Article by Kevin Tutani
Illicit financial flows (IFFs) refer to the cross-border movement of money which is either illegal or has harmful consequences for the economy from which it is withdrawn. The main perpetrators behind IFFs are; multinational firms, ultra-wealthy individuals within the economy, criminals and also corrupt politicians.
Illicit financial flows are commonly facilitated through mechanisms such as; trade mis-invoicing (also known as trade mis-pricing), and capital flight.
Multinational corporations (MNCs) are companies which are registered in 2 or more countries. Typically, MNCs are motivated to engage in illicit financial flows because of their desire to evade the payment of taxes (tax evasion). It is also critical to emphasize that, not all multinational corporations are involved in illicit financial flows.
Tax evasion can be facilitated through IFFs, when multinational corporations hide their income through one or more of their foreign subsidiaries or affiliate firms. It is an illegal practice.
As an example, a greatly profitable Zimbabwean company can decide to import raw materials from one of its foreign subsidiaries in Dubai at a hugely inflated price. The inflated price (mis-pricing) would be used in order to reduce the portion of the multinational company’s profits which are taxable in Zimbabwe.
This is known as transfer mispricing or mis-invoicing. The result would be that the Zimbabwean based company will eventually report having made much lower profit than it could have made, if it had purchased its imports at normal market prices.
The lower profit means that the Zimbabwean government will only tax a relatively small portion of the Zimbabwean based company’s income. If the Zimbabwean company reports making only US$1 000 in profit, the government will only be able to benefit from 25% of the US$1 000 (or US$250), in line with Zimbabwe’s corporate income tax rates. On the other hand, the Dubai based subsidiary of this multinational company, will report much higher profits. These huge profits reported in Dubai would obviously be a result of the arrangement to overprice products that were supplied to the Zimbabwean subsidiary. In Dubai, corporate income tax used to be 0%. It was only introduced in 2023, and is now 9%. This is much lower than Zimbabwe’s corporate income tax rate of 25%. So, by inflating profits which accrue to the Dubai based subsidiary, the multinational company would have evaded paying some taxes which were supposed to be paid in Zimbabwe. At a group level (considering all subsidiaries), the MNC would have maximised its profits.
Examples of low-tax jurisdictions which are notorious for receiving illicit financial flows include; Bermuda, Switzerland, Singapore, Ireland, Mauritius, Hong Kong, Cayman Islands, British Virgin Islands, Netherlands and Dubai. It is also critical to state that several companies and people behind IFFs, usually use the aforementioned countries (low-tax jurisdictions) as intermediary destinations. When they have achieved their goals of moving their funds illegally and evading taxes, perpetrators behind IFFs typically use the USA, UK, Europe and other advanced economies as the permanent destination for their funds.
By manipulating how they report profits, as explained above, multinational companies can successfully (and deceitfully) limit the amount of corporate income tax which they should pay. Unfortunately, the country from which the profits would have been under-declared, such as Zimbabwe, would be the one in which the MNCs would have generated much of their unadulterated revenues. The negatively affected country is left with a narrow tax base and very limited government funding. Overall, this works to keep the affected economy poorer, through various undesirable effects.
In many cases, errant multinational companies even use shell companies in order to manipulate profits in different tax jurisdictions.
A shell company is a corporation which is simply registered on paper, whilst it has no physical presence or operations at any location.
Low-tax jurisdictions, which are also known as tax havens, are usually preferred by perpetrators, if they offer the added feature of secrecy in their banking laws. So, most of these tax havens are also called secrecy jurisdictions. This is because the laws within the tax havens usually prohibit their banks from divulging banking details and transaction history of any individuals or corporations which deposit their funds within them. It can be a complex process and in several instances impossible, for investigators from a foreign country to get banking details pertaining to bank accounts and other financial investments which are located within tax havens. So companies and individuals behind IFFs have an assurance that their misdemeanours can be hidden, through the financial secrecy which is rife in tax havens.
Intra-company cross-border loans can also be used by MNCs to manipulate the profits which they will eventually report in different countries. A shell company in Dubai (a low tax jurisdiction) affiliated to a Zimbabwean company, may issue a “loan” to the Zimbabwean subsidiary, with exorbitant repayment and interest charges. This arrangement works to drain profits from the Zimbabwean company, whilst benefiting its affiliate company in Dubai, where profits are subject to much lower corporate income taxes.
The result is that, at a group level, the MNC will manage to make much larger profits, than it would have made, if it had not manipulated costs and revenues at the Zimbabwean and Dubai branches.
Errant MNCs can also “transfer” intellectual property (IP) such as the right to use a brand name, or certain technologies, from a low-tax jurisdiction, to a high tax jurisdiction and then charge exorbitant fees for the IP. For example, a Dubai (low tax jurisdiction) based affiliate company can be given the mandate by the MNC group’s senior management, to distribute and sell IP rights to the corporation’s other subsidiaries in high-tax jurisdictions. The exorbitant IP fees will then be used to drain profits from high tax jurisdictions such as Zimbabwe, whilst increasing profits for the subsidiary in the low-tax jurisdiction.
Dishonest MNCs and ultra-wealthy individuals are also notorious for facilitating another type of illicit financial flows, known as capital flight. Illegal capital flight involves the movement of funds to another country by a company or individual, without informing the regulatory authorities such as the central bank, which is responsible for overseeing and managing the home country’s cross-border financial transactions. It (capital flight) can occur when individuals or companies smuggle cash outside of the country or falsify online payments to another entity located beyond the country’s borders (whilst the money is destined to a foreign bank account which they control). Capital flight can also be facilitated through the purchase of liquid financial assets such as bitcoin- the buyer of the bitcoin (cryptocurrency) can go on to sell it online and use the proceeds to replenish a foreign-based bank account.
For most countries, when citizens or companies decide to set up investments in a foreign country, using money which was generated within the home country, they should notify financial regulators such as their central bank. This enables the home country government to tax them accordingly on the income which they would earn overseas. However, if the home country is facing economic and financial difficulties, most citizens and businesses will not notify authorities when they move funds from home country, to a foreign destination. One of the main reasons for this could be in order to avoid foreign exchange controls, which are rampant in struggling economies. Other motivations for capital flight could simply be the concealment of funds which were earned through corrupt or criminal activities, etc.
Some experts estimate that global MNCs shifted as much as 40% of their profits to tax havens, in 2015. With regards to neighbouring South Africa, some estimates report that the country losses around US$6 billion each year, due to illicit financial flows. The Tax Justice Network estimates that developing countries are worst affected by tax havens. A 2015 study of 39 African countries concluded that US$1.3 trillion was siphoned to tax havens and other jurisdictions through illicit financial flows, between 1970- 2010. Another study found that funds lost to capital flight among 33 sub-Saharan African countries exceeded foreign direct investment (FDI) inflows by US$150 billion between 1970- 2010. These illicit outflows are one of the major reasons why the currencies of African countries continue to depreciate through time.
As can be seen from details provided above, illicit financial flows are usually motivated by- tax evasion, the need to launder the proceeds of crime, crooked repatriation of capital by investors (where an economy’s foreign exchange controls hinder repatriation- this remains crudely illegal though) and the need to hide political influence or corruption on the part of politicians. A major challenge in detecting and measuring these financial flows is that data on intra-company cross-border transactions is not easily available to the public. Also, proving that the transactions were driven by the need to facilitate IFFs can be difficult in some cases. Next week’s column will dwell on real-life case studies of illicit financial flows.
Kevin Tutani is a political economy analyst, he can be contacted at [email protected]
