves determining the sales prices between different entities within a multinational.
In most countries this must be done using the “arm’s length principle”, that is to say, the price must be equivalent to the open market price that would apply between unrelated and independent companies.
Normally, trading parties want to get the best price for themselves. But when two companies trade that belong to the same ownership they do not want the best price for the individual company, but a price that creates the best overall result for the multinational corporation to which they both belong.
The companies may therefore allocate the profit between the two subsidiary companies in such a way that a minimal amount of tax has to be paid.
When a multinational company deliberately manipulates the prices they charge for goods or services to artificially high or low prices to shift profits to low tax jurisdictions, this is called transfer mispricing.<br /> Global Financial Integrity has estimated the volume of capital flight from developing countries as a result of transfer mispricing.
They found that during the year 2006 this amounted to between US$471 billion and US$506b.
International financial reporting standards (IFRS) only require multinational groups of companies to report on a consolidated basis – that means one set of accounts showing the overall financial activities and results for that group, without breaking them down for each country.
This makes it very hard for tax authorities in developing countries to know what profit is made by a multinational company from activities in their country, what tax should be paid, and to uncover evidence of transfer mispricing.
Falsified invoicing could be performed in several ways, all of which have in common that the import or export of goods are not reported truthfully or are even completely falsified.
A company in a developing country that is importing goods could inflate the price it declares that it has to pay to the foreign supplier, so that it can report lower profits and therefore pay less tax.
The reverse can also happen.
A person exporting goods from a developing country could deliberately undervalue what is being sold, at least in official documents, so that profits are once again hidden.
Since it is often based on verbal agreements between buyers and sellers, falsified invoicing is difficult to detect and is widespread.
It is, for example, estimated that 60 percent of trade transactions in Africa are mispriced by an average of more than 11 percent.
Some of the money made from, for example, transfer mispricing, returns to the country of origin through what is called “round tripping”.
This means that a company that has shifted profits from a developing country towards a tax haven reinvests part of the profits in the same developing country.
This time it is being considered as foreign direct investment and thus it can benefit from favourable fiscal conditions like tax holidays offered by the host country.
Round tripping allows not only tax evasion and avoidance, but also takes advantage of the tax exemptions that many developing countries grant to incoming investment.
Similar ways are also used to recycle money coming from criminal activities into the legal economy.
Failing Tax Authorities
Another condition that makes illicit capital flight from developing countries possible is that tax administrations often are poorly-resourced and lacking in staff capacity.
Lack of technology and capacity to collect taxes, as well as the inefficiency and lack of expertise of tax authorities create loopholes that otherwise would have been plugged.
Weak tax administrations and poor tax compliance reduce the tax revenue available to governments, and force them to rely on the taxes that are the easiest to administer, which may not be the most progressive ones.
Rich people benefit most from weak tax administrations. These are the people who can afford to put in place tax avoidance and evasion schemes that require time and resources to investigate.
Some of the reasons for the gap in tax efficiency between rich and poor countries are structural.
In rich countries, more people are earning above the threshold at which they can afford to pay taxes and still finance their basic needs.
Rich countries are also able to raise more tax than poorer ones because a much larger proportion of the economic transactions take place in the formal economy.
However, investments in tax authorities’ capability have shown significant differences in tax revenue income.
Ghana, for example, worked with the German government’s development agency GTZ to improve its tax policy and administration between 2003 and 2005.
This contributed to an increase in corporation tax revenues of 44 percent in real terms.
International development co-operation to improve the capacity of the Rwandan revenue authority helped to increase tax revenue collected from around US$96 million in 1998 to over US$384m in 2006.
• This article has been extracted from a 2001 report titled “Bringing the Billions Back: How Africa and Europe can end illicit capital flight”.