Finding a solution to put an end to illicit financial flows

by Erwan Malary

Swiss Leaks, Panama Papers, Offshore Leaks, LuxLeaks, Paradise Papers … the list of financial scandals we have witnessed in the last few years seems to be never-ending.

In each instance, financial documents were made available for journalists and investigators to expose tax evasion cases and their beneficiaries. Each time, courageous whistle-blowers decided to expose themselves, their career and their families to uncover the truth. Each time, politicians claimed by any possible means that they would work to end tax evasion once and for all.

But in each instance, the public outcry was strong, with documents proving the lack of political will deployed to stop illicit financial flows. Each time, people could acknowledge the impunity of the offenders. Each time, the beneficiaries were the same, wealthy individuals and multinational companies, both considering themselves too privileged to declare fairly their assets and revenues and pay taxes accordingly. And sadly, each time, we thought it would be the last.

But will this ever end? Has anything changed? How many scandals will we need to witness to finally see the end of those practices that are slowly undermining our democracies?

Illicit financial flows today: a stark situation

Let’s first try to understand why this is a key subject to all of us, rich and poor. Most of the time, tax losses are considered as the main problem. And indeed, it’s a major problem for states funding all over the world. African countries are for instance losing yearly $50-billion, making underdevelopment endemic and depriving states of key resources. In the “developed” economies, taxable bases are suffering huge losses. European Union member states are for example losing together $1,000-billion a year, making it harder and harder to fund public services and maintain public infrastructure. Globally, it paves the way for austerity policies, rising inequalities and therefore growing insecurity.

However, another untold problem comes along with those tax losses. By facilitating tax evasion for both the wealthiest (personal income tax and wealth tax) and major multinational companies (income tax on benefits), tax havens participate in what is called wage evasion. It defines the fact that in addition to depriving states of resources, it also deprives local economic actors (companies, employees, etc.) of funds to invest and participate into the economy.

It means that a local subsidiary of a multinational company cannot really retain its best employees by increasing their wage; neither can it invest to improve its production capacities. Why? Because its parent company corners the whole profit, for tax purposes, but not only that: non-funded investments and underpaid workers are the result. The indirect consequence of this wage evasion is cruel: economies are now competing to attract investors. In other words, tax evasion not only means tax losses. It is also a modern form of rent extractivism from local economies by multinational companies. It is at the core of the present fiscal, social and environmental dumping between national economies. Basically, it binds nations to a never-ending race to the bottom, a race no one want to win but everyone has to compete in.

Reforming the international tax system: A need to break down complexity

So the next question is what to do? If this is such a massive problem, why is nothing changing? Two main obstacles exist. The first one is that by definition, the international tax system is… international. Since countries are bound to this race to the bottom, no one wants to act first and lose some of its competitiveness. It means hat without an international consensus nothing is going to change. Second, the international tax system is extremely complex. Together, these obstacles make it extremely hard to change anything. National tax systems are each built on specific architecture offering loopholes to attract foreign investments. It means any international agreement will make losers and benefit others, making the consensus unachievable.

However, public opinion is now pushing for change, and slowly, loopholes are being closed. But this takes time, and as Keynes said, “in the long run we are all dead”. It seems a major change is needed to rethink our international tax system toward less complexity. Why? For two reasons. One, the weakest states and their less capacitated tax authorities can’t deal with actual levels of technicalities. It leaves wide open the door for powerful law and accounting firms to organise companies’ tax planning as they wish. Second, because facilitators of tax evasion are often a step ahead, making the fight against illicit financial flows a game of cat and mouse. Let’s take one example to unfold this before going further.

Let’s consider the problem of trusts. Trusts are companies created for specific purposes, such as inheritance, to make sure people unable to manage their wealth can still benefit from it or make their relative benefit from it. Basically a trustee (a third person) will hold and manage the wealth and assets of the trust, on behalf of the beneficiary. The problem is, by doing so, the identity of the beneficial owner is hidden to most tax authorities since the holder of the trust is legally the trustee. Here comes the trick. Since there is hardly any national registry of trust allowing tax authorities to ask their foreign counterparts to uncover the name of the real beneficial owners, trusts basically allow beneficiaries to hide their money offshore safely and assets in companies located in low-tax jurisdictions.

You could well imagine the South African owner of shares of an SA company hiding its real identity behind a trust abroad, making it nearly impossible for SA tax authorities to know about these assets and the income they provide. Of course, the owners of assets normally use the services of asset managers to help them hide their wealth behind several layers of trusts, foundations and closed corporations, making it nearly impossible for tax authorities to prosecute them.

However, recent efforts to erase this unlawful method of tax evasion led to reform of the international tax system. Slowly, a registry of beneficial ownership is being created by national tax administrations, and agreements between tax authorities are starting to be signed. The results can be astonishing. New Zealand for example implemented in July 2017 a reform of its trust law, forcing foreign trusts to register their beneficial owner. The result? Between two-thirds and three-quarters of the trusts chose to close rather than comply with the new legislation, uncovering the scale of the problem.

When added to the new set of agreements to implement more widely the automatic exchange of information between tax authorities, this kind of reform is very efficient. These progresses are very encouraging since they show that decision-makers can’t ignore any more the pressure advocacy campaigns, civil disobedience movements and scandals put on them.

The problem is that to track illicit financial flows creates new loopholes. Many jurisdictions such as Jersey or Antigua and Barbuda are starting to provide citizenship-through-investments programmes. It means that wealthy people can benefit from a second passport without their origin country knowing.

De facto tax havens providing information to foreign tax authorities will no longer have to provide information on their new “national” citizens, automatic exchanges of information applying only to foreigners (it would be a shame if banks and asset managers forget to ask their clients if they have a second nationality!). Altogether, this shows how hard it is to know who the offenders are and to have enough information to prosecute them. New policy development make it slightly easier, but de facto, the global game of “hide and seek” is not yet about to stop.

What to do then? Will this battle ever end? Is it even winnable? One shouldn’t be pessimistic. Of course, this battle will still take a long time, but slowly things are changing. First, scandal after scandal, the main loopholes are now widely known, and recognised as such by international bodies: lack of co-operation between tax jurisdictions, double tax agreements allowing double non-taxation, lax accounting standards, lack of oversight of the helpers/facilitators (legal or accounting firms), etc.

Public pressure has therefore never been as high as now. Then, as mentioned previously, under this pressure from civil society (but also put under economic constraints with the economic crisis of 2008), many powerful states have started to push for reforms, nationally and internationally. Lists of non co-operative juridictions, even though very loose and politically motivated, are starting to be drawn worldwide, putting pressure on them. Slowly, under the OECD and its base erosion and profit shifting agenda, results are also starting to appear: automatic exchange of information is slowly becoming the rule, double tax agreements should partly be modified through the whole process once it is widely accepted, transfer pricing rules are being modernised, etc. In short, transparency is slowly replacing the entrenched culture of secrecy of the financial world.

From timid reforms to the need for a paradigm shift: Moving away from the arm-length principle

If those reforms are a positive sign that things are finally starting to change, the way to go is still very long since a shift of paradigm will probably need to happen to tackle multinational companies’ wage evasion. So let’s go a little deeper into the analysis to understand what’s at stake.

The first thing to consider is that tax loopholes were first designed to allow colonial powers to keep their rent-extracting industries and companies feeding a financial system they controlled (Watch The Spider’s Web: The Second Bristh Empire by Michael Oswald). Under the banner of free market policies, it basically allowed big multinational companies to benefit from biased competition rules. Whereas local emerging companies have to pay taxes, multinational companies can easily shift their profits from one place to another through what’s called transfer pricing. They indeed have extremely low controls from tax authorities since they follow a lax principle called the arm-length principle. It basically allows companies to choose the price they want when transferring goods or a service from one subsidiary to another. The only safeguards is, it’s fine as far as it would have been priced the same if sold on the market.

But of course, proving the price chosen wasn’t market-related is very hard if not impossible, especially when it comes to trade of services. Since nearly two-thirds of the international trade is made between subsidiaries of the same multinational, it gives the reader an idea of the extent to which a multinational can choose where to locate their profit, and indirectly, where to pay their taxes.

Of course, reforms are under way to provide new weapons to tax authorities when it comes to this transfer pricing issue, to make it easier to prosecute those companies. For example, the notion of permanent establishment (allowing a country to claim tax for economic activity on their territory) has been modernised to take into account e-companies such as the GAFAs (Google, Apple, Facebook and Amazon) who are easily avoiding tax throughout the world.

However, this kind of reform keeps the arm-length principle, which still gives multinationals a huge space to choose where to pay taxes. This is especially true within developing countries since tax authorities don’t often have the human and technical resources to deal with companies whose turnover is higher than their national GDP. We can consider these reforms to have some merits, but more often, they will only marginally level the playing field.

Another approach is to advocate for a unitary tax system, independent from this arm-length principle. This idea would be for states not to depend any more on transfer pricing methods but instead to rely on a system that split the profits globally by calculating the share of it depending on each national country. This way, every country would have a share of profit to tax, granted in accordance with the real economic activity of each multinational. This could take into account how much investment has been made in the country, how many employees work there, what is the amount of the sales made locally, etc. All of these would leave multinationals in a position where they couldn’t manipulate any more their taxable base globally.

“Tax planning” as they like to call it would become nearly impossible. It would for example make it worthless to use subsidiaries in offshore jurisdictions to hold your patents and copyrights/brand rights since very little of their real assets (capitals, markets or employees) are located there. Inoperable system? It is more or less the system used within the USA to split the share of taxes going to the federated states where a company is established in several. The result is quite amazing: for decades, (the recent reform of corporate tax Donald Trump is implementing with the help of the Republican Party is de facto changing this status quo) the absence of tax competition between those federated states has allowed the US to keep its corporate tax at a relatively high level (35%) without hurting businesses and fair competition in the US.

The impossible international consensus v/ The new weapon of transparency

The problem is that implementing such a reform by finding an appropriation formula for every economic sector is difficult. Every economic activity has different things to take into account. One sector might depend hugely on the market they have access to (e-companies) whereas another might depend mostly on its employees (R&D focused companies), while others might depend mostly on their local capital assets (mining with their mining deposit). Each sector will need specific regulations to make it fit with the reality of its economic activity. The problem becomes to find consensus for each of the main industries and economic sectors.

If such a consensus can seem unreachable, an interesting development is starting to take place: reporting country by country, subsidiary by subsidiary. More and more countries are indeed changing their legislation to implement a new set of rules to make transparency the rule rather than the exception. It means that for the first time, people from all over the world are starting to see how multinational companies really managed their tax obligations globally, but also in some cases, what is the reality of the economic activity of companies in each country (number of employee, of customers, etc.). And this is a game changer! It will put in the public space new sets of data that will feed a much needed public debate around the international division of wealth produced by international value chains.

In my opinion, two main developments could come from such a reform of international tax rules towards a fair international distribution of globalised value chains. The first is the opportunity to give back to people and states the means of their economic sovereignty. By re-establishing states’ taxable base, international reforms have the potential to bring back into the hands of people the possibility to choose their own path to development. As says John Christensen, director of the Tax Justice Network, “Tax is the lifeblood of our democracies,” and these reforms will restore our taxable base. The second, as expressed by Thomas Piketty in his book Capital in the Twenty-First Century, is the possibility to reduce inequality massively. Once an international breakdown of value is chosen, it will open up the possibility for a fairer division of the value nationally, and potentially to the decrease of inequalities.

What can South Africa do?

In this context, South Africa’s position is complicated. Representing less than 1% of the world population and around 0.5% of the global GDP, it cannot influence international trade heavily, neither does it have many companies being global players able to influence new regulations. However, being in this in-between position between high and low income economies, it still means it should make its share. It should for example reform publication requirements for companies to make transparency the rule. Reporting country by country, subsidiary by subsidiary is key! It should apply at least to JSE-listed companies and to companies working in strategic economic sectors (mining, defence, basic services, energy, etc.) if not all to all of them.

South Africa could also put pressure on multinationals by imposing on those with a subsidiary in South Africa to have publication requirements internationally at least as strong as those required locally. The message would be simple but powerful: you are welcome to help build up our economy but only if you play fairly. It would leave those highly dependent on transfer pricing methods with the choice either to comply and possibly change their tax practices, or leave South Africa.

Equally, a public registry of trusts and companies disclosing the beneficial ownership of these companies should be created. Last, pressure should be increased on helpers and facilitators of illicit financial flows. It’s not acceptable to see law, consultancy or accounting firms (the so-called big four especially) helping to build tax evasion and wage evasion schemes, doing so with impunity. Professional codes of conduct and legal obligations have to be reformed to make sure they carry the responsibility of their illegitimate behaviors. Why not forbid auditing firms from giving tax advice as a side activity? Why not make it compulsory for auditing and accounting firms to warn public authorities if any wrongdoing is visible?

In the diplomatic field, South Africa should continue its efforts. As one of the leaders of the African Union, it should push developed economies to sign automatic exchange of information agreements with the whole of the African Union, and not only with regional powers such as SA. Equally, South Africa should continue to expose the base erosion and profit shifting process and its shortcomings.

It is not normal to see a club of rich countries, the OECD, driving international reforms that will impact on the most developing economies. As states the campaign for a global tax body, “If you are not at the table, you are on the menu.” The UN tax committee is definitely one of the tribunes to use, and promoting there a major reform of the international tax system is probably wise. If alone, SA will definitely not be able to shift the balance of power, the increasing attractiveness of African countries to international investors could allow them to increase their bargaining power: why not for instance close our borders to unco-operative investors? Attracting foreign investment should never lead us to feed the race to the bottom among ourselves. Let’s keep it co-operative, at least among us.

 

This article originally appeared in the Daily Maverick and is republished with permission from the author.